What hedge funds are really good at is creating a tax strategy for the rich. Let's say you have a business and you want to pay less tax. You talk to a hedge fund.
The hedge fund says, let's convert all your earnings that should be taxed at the short term gains rate and convert them to long-term capital gains!
The hedge fund takes two well-correlated stocks, let's say Coke and Pepsi. They make a hedge going long Coke and short Pepsi. The hedge doesn't make or lose money, but you engineer the hedge so that you hold your long Coke shares 366 days (long-term). You sell your Pepsi shares after 364 days (short-term).
You haven't made any money, but you've engineered short-term capital losses and long-term capital gains. Of course you've created your hedge such that your short-term losses offset your business' short-term gains. Now your profits are in the long-term Coke stock, and rather than paying a 50% marginal tax rate, you pay 20%.
This doesn't actually happen. Tax avoidance is all about related party transactions these days, and there are more efficient ways to convert ST cap gains into LT cap gains.
Whether or not you approve of hedge funds, they don't exist for the sole purpose of helping companies reduce their tax bill. Most companies of significant size can play tax games without the help of a (sometimes expensive) intermediary.
There's not much that needs to be elaborated. Hedge funds don't make any money if they're not generating alpha. the 2 and 20 structure is powerful motivator to search for outsized returns. Hedge funds are in a hard place right now, with a lot of capital being moved out of the industry due to poor performance.
Every hedge fund guy I know constantly stresses about the overall lack of alpha generation in the industry right now. To say thet the point of hedge funds is to avoid taxes is just ridiculous. A company doesn't need to invest in a hedge fund to engineer the type short-term losses and long-term gains. And there's no reason they would, the fees are simply too high for anyone to ever do that.
Don't hedge funds still take the very high 2% fee even if they don't make any profit? Doesn't the 2 and 20 structure just incentivize making risky investments (where you either win big and take the 20% or lose big and take the 2%). Hedge funds seem like a terrible investment these days given how ridiculous the fees are.
Why hasn't competition brought the fees down when hedge funds aren't consistently beating the market?
A 2% fee isn't very much considering the AUM of hedge funds. If you have a 250m fund, that's only a fixed 5m fee per year. Also, investors are very fickle with their money, you can't not be generating alpha for that long before clients pull all of their money.
Fees have gone down in the past couple years, Tudor slashed their fees from 3 and 30 (which is ridiculous) to 25 and 2.25 (still kinda high). Many other hedge funds have gone to 15 and 1.5.
The problem with hedge funds at the moment isn't that they are making bad security choices individually, but that taken together, a short list of securities becomes very crowded, which really hurts liquidity (though this crowding isn't calculated in their liquidity metrics, so they think they have liquidity even though they really don't)
2% being big or small has nothing to do with the size of AUM. In this age of NIRP, 2% is yuuuge especially compared to costs associated with passive funds. Personally, I can see the 2 and 20 model dying within the next few years. The plebes will no longer associate hedge fund managers with the shadowy pinnacle of intellect (Limitless anyone?)
I'm not in the finance industry, but articles like this one http://www.businessinsider.com/hedge-funds-returns-in-2015-2... where hedge funds returns aren't beating the market well having ridiculously high fees compared to something like an index fund seems strange. If the market is crowded, why isn't competition acting to reduce hedge fund fees to levels more in line with the amount hedge funds consistently beat the market?
I'm not sure the fees are going to go down so much as that a ton of hedge funds are going to go out of business. There are many funds generating real alpha and have made outsized returns year after year (Renaissances' medallion fund has made something like 40% per year average since inception). DE Shaw, 2 Sigma, Renaissance, Tudor, Bridgewater, AQR have all historically done pretty well.
On the other hand, there are a ton of hedge funds that have never generated alpha in their entire existence and lack even the most basic modicum of skill.
Comments
What hedge funds are really good at is creating a tax strategy for the rich. Let's say you have a business and you want to pay less tax. You talk to a hedge fund.
