One of the promises hedge funds make is that you can make money when the market is going down too, not just when it's going up. That's a win-win. However the way they structure their fees it would seem that "win-win" means they win twice!

Whether they get it right or get it wrong, hedge fund managers still walk away with a big slice of your pie.

In May 2006 Warren Buffett, the most successful investor in the world, offered a bet to any takers. Having said for years that most investors would be better off investing in index funds rather than letting active managers gamble with their funds, he offered to bet anyone a million dollars that the index would outperform a basket of active hedge funds.

Well, earlier this year a New York ‘fund of fund' hedge fund manager, Protégé Partners, took him up[1].

The deal is that the average return of a basket of Protégé's pickings has to outperform the S&P500, after fees, for the period 1/1/2008 to 31/12/2017.

It's not the first time that a bet has been made that an index fund would outdo an active fund, either. In 2000 Markman Funds lost a five year bet to Vanguard on performance, forking out the princely sum of $25.

Ironically, Protégé only gives its chances of success at 85% -- quite a statement when you consider hedge funds make this bet every day ... with someone else's money. Clearly gambling with their own money is a different proposition.

Fees biggest problem

Picking winners and timing the markets is remarkably costly. Together they act like a relentless current that active managers must swim against. Buffett argues that the biggest impediments to success are the fees that these ‘funds of funds' charge. To explain ...

"It's a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing - or, for that matter, loses you a bundle - and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide.[2]"

For example, a manager in charge of a $3 billion fund that produces a gross return of 10% makes himself a cool $108 million. "He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee."

The house always wins

This "grotesque arrangement", as Buffett calls it, effectively transfers investors' wealth to the balance sheets of fund managers. Alpha Magazine's annual report[3] on manager remuneration shows it to be a sound business proposition for fund managers.

Last year, for instance, three managers pocketed over one billion dollars each. The salary of your average hedge fund CEO is US$475k plus cash bonuses of over US$2.5m and non-cash bonuses of over US$5m[4]. Even the average junior portfolio manager (aged 20-something) is paid a salary of US$155k and bonuses of another US$480k.

This cash can only come from one place: directly from investors' accounts by way of fees.

Investors poorly paid for the risks they are exposed to

Investors probably don't mind sharing a quarter of their gains when the markets are roaring. But what about when their allegedly winner-picking managers aren't even able to eke out returns a few points above the general market? And this poor performance in spite of the additional risks active managers take with investors' capital.

And this is the real question: are investors are being adequately compensated for the risks their capital is being exposed to?

There is an answer, too. A wide body of academic research verifies that active managers simply don't earn superior returns after fees once risk is taken into account.

There is no free lunch: when you measure the additional risks that actively managed money is exposed to, investors are not earning returns sufficient to offset those risks.

The truth is that investors would be horrified if they were aware of the risks their manager, desperate to earn that bonus, had just taken with capital that doesn't even belong to them.

[1] Fortune Magazine, www.cnnmoney.com, 9/6/08

[2] www.berkshirehathaway.com 2006 letter to shareholders, page 21.

Alpha Magazine, www.news.efinancialcareers.co.uk, 24/4/07

[4] Institutional investor, www.iimagazine.com, 14/6/08

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