A couple of weeks ago, we examined the “rational irrationality” in the way that closed-end hedge funds are traded.  While you’d expect a flood of new hedge funds listings during periods when secondary market discounts were low; that was not always the case.  In fact, a lot of hedge funds IPO’d closed end funds during recent rough spots for the industry.

Our friends at Opalesque report last week from Monaco where Tarun Ramadorai of Oxford University was discussing his research into the field of closed end hedge funds.  Regular readers may remember Ramadorai from a post we published last spring on secondary market pricing data from HedgeBay.

At the time, we only discussed the endogenous factors that went into determining hedge fund discounts - recent performance, historical volatility, portfolio liquidity etc.  But there was one important exogenous factor that helps explain both closed end hedge fund and closed end mutual fund pricing: interest rates.

As this chart from Ramadorai’s 2008 paper clearly illustrates, discounts fall (premiums rise) when interest rates are down.  (black and green = closed end HF premium, blue = 3 month T-Bill rate, both on a scaled vertical axis) More…

Long-only equity strategies may have recouped most of their 2009 YTD losses, but there is little question the past year has left them with a volatility only their mothers could love.  The FT reports this week that UK pensions are “paying the price for an equity bias”.  Reports the paper:

“…UK company pension schemes are among the most heavily invested in equities when compared with employers based elsewhere. The average allocation to equities was 48 per cent at the end of 2008 - a figure that reflects the collapse in stock markets - and is higher than that in any other country where the private sector accounts for a significant proportion of pension schemes.”

At the same time, Hedge Funds Review points to a survey showing that pensions continue to allocate to equities.  Reports the magazine:

“On the issue of active management, 27% said their allocations to active management would be reduced.  A further 37% said they would increase their allocations but only if fee terms rewarded actual, not expected, out performance.”

Meanwhile, Pensions & Investments reports that European pensions are actually giving a “cold shoulder” to equities… More…

When I was in business school, I recall asking my accounting professor why stock prices change in the absence of any new information.  If stock prices really did represent the present value of future cash flows (an allegedly idiosyncratic number), then how could all stock prices crash in tandem - with little or no fundamental rationale?  It’s as if stocks weren’t simply a representation of a company’s economic prospects, but instead had demand and supply characteristics all their own.

This is essentially the question raised in an interesting article by Oliver Dietiker of the University of Basel called “Investor Irrationality and Closed-End Hedge Funds.”

Dietiker jumps right to the point in the opening stanza:

“The purpose of my study is to question the rationality of people investing in hedge funds (HFs). My investigation is based on the following simple proposition: it is irrational to have similar expectations about the future performance of different HFs.”

“How can he question the rationality of investing in hedge funds?” I hear you say (with tongue firmly planted in cheek).   He asks why the discounts or premia attached to new closed-end hedge funds seem to apply to apply across the board to supposedly idiosyncratic investment funds.  After all, if the whole hedge fund value proposition is to deliver uncorrelated returns, then how you apply beliefs about one group of funds to your forecasts for another? More…

The cast and crew of AllAboutAlpha.com are in Bermuda for part of this week and today I had lunch with some local dignitaries from the island’s highly respected hedge fund administration community.  The topic of fund liquidations came up as we discussed the phenomenon of hedge fund managers closing down one (underwater) fund only to open up another that does not have to make up for previous losses before it charges a performance fee.

I have not yet seen any hard research on this phenomenon, but it couldn’t be that hard to complete.  Like many facets of hedge fund manager behaviour, we often assume that the economic interests of a manager dictate reality.  The reality for many managers who close down may not be so bright.

But regardless, closing down an underwater fund is tantamount to removing a (hard-won and costly) fee discount that stands to accrue to investors.  After paying performance fees in the good times, investors expect managers to stick around in the bad times.

However, as we have seen in the past year, many investors also did not stick around in the bad times.  By redeeming their investments, those investors have voluntarily relinquished their right to a hard-fought performance fee holiday.

While some former hedge fund investors may have sworn off them for good, many who redeemed last year will likely re-invest in hedge funds in the near future.  In fact, a Barclay’s Capital report released last week predicted that asset inflows were just around the corner.  Like water in a child’s bathtub, it seems that assets slosh out of the industry only to slosh back in again.

Lipper predicted the same thing just yesterday.  As Reuters report: More…

The Wall Street Journal reports that the head of the Utah Retirement System is taking a stand on what he says are unfair hedge fund fees.  As the Journal reports, Utah’s Larry Powell has extracted “better fees” from 10 of the 40 hedge funds in which Utah has a direct investment.  In doing so, he has won fans in the institutional investing community, such as the head of the Illinois State Board of Investment, who told the Journal that:

“It’s a laudable effort and it’s the right time to do it…The current fee structure does not work going forward, at least not for the client.”

There is no question that this is a buyers market for (most) hedge funds.  That’s why it’s somewhat surprising that Powell is demanding so little. More…

With 2008 hedge fund performance figures coming in at around -15% to -25%, the inevitable question of hedge fund fees has bubbled back up to the surface.  It often seems that the underlying issue driving the backlash against hedge fund fees isn’t that they are a drag on returns or even that they aren’t commensurate with the value creation anticipated by the investors who agree to pay them.  Instead, it seems the backlash against hedge fund fees is often driven by the sheer size of the largest compensation packages of the most successful managers.

