[Periodic]

Why aren't hedge funds compensated based on some sort of alpha, the difference from a benchmark? One of the common memes of investing over the last few decades is that no one can reliably beat the market. It's very easy to use an index fund to track the market at very low cost. If I invest in an actively managed fund I want them to be compensated for doing better than I could have done myself.

There are a few advantages to this, in my eyes:

1. They only get compensated for their value, not the rising of the economy. It's terrible for the investor to have an economy that's going bonkers and the hedge fund that's taking 20% of that while not providing their own value. You could easily be doing worse after fees. 2. It incentivises managers to figure out ways to avoid losses. If the market drops 10% in a year, but the fund only drops 5%, treat it similarly to a profit of 5% because that's the value the hedge fund provided.

Looking at any investment gains in isolation is outdated. Investing is easier than ever for the layperson. We need to start looking at the opportunity costs.

[n00b101]

"Why aren't hedge funds compensated based on some sort of alpha, the difference from a benchmark?"

This is called a "relative return" strategy. Suppose the benchmark falls 70% and the hedge fund loses 50%. Your hedge fund manager has lost half your money, but has beat the benchmark by 20% (i.e. "positive alpha"). How does a fee based on alpha work in this case?

Hedge funds generally claim that they aim to achieve a positive return on investment regardless of whether markets are rising or falling (i.e. "absolute return strategy"). In theory, this means that hedge funds should have low correlation with the benchmark. This low correlation is attractive to investors because it provides a diversification benefit and (in theory) improves their efficient frontier. Low (or ideally zero) correlation to the benchmark is the main reason that institutional investors are willing to pay expensive hedge funds fees. However, if hedge fund managers have incentives based on relative returns to the benchmark, then hedge funds will be more correlated to the benchmark.

[Kadin]

> Suppose the benchmark falls 70% and the hedge fund loses 50%. Your hedge fund manager has lost half your money, but has beat the benchmark by 20% (i.e. "positive alpha"). How does a fee based on alpha work in this case?

Some percentage of 20%, the amount by which the fund outperformed the benchmark. This makes total sense to me, at least. Or rather, it's no more nonsensical than letting the fund manager take a cut of all the assets under management, win or lose, which is a common compensation strategy and has never seemed remotely reasonable.

You obviously need a way of compensating the fund manager during a bear market, or else you're going to have your staff leave as soon as the market starts declining, because they won't be getting paid. So any scheme that doesn't pay the fund manager for losing less money than the dead-hand benchmark is pretty severely flawed.

[philipodonnell]

There is usually a separate fixed percentage of assets fee for just this reason, typically 1%.

[escape_goat]

I'm asking for my edification, rather that putting forward a line of argument, but assuming for a moment that the trades are not so large as to have a direct impact on the market, there would appear to be a great deal of hindsight information available upon which to build a benchmark.

A hedge fund appears to be an investment strategy that compensates for having imperfect information. Why is it not possible to estimate an alpha on the range between the results of a completely naive Monte Carlo simulation ("no information") and the results of a search for the optimal hindsight strategy ("perfect information")? That is, the payoff for the manager will be fixed and proportional to the fraction of hindsight performance that he achieves.

You might not want to peg compensation directly to this, but rather to relative performance against the alpha (compared to other management strategies), but that's more of a salary negotiation detail.

This is the sort of idea that my brain comes up with when I try to think, except I somehow doubt that I am all that much brighter than the average hedge fund manager. I hope I'm not just wasting your time with the obvious, but why doesn't a system like that work?

[imcoconut]

These days a lot of the money in Hedge Funds is institutional. Typically institutional investors coming to funds already have a specific allocation to an investment style, market, or asset class that they are trying to fill. So they already have an idea of whether they want market exposure, which would be benchmark oriented and should have high correlation to the benchmark/market, or whether they want no market exposure, which would would have low to zero correlation to the market (they also could want exposure anywhere in between). So in long only (no shorting) funds benchmarks can be arbitrary (though are usually indexes), but they are fixed and agreed upon by manager and investor.

The mandate for the manager in benchmark oriented strategies is to track the agreed upon benchmark with a correlation (or more accurately Beta) of as close to 1 as possible, while still beating it by a certain margin. So if the benchmark is up 10, the fund should be up 15. If the benchmark is down -10 the fund should be down -5. Technically, this margin is often measured not as the difference between the fund and the benchmark but as the annualized standard deviation of the difference, known as the Tracking Error(TE). The TE is typically agreed upon between the fund and investor(s).

