Background: Hedge Fund Fees, Terry Smith and Warren Buffett

Terry Smith has written again about the kerfuffle he’s raised about his last entry on the Hedge Fund 2 & 20 deal.  He says that commentary on his calculation has centered either against the calculation methodology or basically said “so what?”  I don’t question his methodology, nor do I think it doesn’t rate some soul-searching.  However, there are a couple of other things that I really have an issues with:

  1. He suggests that somehow Warren Buffett may be the way to go.  I certainly would have jumped at Warren Buffett the fund manager even if he was charging 3 and 30 (3% of assets and 30% of gains) because he would very probably be worth it.  On the other hand, as the shareholder base of Berkshire Hathaway got smaller and Warren’s share got larger, Berkshire was (and still is to a large extent) running Warren’s own money.  Don’t forget, though Berkshire owns a lot of companies that throw out cash by the bushel-load, Berkshire itself (and feel free to correct me if I’m wrong) has never paid a dividend.  One was, and is, expected to hold on to Berkshire shares for eternity, without any cash coming out of it.  Interesting.
  2. He suggests that HF managers should come with their own skin in the game.  He’s got a point in that this aligns their interests with mine.  To the extent possible, I’ve done that, investing with people like Jabre and Browder when they’ve made it rich and started managing a lot of their own money.  But what do you do when Jabre is this scrappy Lebanese Christian trader with no real pedigree (or that much money of his own for that matter)?  Or when Bill is a young HSBC guy in Moscow in the mid 1990’s and is spinning a story about how you could make a boat-load of money out of post-perestroika Russia?  I know what did happen is that most people walked.

It’s the latter point that worries me.  It’s hard enough separating the wheat from the chaff of myriad managers one sees every day, all promising double-digit returns with low volatility.  If I insist they then also bring their own money, I may be limiting the potential field overmuch.  But I do get Terry’s point:  managers get greedy and that fee structure does not bode well for the investor most of the time.

 

Dr. Michael Burry in his home office, in Silicon Valley. Vanity Fair

 

Perhaps there is a different way.  Mike Burry of Scion Capital had a similar view of things.  This is the guy who, like John Paulson, bet against subprime and made a packet.  He was subsequently made famous by Michael Lewis in his book “The Big Short.”  I’ll let Lewis explain Burry’s structure:

By the end of 2004, Mike Burry was managing $600 million and turning money away. “If he’d run his fund to maximize the amount he had under management, he’d have been running many, many billions of dollars,” says a New York hedge-fund manager who watched Burry’s performance with growing incredulity.  “He designed Scion so it was bad for business but good for investing.”

Thus when Mike Burry went into business he disapproved of the typical hedge-fund manager’s deal. Taking 2 percent of assets off the top, as most did, meant the hedge-fund manager got paid simply for amassing vast amounts of other people’s money. Scion Capital charged investors only its actual expenses—which typically ran well below 1 percent of the assets. To make the first nickel for himself, he had to make investors’ money grow. “Think about the genesis of Scion,” says one of his early investors. “The guy has no money and he chooses to forgo a fee that any other hedge fund takes for granted. It was unheard of.”

Maybe a solution may be a page from both books:

  1. It would be ideal if the managers had their own skin in the game, however much it was.
  2. They shouldn’t charge a flat management fee, that just encourages them to get as big as possible, spending most of the portfolio manager’s time raising ever more money.  I’d say, have audited costs charged to the Fund, and have the costs capped at 1% of assets.  The shareholders, just like in any “real economy” company, have a say on the costs.  This also has the benefit of the manager being careful how he spends the Fund’s money paying brokerage fees or “round tripping” the portfolio to keep the Prime Brokers happy.
  3. I still think a performance fee aligns the manager’s interest with mine, so by all means there should be one.  But only half of the performance fees can be cashed in on any given year, the rest stays in the fund.  Yes, as the years go by, and the Fund has been as spectacularly successful as Buffett or Burry, the manager’s share gets bigger and bigger, but I don’t really have a problem with that.

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