DeLong: Hedge Fund Comp Fine for Top 20, Silly For Everyone Else

Brad DeLong concludes that the top hedge-fund managers--Simons, Soros, Lampert, Cohen, etc.--who took home an average of $240 million apiece last year (per the New York Times) may have earned their money, but that the average hedge-fund Joe who banked, say, $500,000 to $50 million, almost certainly did not.  No argument here.

The average hedge-fund Joe is a brilliant 25-40 year old with great breadth of knowledge, great information, great speed, and a proven ability to out-trade his or her competition more than, say, two-thirds of the time.  Unfortunately, beating the competition two thirds of the time doesn't come close to offsetting the costs of this trading and the gigantic sum (two and twenty) that said hedge-fund Joe will take home at the end of the year.  Although the hedge-fund Joe's clients, therefore, will likely be impressed with his/her insights, they are also likely to be made poorer by the deal.

DeLong:

Not at the top, further down the food chain, however... it is a mystery how the hedge funds staffed by very smart and hard-working people who nevertheless do not seem to have much of a risk-adjusted edge over the market indices nevertheless collect fees of 2% of assets and 20% of returns each year:

One theory is that is is a disequilibrium phenomenon, and that market entry by those who promise to produce whatever alpha the typical hedge funds achieves and to produce it with lower fees will drive down the compensation structure:

A second theory is that the 2-and-20 fee structure is a sociological fact embedded in the social network of midtown Manhattan and the City of London, and will stick--a modern-day equivalent of Fidelity Investor Services. For a generation, investors in Fidelity funds received net annual returns of S&P - 2.5% + noise, as high fees plus the price pressure that Fidelity generated against itself by herding with the Wall Street crowd took their toll. By contrast, investors in Vanguard received net annual returns of S&P - 0.6%. The gap compounds: Over 35 years Vanguard investors double their relative wealth. This gap drove John Bogle insane. But it did persist.

A third theory, related to No. 2, is that most hedge-fund investors just don't know how to evaluate the services they are receiving and/or are so focused on near-term performance that they are willing to trade away pots of long-term money for a chance to outperform during the next downturn.  My money's on No. 2 and No. 3.   

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