Hedge Fund Roulette

Hedge Fund Roulette

Paul Tudor Jones is an investment legend.  He founded Tudor Investment Corporation in 1980 and has delivered net annual returns of 19% since inception.  That is an incredible track record.

However, the returns are somewhat skewed.  PTJ had massive returns early on in his career.  His fund returned 126% in 1987, 87.4% in 1990 and 48% from 2000-2002.  In the last decade, his magic hasn’t been as spectacular.  From 2010-2012 he returned only 5% annually.

Criticism of hedge funds has taken center stage of late as their high costs and lackluster performance has exposed them to growing backlash.  As Bloomberg reported earlier this week, even a legend like Jones isn’t immune…

The $11.6 billion firm, run by billionaire Paul Tudor Jones, will reduce fees for a share class that contains most of its biggest fund’s money to 2.25 percent of assets and 25 percent of profits, starting July 1, according to a letter sent to clients on Monday and obtained by Bloomberg. The fees were 2.75 percent and 27 percent.

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For the layperson, Jones makes money by charging investors in the fund 2.25% of their total assets each year PLUS 25% of any profits he makes them.  If you invest $1 million and the fund returns 20% in a year, you won’t have $1.2 million but closer to $1.1 million.  The calculation isn’t exact but you’ll pay 4% of $1.2 million = $48,000 and 25% of $200k = $50k.

That’s just one share class of his funds though.  What about the other ones?

The firm is keeping fees for the main fund’s oldest share class unchanged at 4 percent of assets and 23 percent of profits.

4% of AUM and 23% of profits.  That is a STEEP price to pay.  Just how good will performance have to be to outperform a low-cost index fund?  All things being equal, here’s what total investment returns would look like over a 10-year investment horizon.

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No surprise.  The fees eat almost all of your return.  In order to make your investment worth it, how much excess return would the hedge fund have to generate over the index?  6.5%, or almost double the index return.

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So is doubling the index return doable?  Sure.  It’s not easy but if you have some money and PTJ is willing to take it, why not take a shot?

These numbers don’t tell the whole story though.  What about taxes?  Hedge funds usually rack up nice tax bills because they need to trade a lot to generate higher profits.  Unless you are a tax-exempt investor like a pension or non-profit, taxes are something you have to worry about.  How do the numbers look after Uncle Sam takes his piece of the pie?

I won’t get too complicated here.  Taxes involve tons of variables.  For simplicity sake, I’ll make the following assumptions:

  1. No state taxes.
  2. No dividend taxes.
  3. Max federal tax rate of 39.6% on gains (I’ll generously ignore the 3.8% medicare surcharge tax)
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With taxes added into the mix, how much excess return will the manager have to generate to compete with the index?  13%.  Nearly TRIPLE the index return.

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20% annual returns for 10 years is no small task.  That is an incredibly lofty expectation!  Do you think most fund managers are capable of something like that?  Is it worth speculating on?

I know, I know.  “Tim, it’s silly to compare a hedge fund to an index because they serve different purposes.”  I suppose that’s true.  Hedge funds allegedly “hedge” and allegedly control risk better than single stock markets.  But…

In 2015, the 20 most profitable hedge funds for investors earned $15 billion while the rest of the industry collectively lost $99 billion. –  (Bloomberg, Jan 2016) 

In 2014, there were over 7,000 traditional hedge funds in existence. Most hedge funds suck.  They do very well for themselves and not so great for investors.  Are there good hedge funds?  Absolutely.  How confident are you in your ability to find them though?  If you want downside protection you’ll probably be much better off using simple, diversified, low-cost portfolios than trying to find the next PTJ in an ocean overflowing with lousy, expensive hedge funds.

60/40 portfolios might sound boring (via @alphaarchitect), but they would probably save pensions, non-profits and HNW investors who like spinning the hedge fund roulette wheel an awful lot of money.


Tim Brennan

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