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.

twitter explained

i felt like it was the end of my ability to grasp technology as i've watched dumbfounded by twitter's staggering growth. but after talking to a number of people about twitter, i think i at least have a clue. so for those that already know and love twitter, move on. for those that can't explain why tweets are taking over the world, read on.

Twitter, quite simply, is a real time set of information for anything. want to know why caesar crossed the rubicon, check out wikipedia. but if you want to know whether 1oak is having a good night, go to search.twitter.com and search for 1oak.

current events like swine flu for example can be scooped by searching twitter. latest restaurant reviews are best viewed by searching twitter.

facebook has really blown their status updates by not making it searchable. presumably because of privacy controls, fb has not made status updates searchable, but it's kind of pathetic that you can't search among your friends for updates which include specific words.

i have often asked the question, why would anyone twitter at all. the best answer i can come up with is because you can. all of a sudden with a few seconds of your time, you can reach out to all your followers and get a point across. further, with their ability to re-tweet what you've written, your idea can reach thousands or even millions of people within a few minutes. that's very powerful! nothing else available today can facilitate that.

if facebook doesn't get their act together, twitter could end of being the social network of choice for the world. when you're up over 500 friends on facebook, what does it matter if your comments are open for the whole world (i don't consider myself to be particularly friendly and i have over 400 friends on FB)?

there's such a thing as bad PR

some famous actress once said, "the only kind of bad publicity is no publicity" (i believe it was elizabeth taylor but i can't seem to find any reference to it so if you know the origin, please let me know).

i have always thought that was the case until this pirate thing came up. somalia has gotten some seriously bad publicity.

finally, the country has an enemy that we can all vilify - these pirates rob aid ships to give to local warlords. not only that, but they seem to be pretty bad at terrorizing. somehow they managed to have a hostage at gunpoint yet they all end up dead or captured.

well, like almost everything else in the world, things are not as cut and dry as the media would like to report. sure, many of the pirates seem to be out for profit, but many more are doing the job of a defunct government.

first of all, the media's portrayal of pirates from the hey day of piracy (around 1700) is just wrong. they were not simply blood thirsty heathens, but were often employed by governments themselves for protection (ron paul is pushing for this now - see below). for example, Sir Francis Drake was one of the first to circumnavigate the globe. To some, he's a great explorer and military men. But to many, he was just a pirate (he robbed many spanish ships).

today, "pirates" from somalia are robbing ships. some are simply criminals, but others, at least began as doing the job that a national navy or coast guard should have been doing. the government of somalia collapsed in 1991. the US and Clinton tried somewhat to bail them out but after the black hawk down incident, we have essentially allowed somalia to exist in crisis ever since.

this set up the situation where you have a coast line nearby a major shipping lane (the gulf of aden) with no policing. international ships began using this area to simply dump toxic waste on the way to or from their ports. that's right, ships began turning somalia into the world's oceanic trash dump.

further, international water rights exist for fishing. but more than $300 mm worth of catches were essentially being stolen without taxation by foreign fisherman.

meanwhile the people of somalia were starving and now they were also being poisoned. so in response, locals began going out to the ships to prevent them from dumping and/or demanding money to fish in the area. and that is largely where the "pirates" of somalia came from.

now, you have dogmatists like ron paul trying to convince the world that we should be instituting the policy of letting private citizens (read: pirates) police that area under the auspices of the united states of america. i'm sorry but the austrian school of economics isn't always the best way of handling things.

i feel badly for the people of somalia. clearly citizens policing waters - whether done by somali's or american's is a bad idea. and some pirates really are thugs. but this super mean pirate who was captured is probably only 16 years old. this is going to turn out to be a mess.

the only clear thing is that somalia needs a lot of help and the world (ie, the UN) must stabilize somalia for the benefit of the world.

pay no attention to the banker behind the curtain

i have to give goldman sachs credit. everytime i think they are completely cornered and have no where else to go other than into the dustbin of history, they manage to pull off another trick. i still believe you can't fool all the people all the time (this is not an endorsement of david einhorn).

but this time i gotta give the wizards at goldman extra credit because this one is obvious and yet no one seems to notice. that's the best kind of trick. goldman announced earnings yesterday which surpassed guidance and by most accounts was a blow out quarter.

but check this out - they reported net income of $1.66 billion from january - march. however, they changed their fiscal year. their year end used to be november but they switched to january. the net effect was they reported their quarter for the last three months and separately reported december as an "orphaned" month. and guess how they did in december? they lost $0.8 billion. so it seems goldman took all its losses and crammed it into the orphaned month which won't show up on any specific quarter.

bravo goldman! i don't think you can use that trick again, so i wonder what you will do for an encore.

how can banks possibly be doing well? banks traditionally make money from the following sources: investment banking advisory work (this business is basically dead except perhaps restructuring), loaning money (they likely made money on this since they can borrow from the government for almost nothing and lend out at higher rates - but that's what caused this whole mess to begin with - so i doubt they are doing much lending), trading (with major hedge funds blowing up and the rest all hating on goldman sachs this cannot be doing well) and wealth management services (this has to be going terribly). so besides some chicanery, how is goldman making its numbers?

lastly, i want to point out that the real problem at Goldman and Citi and all the other banks is the toxic assets which are not marked correctly. with the suspension of mark to market accounting we are likely to create zombie banks that never make money as they slowly trickle out the losses on their balance sheet. think of it like this - if you have a loan portfolio that you've said is worth $100 billion but if you went to sell it, would only fetch $80 billion, then what does $1 billion or $2 billion in profit really do for you? you're still $20 billion in the hole. so when citi reports earnings for the quarter, how does it matter when their assets are massively mismarked? it reminds me of my friend who reported winning $3,000 in blackjack. so i said, "congrats, drinks on you tonight!". he responded, "no way, i lost $10,000 on blackjack this morning". i don't see how you can call any of these banks profitable.

good news

while the administration continues to set up the country for a financial implosion, i do want to give some credit for for some of their other moves.

specifically, the relaxation of the trade restrictions with cuba is a great idea.  i'm not exactly sure what the thinking was when the embargo was put in place, but clearly it has not worked on any level.  people in cuba suffer because of a mostly insane government, but they suffer more so because of our misguided embargo that keeps their economy in shambles and keeps things as basic as simple medicine out of reach.  hopefully this is a pre cursor to something more sweeping with cuba.

additionally, while i understand that his hand was forced and the military deserves most of the credit, it still happened on his watch.  and the rescue of the ship's captain, at least at this point, seems like it was a perfectly executed operation.  hopefully, as i mentioned earlier, this will cause the US to take a larger role in policing that region of the world.

finally, i want to give props to obama for hosting a seder.  not only does this show a general open-mindedness and kinship with another faith, but i believe the lessons of the story of passover are important ones for the current administration.  now, which kind of son do you think obama was?