It's very common for a fund to charge only a management fee in benchmark oriented strategies. In a benchmark oriented fund with a target TE it would not really make sense to charge performance fee on the magnitude total fund performance since that will largely (or completely) be a function of the benchmark/market - remember correlation should be 1. It also would not make sense to charge performance fee on the excess return over the benchmark because that is incorporated into the TE and should be relatively constant over time (in the example earlier the fund should always beat the benchmark by %5.

So usually there is just the management fee. The reasoning is that if a fund can yield consistently high returns with a consistently low risk (as measured by vol/std. dev. of excess returns a.k.a. TE) then they have some skill and should be compensated accordingly. The excess returns adjusted by risk of excess returns is called Information Ratio (IR). IR is analogous to Sharpe Ratio(SR) in non benchmark oriented funds. In a long/short fund, the higher the SR the higher the fees usually. Similarly, in the long only benchmark oriented fund, the higher the IR the higher the management fee.

This is how fees usually are determined for funds that have benchmarks.

[ctrl_freak]

I'm not an investment expert, but wouldn't there be virtually unlimited upside in an optimal hindsight strategy? I.e. you could use derivatives and other financial instruments to gain an arbitrary amount of leverage and hence return, since there would be no risk.

[pyromine]

Expanding on this, this idea of looking backwards as a method determining what returns you could have made is actually the root of a lot of _bad_ investment advice.

People often look back and try to determine some type of optimal portfolio that they claim is the best in all economic environments because they found it to be the best portfolio in the certain timeframe they looked, but they had the benefit of checking hundreds of different potential sets of funds and if you were to actually calculate the probability that composition of funds is better than any other composition you'd find that it was just random chance it provided the best returns over that time frame.

Granted there is a lot to learn from looking back, but it's also very imperfect if you're not taking in to the benefit of hindsight.

[cocoablazing]

Compensating for this effect of training may be done by properly discounting the measure using the Deflated Sharpe Ratio or similar corrected SR's. I always ask any interviewee who cites experience producing these measures a question with this effect as the crux. Few come back with a correct answer.

[savanaly]

>This is called a "relative return" strategy. Suppose the benchmark falls 70% and the hedge fund loses 50%. Your hedge fund manager has lost half your money, but has beat the benchmark by 20% (i.e. "positive alpha"). How does a fee based on alpha work in this case?

I'm not who you're responding to, and I've never heard of "relative return" strategy, but it makes perfect sense to me and your hypothetical poses no confusion in my eyes. If the benchmark (agreed upon in advance of course) would have caused my money to go from M to B by the end of the year, and the hedge fund actually caused my money to go from M to H, then they get paid some percentage of H - B. It's completely irrelevant what M is in relation to H or B.

[hendzen]

There is usually an inverse correlation between Sharpe ratio and capacity. That is, strategies that produce very high risk-adjusted returns stop working if you crank up the size of the book. So the groups running the really high sharpe stuff (HFT latency arb, for example) don't even bother taking outside capital since they wouldn't know what to do with it. This also allows them to keep a higher portion of the profits. On the other hand, groups that are doing lower sharpe but higher capacity strategies (say, Bridgewater) need to raise giant pools of money from outside investors. So really, the most sure bets aren't available to the public.

[vostok]

> So the groups running the really high sharpe stuff (HFT latency arb, for example) don't even bother taking outside capital since they wouldn't know what to do with it. This also allows them to keep a higher portion of the profits.

There are some hedge funds that run prop shop style strategies, but they charge far more than 2/20.

[wheaties]

Some strategies aren't about beating a benchmark but providing non-correlated market returns. By that I mean returns which don't go up or down based on the direction of the market.

A good example are catastrophe bonds and weather derivatives. Both are completely uncorrelated with the market, dependent more on weather forecasting, actuarial tables and region specific data.

[lordnacho]

A fund could simply pick a tradable benchmark like the S&P 500 and short it against its stock picks. Then the investor would pay only on the difference. There's plenty of long-short funds that are essentially flat the market.

