Hedge funds were the darlings of the past decade. The 2 and 20 compensation lure of hedge funds is a major factor in the over compensation of bankers. The argument was that if the banks did not match the hedge fund money, they would lose all their most talented people.
In 2011, 67% of hedge funds were below their high water marks according to a study by Credit Suisse.
What hedge funds promised was a Free Lunch. But There’s No Such Thing As A Free Lunch!
The Economist summed it up perfectly in this letter to investors from the Zilch Capital Hedge Fund:
In line with the rest of our industry we are making some changes to the language we use in our marketing and communications. We are writing this letter so we can explain these changes properly. Most importantly, Zilch Capital used to refer to itself as a “hedge fund” but 2008 made it embarrassingly clear we didn’t know how to hedge. At all. So like many others, we have embraced the title of “alternative asset manager”. It’s clunky but ambiguous enough to shield us from criticism next time around.
We know we used to promise “absolute returns” (ie, that you would make money regardless of market conditions) but this pledge has proved impossible to honour. Instead we’re going to give you “risk-adjusted” returns or, failing that, “relative” returns. In years like 2011, when we delivered much less than the S&P 500, you may find that we don’t talk about returns at all.
It is also time to move on from the concept of delivering “alpha”, the skill you’ve paid us such fat fees for. Upon reflection, we have decided that we’re actually much better at giving you “smart beta”. This term is already being touted at industry conferences and we hope shortly to be able to explain what it means. Like our peers we have also started talking a lot about how we are “multi-strategy” and “capital-structure agnostic”, and boasting about the benefits of our “unconstrained” investment approach. This is better than saying we don’t really understand what’s going on.
Some parts of the lexicon will not see style drift. We are still trying to keep alive “two and twenty”, the industry’s shorthand for 2% management fees and 20% performance fees. It is, we’re sure you’ll agree, important to keep up some traditions. Thank you for your continued partnership.
Zilch Capital LLC
There probably are a handful of money managers who are actually worth the 2 & 20. But think about it, someone has to be on the other side of all of those trades where the hedge fund managers are winning. Eventually, everyone who has money that is invested with a manager (or themselves) who loses every time either runs out of money or hires another manager, until more and more of the money is managed by people who are aware of all the ways that the hedge funds have changed the investment markets.
And the hedge fund tricks no longer work.