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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 decade

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 Looking at any investment gains in isolation is outdated.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.

JumpCrisscross 10y ago
> 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 10y ago
  "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.
  - deleted 10y ago
    [deleted]
n00b101 10y ago
"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.
- savanaly 10y ago
  >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.
- escape_goat 10y ago
  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?
hendzen 10y ago
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 10y ago
  > 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 10y ago
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.
edblarney 10y ago
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 10y ago
  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.
rbcgerard 10y ago
picking a benchmark is actually quite hard adjusting for net and gross exposures and volatility is makes things more complicated
lordnacho 10y ago
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 10y ago
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 10y ago
  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
- deleted 10y ago
  [deleted]
- plinkplonk 10y ago
  "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.
godzillabrennus 10y ago
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 10y ago
  > 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.

JumpCrisscross 10y ago

> 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 10y ago
"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.
- deleted 10y ago
  [deleted]

n00b101 10y ago

"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.

savanaly 10y ago
>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.
escape_goat 10y ago
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?

hendzen 10y ago

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 10y ago
> 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 10y ago

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.

edblarney 10y ago

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 10y ago
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.

rbcgerard 10y ago

picking a benchmark is actually quite hard adjusting for net and gross exposures and volatility is makes things more complicated

lordnacho 10y ago

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 10y ago

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 10y ago
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
deleted 10y ago
[deleted]
plinkplonk 10y ago
"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.

godzillabrennus 10y ago

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 10y ago
> 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.