re-thinking hedge fund fee structures

currently, most compensation for hedge funds works like this:

2% management fee (received regardless of performance)

20% incentive fee (hedge fund receives 20% of upside)

1 year lockup and after 1 year, quarterly redemptions

in the event of a down year (as many funds had last year), funds need to recover the money they lost for an investor before they make an incentive fee.

let me provide an example. since the 2% management fee is always charged, i'll talk numbers net of management fee. let's say an investor put in $1mm in a hedge fund at beginning of 2008. let's say the fund was down 20%, the investor now has $800k. the fund would need to be up over 25% to get the investor over $1mm before the fund took a 20% fee.

this seems to work fine but let's say 2007 was a big year for the hedge fund. for example, let's say someone put in $1mm in 2007 and the fund was up 50%. then the investor would now have $1.4mm (net of the 20% incentive fee) and the hedge fund made $100k. now let's say that same fund was down 50% in 2008. now the investor has $700k, down $300k from his initial investment but the fund has clipped $100k in performance fee. how is that fair for the investor?

the current fee structure rewards those that take big risks and provide outsized performance for the short term without penalizing the funds for losses in future periods.

another issue is redemptions. let's say i was a fund and through research i realized that a small cap stock, across the next 2 years, would become a big company. but today it is very thinly traded. a hedge fund may be unlikely to take a position today because they don't have capital that they can rely on for a long period of time. and if they get redemptions, they will have to sell an illiquid security which would depress the value and maybe spur others to redeem.

one solution that hasn't been done but i believe should be the right structure is something more like the following:

same fee structure as above, however money is locked up for 3 to 5 years. at the end of that period, all monies are returned to investors. also at the end of that period, incentive fees are taken. during the 3 to 5 year period, investors can see monthly performance but have no way to redeem their money. this would prevent fund managers from taking fees for short term aberrations and it also allows the fund managers to invest in the best ideas, without having to be worried about liquidity or managing for a month to month performance (steady month to month performance probably means you're a madoff anyway).

clean it up

diverging a bit from my usual topics to talk about the blueprint cleanse which i just completed. it's a very interesting exercise in self control. and i like to try new things. i would do it again, but not for a while. i wouldn't call it pleasant, but it wasn't awful.

i did a 3 day rejuvenation cleanse. that means i drank 6 bottles of fruit / vege juices exclusively for 3 days. no other food. i drank a lot of water in between.
generally, i found that i was not hungry during the cleanse, but i still craved food. it's strange not eating for 3 days. today, i started eating and my jaw was sore after eating a bagel. not chewing for all that time weakens your jaw. who would have thought?

i lost 7 lbs in 3 days. that seems like a lot! but more importantly, i feel healthier. i have lots of energy. and if the eyes are the windows to the soul - than my soul is clean - because my eyeballs are super white.

the major downside is the cleanse is quite expensive ($65 / day in nyc). so each bottle is more than $10! the other downside is that you can't go out with friends for drinks or dinners.

the post cleanse diet is frankly worse than the actual cleanse. while i didn't cheat at all on the cleanse, i'm going to cheat a lot on the post cleanse. pizza here i come. i like pizza.

site news and GM

sorry. i've been busy lately. which i guess is a good thing. but hopefully i'm back to writing.

lots has happened in the 6 weeks since i've written. maybe it's a modern day lazarus but no one ever talks about what happened to lazarus after he was resurrected. i'm pretty sure he died a second time. point being, GM died. here's my next prediction - it will reorganize and wait for it, wait for it... yes, it will die again. in 2020, there will be no GM.

so as i predicted on march 6, GM did in fact die. so now the natural question is, well, did i profit from this prediction? sadly, the answer is no.

i knew it would go bk, but the problem is timing. just like i know that newspapers will all go bk too. the NYT is worth almost a $1 billion in equity (another $1 billion in debt). clearly, NYT will be worth $0. smart money would short this thing. problem is 2-fold. first one is timing - it may be swift like GM, or it may take years and there's an opportunity cost to investing in something that may not pay off for a while. second major issue is i'm pretty gun shy in my personal portfolio. i play around, but generally, i'm super risk adverse especially when trying to trade in places that the government is interested in fooling with (as in, where did all the money from the original GM bailouts go? - so maddening. these people are stealing our money).

anyway, i'll make money off of my biggest conviction trades in the future. in the book stumbling on happiness i learned the things people are most sad about are the things they never tried, rather than the things they tried but failed at. so, next time, i'm investing. i'm not shorting NYT yet because i think it will be a while before it falters, but if you have 10 year capital, it makes sense to short both NYT and TWC.