Hedge funds have been an attractive investment over the last decade for high net worth investors and institutions. Their structure allows for managers to engage in riskier investment strategies and justifies a “2 and 20” fee structure, a 2% management fee and a 20% performance fee. For example, if you were to invest $5 million in a hedge fund, you would pay $100,000 up front. If that fund makes 10% after that fee has been taken, the investor would pay an additional $98,000 in performance fees. Managers have promised these qualified investors unique investment strategies and shown returns that have surpassed the Dow Jones Industrial Average and S&P500 year after year, but what happens when those funds do not perform?
In Zerohedge’s latest posting Career Risk Panic: Only 11% Of Hedge Funds Are Outperforming the S&P in 2012, anonymous industry insider “Tyler Durden” comments on how many hedge funds are failing to keep up with the S&P500, a task previously thought to be a non-issue. If these managers do not meet their bench marks, they could face account liquidations that would be crippling to their funds’ existence (see Matt Taibbi’s Rolling Stone blog).
The implications of these funds not meeting their investment goals reach beyond what one might think. Hedge funds are open-ended, meaning that investors can put money in or take money out at specified time intervals pre-determined by the funds’ managers. If a fund manager does not meet their performance goal, the fund will likely face a massive wave of withdrawals. These withdrawals could potentially be devastating to a fund’s long term viability, and could also wreak havoc on the markets.
Since hedge funds can take on riskier positions, i.e. derivatives contracts, they must maintain a margin account. If stocks that the fund owns begin to decline (and could potentially decline even further if hedge fund participants exit putting downward pressure on the stocks previously held), hedge fund managers will be faced with margin calls. When purchasing on margin, an investor borrows cash from a broker using other securities as collateral. If their debt to equity ratio exceeds 50%, cash must be added to the margin account or securities sold, usually the most liquid securities first. Margin calls were a precursor to the crash in 1929 and were a triggering market event in 2008 as well.
If hedge fund investors leave in droves and hedge funds are forced to meet margin calls, investors can be certain of 2 things. First, many of the world’s most well respected hedge funds will be on the brink of collapse. They simply will not have the cash or securities to continue on. Second, the instability caused by these funds’ missteps will be felt by the rest of the market. It may not be a long term trend and may perhaps only last a week, but there will more than likely be a period of volatility following their demise.
We have said it time and again that complex investing solutions are usually anything but. They can create massive problems not just for those that use them but for overall market participants as well. Had hedge fund managers simply chosen longer term positions in stocks or mutual funds that utilized sound economics and not focused on creating complex investing instruments to sell to high net worth individuals, we would not have half of the problems that we currently do in the markets.
This piece is in no way intended to be a scare tactic or a cause for concern, but merely intended to provide an “if-then” scenario. A quote came across my desk recently from Hyman Minksy that read “stability leads to instability,” and the opposite is also true. It is when we as people become comfortable in our routine actions that we begin to take on new risks or allow risks to pile up until it is too late to do anything about them. Likewise, only in periods of relative chaos are we able to get our houses in order and move forward in a more orderly fashion. If our theory on hedge funds come to fruition, no worries, it will be all for the better for the long run.