Depends on what you're after. You might be touting your ability to guess the market as a whole, in which case absolute return would be a reasonable target. Or you claim to be able to beat the market, in which such a scheme makes sense.

[iav]

We had one investor who asked and got this kind of model. It creates a ton of complexity (say if the investor takes some money out, you don't count the gains that this money would have earned since that point. Then imagine they put more in later - now you have to track the hypothetical returns on that new money, but not from the original investment but from the add-on time. Trust me the math gets heavy). It just proves unworkable for a fund with hundreds of investors to track everyone's benchmarks separately. Then imagine trying to show net of fees returns for the fund for marketing purposes. Do you show the returns of the guy who invested when the benchmark was low and may not have paid any fees due to relative underperformance? Or the guy who invested at the optimal time and got the biggest outperformance and paid a lot more in fees relative to the first guy? Good luck justifying your choice to an SEC examiner. This is why even the savviest investors don't ask for what you are suggesting.

[SalvatoreDali]

This does not seem like a serious objection to me. Hedge funds track, keep track of far more complicated financial arrangements. Just valuing options to see when they are in the money is orders of magnitude more complicated. What the op suggests can be done using nothing more complicated than a spreadsheet. "It just proves unworkable for a fund with hundreds of investors to track everyone's benchmarks separately" - huh? Maybe 300 years ago when you had nothing but pen & paper. This is like saying it would be impossible for a mortgage issuer to keep track of each lenders current (adjustable) rate

[plinkplonk]

"It creates a ton of complexity (say if the investor takes some money out, you don't count the gains that this money would have earned since that point. Then imagine they put more in later - now you have to track the hypothetical returns on that new money, but not from the original investment but from the add-on time. Trust me the math gets heavy). It just proves unworkable for a fund with hundreds of investors to track everyone's benchmarks separately"

Computers are good for these kind of things. It isn't as if the hedgefund analyst has to use an abacus to calculate and record the data by hand inscribing stone tablets. I'm sure the existing procedures for other parts of the business (say valuing options) are equally or more complex and computers are handling them just fine.

[twic]

And if you really can't be bothered to keep track, restrict subscriptions and redemptions to the end of each quarter, and work out performance and fees quarter by quarter.

[godzillabrennus]

Its only become clear lately that most managed funds don't out perform index funds.

No matter your trade, if you are smart you want to be paid for your time invested into something and get some upside, regardless of what you are doing for a profession.

Some funds take years to show a return, would you develop software for years and build the business for it without drawing a salary for that work? Most people can't afford to try.

Most folks in finance who can raise this kind of money for a fund can simply make money doing something else, like raising money for established businesses in investment banking. Give the market has shown this model is dead now they will.

[FabHK]

> Its only become clear lately that most managed funds don't out perform index funds.

Malkiel's A Random Walk Down Wall Street, in which he explains the Efficient Market Hypothesis and argues that active managers can't consistently outperform the market, was first published in 1973.

So, it might only recently have entered common knowledge, but the evidence has been piling up for a while.

[edblarney]

Because you want your fund manager to outperform the overall market.

If the economy tanks, and everything is down 10%, and you are only down 5%, that's definitely a 'win' for you.

This is not the 'bad part' about hedge fund, there are other schemish things they do.

[SalvatoreDali]

Considering how hard it is to be 'up' when the entire market is 'down' this doesn't seem so bad. Considering the average hedge fund performances in a down market, it definitely looks like a win to me.

[JumpCrisscross]

> Why aren't hedge funds compensated based on some sort of alpha, the difference from a benchmark?

They usually (EDIT: sometimes) are. The 20% is typically (EDIT: has been in my recent experience) measured against a benchmark. The trick, however, is in selecting and/or constructing that benchmark. There are also as many definitions of alpha as there are hedge funds.

[n00b101]

"They usually are. The 20% is typically measured against a benchmark. "

That is incorrect. The 20% refers to a fund management performance fee equal to 20% of all profits (without reference to any benchmark index). However, there is usually a "hurdle rate," like 5%, so 20% refers to 20% of all profits above the hurdle rate. There is also a "high water mark," so that past losses are counted against any "profits" to which the performance fee is applied.

[rbcgerard]

picking a benchmark is actually quite hard

adjusting for net and gross exposures and volatility is makes things more complicated