The hedge fund says, let's convert all your earnings that should be taxed at the short term gains rate and convert them to long-term capital gains!
The hedge fund takes two well-correlated stocks, let's say Coke and Pepsi. They make a hedge going long Coke and short Pepsi. The hedge doesn't make or lose money, but you engineer the hedge so that you hold your long Coke shares 366 days (long-term). You sell your Pepsi shares after 364 days (short-term).
You haven't made any money, but you've engineered short-term capital losses and long-term capital gains. Of course you've created your hedge such that your short-term losses offset your business' short-term gains. Now your profits are in the long-term Coke stock, and rather than paying a 50% marginal tax rate, you pay 20%.
Yay hedge funds!
This doesn't actually happen. Tax avoidance is all about related party transactions these days, and there are more efficient ways to convert ST cap gains into LT cap gains.
as someone fascinated by this but outside of that world, can you elaborate?
Whether or not you approve of hedge funds, they don't exist for the sole purpose of helping companies reduce their tax bill. Most companies of significant size can play tax games without the help of a (sometimes expensive) intermediary.
I work at a hedge fund and you have no idea what you are talking about.
Elaborate then please, and I vote accordingly.
There's not much that needs to be elaborated. Hedge funds don't make any money if they're not generating alpha. the 2 and 20 structure is powerful motivator to search for outsized returns. Hedge funds are in a hard place right now, with a lot of capital being moved out of the industry due to poor performance.
Every hedge fund guy I know constantly stresses about the overall lack of alpha generation in the industry right now. To say thet the point of hedge funds is to avoid taxes is just ridiculous. A company doesn't need to invest in a hedge fund to engineer the type short-term losses and long-term gains. And there's no reason they would, the fees are simply too high for anyone to ever do that.
Don't hedge funds still take the very high 2% fee even if they don't make any profit? Doesn't the 2 and 20 structure just incentivize making risky investments (where you either win big and take the 20% or lose big and take the 2%). Hedge funds seem like a terrible investment these days given how ridiculous the fees are.
Why hasn't competition brought the fees down when hedge funds aren't consistently beating the market?
A 2% fee isn't very much considering the AUM of hedge funds. If you have a 250m fund, that's only a fixed 5m fee per year. Also, investors are very fickle with their money, you can't not be generating alpha for that long before clients pull all of their money.
Fees have gone down in the past couple years, Tudor slashed their fees from 3 and 30 (which is ridiculous) to 25 and 2.25 (still kinda high). Many other hedge funds have gone to 15 and 1.5.
The problem with hedge funds at the moment isn't that they are making bad security choices individually, but that taken together, a short list of securities becomes very crowded, which really hurts liquidity (though this crowding isn't calculated in their liquidity metrics, so they think they have liquidity even though they really don't)
2% being big or small has nothing to do with the size of AUM. In this age of NIRP, 2% is yuuuge especially compared to costs associated with passive funds. Personally, I can see the 2 and 20 model dying within the next few years. The plebes will no longer associate hedge fund managers with the shadowy pinnacle of intellect (Limitless anyone?)
I'm not in the finance industry, but articles like this one http://www.businessinsider.com/hedge-funds-returns-in-2015-2... where hedge funds returns aren't beating the market well having ridiculously high fees compared to something like an index fund seems strange. If the market is crowded, why isn't competition acting to reduce hedge fund fees to levels more in line with the amount hedge funds consistently beat the market?
I'm not sure the fees are going to go down so much as that a ton of hedge funds are going to go out of business. There are many funds generating real alpha and have made outsized returns year after year (Renaissances' medallion fund has made something like 40% per year average since inception). DE Shaw, 2 Sigma, Renaissance, Tudor, Bridgewater, AQR have all historically done pretty well.
On the other hand, there are a ton of hedge funds that have never generated alpha in their entire existence and lack even the most basic modicum of skill.
so you buy this fund, have no market exposure, have some correlation issues, pay tons of fees, and make nothing?
i think you need to brush up on hedge funds and investment management generally.