It's no secret that hedge fund managers are a super-smart lot. How do we know that? Because they went into the hedge fund business!
After all, what's the worst thing that can happen to a hedge fund manager? He can lose so much of his investors' money that they yell at him and take the rest back. Nothing ventured, nothing gained.
And what's the best thing that happen? Well, John Paulson's $3.7 billion compensation last year is a reasonable benchmark.
And let's say that the hedge-fund manager is neither a failure nor a John Paulson -- he's just somewhere in the middle. He does pretty well in years in which the markets are going up, and he gets clobbered when they're going down -- just like most hedge funds have this year. How well would this hedge-fund manager do?
For example, let's consider the hedge-fund manager of a fund called Capital Compensation Partners, LLC. Let's say the firm raised a $1 billion fund at the end of 2002 with a typical 2/20 fee structure (2% of assets and 20% of gains each year). Let's say the fund manager invested the entire fund in an S&P 500 index fund on Jan 1, 2003. Here's how the manager would have done over the next six years:
2003 Performance: +25%
Total Fees: $65 million
2004 Performance: +10%
Total Fees: $46 million
2005 Performance: +2%
Total Fees: $30 million
2006 Performance: +14%
Total Fees: $58 million
2007 Performance: +4%
Total Fees: $36 million
2008* Performance: -39% (*Assumes year ends now)
Total Fees: $27 million
Total Fees Over 6 Years: $261 million
Gross Performance Over 6 Years: 1%
$261 million over six years. Amazing! The hedge-fund manager was clearly a genius for going into the hedge-fund business.
But what do I mean "gross performance over 6 years: 1%"? The hedge fund manager had five good years, didn't he?
Well, he had five years in which he matched the S&P 500. And he also had the sixth year, in which he again matched the S&P 500... and lost just about every penny he "made" over the prior five years. So the hedge-fund manager's clients didn't do quite as well as he did over the period. Specifically, he made $261 million. They made, in aggregate, on a gross basis, $10 million.
No, of course not really. Because, every year, while the hedge fund manager was subtracting the fees that eventually added up to his $261 million, he was reducing the amount of capital the clients had in his fund. On a NET basis, therefore -- which is the only basis that matters -- the hedge fund manager's clients LOST $203 MILLION OVER THE SIX YEARS. That's an aggregate loss of 20%.
To summarize: Over the six years Capital Compensation Partners was in business, the firm made $261 million, and the firm's clients lost $203 million. All the risk, meanwhile, was borne by the clients, who got obliterated in the end.
See how smart hedge-fund managers are?