Guest Post: When Will Capitalism Come To Wall Street?

Tyler Durden's picture

Submitted by Omid Malekan via Visual Stories blog,

Ralph Waldo Emerson once said “Doing well is the result of doing good. That’s what Capitalism is all about,” and nowhere is this description more embraced than on Wall Street. There, the idea of the meritocracy, where those that produce the most financial value get to take home the biggest rewards is almost a cliche  All of which begs the question, why do most hedge funds exist?  If Capitalism existed on Wall Street, and compensation was tied to the creation of economic value, most of the “absolute return industry” would go out of business. To understand why, we need to go back a decade.

Back in the Spring of 2005, I and my boss at the small fund where I worked had a meeting with the manager of a large fund of hedge funds, an entity whose function is to farm out investor capital to different hedge funds. The manager had brought a printout of the prior months returns of every fund they invested in, looking to answer a pressing question. In the prior month the stock market had had a small selloff, and for whatever reason, the majority of hedge funds they invested in had lost money.

The manager was confused, and so were we. Hedge funds were invented to make money regardless of what the markets were doing, and up until then, they mostly did. The industry came to fame amid the ashes of the 2000 to 2003 equity bear market, where hedge funds demonstrated they could make money in a falling stock and interest rate environment. That’s why towards the front of almost every fund’s private placement memorandum there is some language on not being too correlated to the movements in any market, and how the goal is to make a steady stream of income in any financial environment. In other words, the ability to generate an “absolute return.” For this service hedge funds have always charged out-sized fees, averaging a fixed 2% managed fee topped with 20% of the profits each year. This fee structure along with the flow of investment money into the industry has made the Absolute Return industry the past decade’s best billionaire maker this side of co-founding Facebook.

Fast forward to today and the idea of the average hedge fund losing money when the market sells off is widely accepted. In the spring of 2014, a down month in the markets that doesn’t lead to most funds losing money would be the big surprise.  To make matters worse, the average fund no longer keeps up with the market on the up swings. A simple Bloomberg analysis last year comparing the HFRX Global Hedge Fund Index to the S&P 500 found that in 8 of the past 10 years, owning the S&P beat the average hedge fund. The under-performance and absolute lack of absolute returns is corroborated by this Morgan Stanley chart of the simple correlation between hedge funds that trade stocks and the overall stock market:

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An industry invented to have little correlation with the overall stock market now mirrors it almost 90% of the time. Google “hedge fund correlation” and you will find many other sources that verify this problem, and not just for funds that deal in stocks, but for the industry as a whole. To make matters worse, there is the issue of their complicated, costly and often times downright dangerous structure.

The first lesson taught in any basic investment course is the relationship between risk and return. Not only do hedge funds presently offer poor returns, but they continue to (as they always have) come with very high costs, Most analysis focuses on the hefty management and performance fees the funds charge, but as bad as they are, its the hidden costs that really cripple investors and add to the riskiness of their investment.

The average hedge fund is among the most illiquid and non-transparent investments you can find. Since the funds do not disclose their holdings (except to the SEC on certain positions and with a significant lag) you have no idea how your money is deployed. This creates a serious diversification problem, compounded by the fact that many funds tend to over-own the same names. So if its 2013 and a wealthy investor happens to invest in 5 hedge funds while owning some Apple stock in a personal account, its possible his exposure to that one name was far higher than he would want. What’s worse, he is paying 5 other people a fee to increase his risk. Compare that to the average mutual fund that gives you a daily snapshot of what it owns or the average index fund that gives you almost real-time information.

As for liquidity, when it comes to hedge funds, there is really no such thing. The industry standard is that your money is first locked up for an entire year, and then only redeemable on a quarterly or monthly basis, but only in pieces, and only after you submit a redemption request far in advance. Buried within their subscription agreement most funds have some sort of language that grants them the right to suspend redemptions in a liquidity crunch, often indefinitely. In other words, not only is your money locked up during the good times, but its theoretically completely inaccessible during the bad. The average mutual fund gives you daily liquidity, while the average index fund can be liquidated almost instantly.

In any other investment field, lack of transparency and liquidity are viewed as added costs that result in a “haircut” – or reduction of value.  When you add the poor transparency and even worse liquidity of hedge funds to the hefty dollar fees their managers charge, they are among the most expensive investments ever devised, many times pricier than their index or mutual fund cousins. All of that expense for the indignity of making less money in 8 out of the 10 prior years.

If Capitalism existed on Wall Street, and profits and compensation were tied to real performance, most hedge funds would not only not be able to charge their hefty fees, but they simply wouldn’t exist. After all, why would anyone in their right mind pay a larger expense to capture a lower return? And yet assets under management in the hedge fund industry just hit anther all time high.

All of which begs the question: when will Capitalism come to Wall Street?