We’ve all seen the headlines about investment bank traders or mutual fund managers leaving their jobs to join or start their own hedge fund. Is it just for the money? Bragging rights? Or a certain cache of saying you’re a hedge fund manager at the local watering hole?
A recent article in All About Alpha explores the other reasons that continue to lure talented traders. Among them, the freedom and flexibility that comes from being higher up in an organization, and not having to kowtow to bosses whose investment philosophy may differ from yours.
However, the article exposes the dark side of traders jumping ship. It cites a new research paper from a group of academics entitled, The good, the bad or the expensive? Which mutual fund managers join hedge funds?
Authors Prachi Deuskar, Joshua M. Pollet, Z. Jay Wang and Lu Zheng found that mutual funds are able to retain their best-performing managers in the face of competition from a growing hedge fund industry by allowing them to manage a hedge fund side-by-side.
However, mutual fund managers with poor past performance are more likely to leave the mutual fund industry. And a small fraction of these poor performers find a job with smaller, relatively unestablished hedge fund companies, especially during the decade of 1997-2007, when the hedge fund industry was expanding very rapidly.
Thus, surging hedge fund industry provided an opportunity for poor performers to end their sagging career in the mutual fund industry by finding jobs with obscure hedge fund companies.
There is some justice, however. The study authors noted that mutual fund managers who fled to hedge funds took in substantially lower assets under management (AUM). This lower AUM meant that making up for the loss of their management fees by earning incentive fees was practically impossible.
The past two years have changed the playing field for everyone, of course. With the hammering that many hedge funds experienced in 2008, from market turmoil and redemptions, every hedge fund manager is now under the microscope for justifying their performance and fees.
The market meltdown and recent scandals involving Bernie Madoff and the Galleon Group insider-trading case may lead to more intense scrutiny and long-term systemic changes for the hedge fund industry, according to Reuters.
Among the changes on the horizon for the industry will be mandatory registration with the SEC, and perhaps closer governmental oversight of the largest funds, the type of which could set off a crisis if they failed.
Institutional investors will be much more cautious about where they invest their money, looking for security as much as performance. They will also demand more transparency, flexibility and actual performance for the fees they pay. Multi-year lock-ups on cash and “gates” on withdrawals could be a thing of the past. Some investors are demanding seperately managed accounts, which insulates them in the event of heavy redemptions in a hedge fund. This would, presumably, lead to higher management costs.
There will also be downward pressure on the fees charged by hedge funds. The “2 and 20″ industry standard is already coming under fire from large investors such as the California Public Employees’ Retirement System (Calpers) who have pressured their fund managers to revise their fees. During the boom times, even funds that did not produce stellar returns still benefitted from the 2 and 20 structure. However, in the aftermath of the past 18 months, some hedge fund fees may already be drifting toward 1.5 percent management fees and 15-18 percent of profits, and other alternative fee structures.
This will put downward pressure on hedge fund compensation. A report published by Job Search Digest, publishers of Hedge Fund Jobs Digest, revealed a disconnect between fund performance and hedge fund compensation. The third annual industry survey of hundreds of hedge fund managers and employees, in mostly privately held firms, showed that bonuses continue to rise despite 45 percent of respondents reporting fund losses. Investors are taking note, and the days of fat fees for dubious performance are dwindling.
In a move mirroring their cousins in the investment banking world, hedge funds are entertaining the idea of deferring bonus payments to take place over longer periods of time.
A greater portion of the typical hedge fund employee’s compensation – as much as 50 percent – may be paid out over longer periods of time, to better align that employee’s interests with those of the fund. So says Adam Zoia, chief executive of the executive-recruiting firm Glocap Search, in an article by Fins.com.
What’s more, hedge fund investors are rethinking their relationship with hedge funds, as well. Some are pushing for incentive fees to be based on a multi-year calculation rather than one stellar year. Others are pushing for clawback provisions that would yank back fees already paid if performance slips. Or they’re proposing 3-year rolling incentive arrangements that require certain targets to be met before incentive fees are paid out.
Either way, the pain of 2008 will likely have a lasting impact on how hedge funds set up their compensation agreements with both investors – and employees.