For many, the prototypical “2 and 20″ fee structure seems greedy.  And for many, hedge funds exemplify greed.  Therefore, hedge funds must have invented “2 and 20″ in the first place.  For example, this recent article by Dow Jones’ David Walker says:

“Hedge funds’ poor performance last year was bad enough to bring into question the fee structure that has been in place since Alfred Jones pioneered the investment vehicles soon after World War II.  He charged investors 2% of assets and 20% of any gains.”

In fact, Jones did not actually charge a management fee at all.  He only charged a 20% performance fee.  And he didn’t even cook up the idea himself.  According to Fortune Magazine’s Carol Loomis, author of a seminal 1966 article on Jones, the king of value investing himself used the same fee structure.  Wrote Loomis:

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If a penny saved is a penny earned, then a basis point saved is also a basis point (of alpha) earned.  So fees obviously matter.  That’s why consultancy bfinance recently polled institutional investors on their feelings about investment management fees.  To the sure disappointment of funds of hedge funds, the firm found that 60% of respondents thought the “value for money” they received from funds of hedge funds was “poor”.  In fact bfinance said that “not one said they get good value from FoHFs and only 40% say they get fair value.”

After the drubbing taken by funds of funds during the recent Madoff saga, this comes as no surprise.  But single manager hedge funds scored a little better with only 30% saying their value for money was poor.  Active long-only equity actually scored worse, with 31% saying their value for money was “poor”. (And according to this Reuters article today, funds of hedge funds aren’t the only ones facing renewed fee pressure).

Not surprisingly, passive long-only investing scored highest, with 70% saying that value for money was good and only 4% saying it was poor.  Global Tactical Asset Allocation (GTAA) funds scored lowest with 86% of respondents saying value for money was poor.

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Hedge fund incentive fees are often called a “free option” since the fund manager can win, but can’t lose.  Since managers can influence the volatility of their funds, many assume that this asymmetry will always give the manager an incentive to “swing for the fences”.

But with so many hedge funds starting off 2009 well below where they were a year ago, we thought it might be useful to examine whether this axiom holds true in the existence of the ubiquitous high water mark.  Last year, two academic studies published before most hedge funds took a dive under water address the impact of high water marks on manager incentives and decision making.  Now is probably a good time to have a second look at them.

The first, by Stavros Panageas of the University of Chicago and Mark Westerfield of the University of Southern California, finds that high water marks mitigate the manager’s potential benefits from goosing their fund’s volatility.  The duo points out that the value of the manager’s “free option” is based on the extent to which the fund is below its high water mark (or, to use the option analogy, below its strike price).  So swinging for the fences and losing has a direct impact on the wealth of the manager.

In a real sense, the “free option” is actually an infinite series of future (annual) options, each with new strike prices in relation to the fund’s value.

In their words:

“A bolder portfolio today could help increase the probability of crossing the current high water mark, but it will also increase the probability that the assets in the fund will be substantially lower next period, while the high water mark will remain unchanged. In the latter case the value of future options will decline, as the assets in the fund will be lower for the same value of the high-water mark. Hence, future options will become more ‘out of the money’.”

So lower moneyness means less value in the option for the manager - an outcome than can make a manager think twice before pointing to center field and taking that Babe Ruth-sized swing for the fences.

While Panageas and Westerfield’s study assumes the hedge fund in question has an infinite life span, the second study, by Susan Christoffersen of McGill University and David Musto of Wharton, recognizes that as small businesses, hedge funds fold on a regular basis.  Thus, investors who are below the high water mark can be shut out of their well-earned performance fee holiday if the manager unilaterally calls it quits.  This can mitigate the negative effect of high water marks on the value of the managers’ “free option”.

Christoffersen and Musto also point out that high water marks can divide investors according to their  tenure in the fund.  As they write,

“…with a HWM, old investment invests on better terms after a loss, because it does not pay the incentive until the loss is made up, whereas new investment has no loss to make up, and therefore pays higher expected fees. So if expected profits after a loss are zero for new investment they must be positive for old investment.”

This is going to be a big issue in 2009.  Most investors are about to embark on a year-long performance fee holiday (which, as an aside, will likely drop the average cost of a hedge fund in 2009 to below that of many mutual funds).  But new investors - or even new assets from existing investors - will face a high water mark of the fund’s NAV on the day of their new investment.

With dramatically different pay-offs, it’s not a huge stretch to imagine potential infighting among hedge fund investors as new entrants pay markedly higher fees than old ones.  The problem is that these “new” investors might just be those who have redeemed from other funds and have reallocated back to the asset class in the form of a different fund.  Just as loyal investors face the frustration of watching their manager give up as a result of  being too far below the high water mark, many other investors will likely frustrate their own chances of success by switching horses - only to have their high water marks reset.

Last week, Peter Douglas wrote on this website that growing competition in the hedge fund industry would lead to what he called “fee differentiation”:

“Investors will be in control, given the new scarcity of investment capital. 2&20 may be the sticker price, tho’ some new funds may go for a more conciliatory 1 & 20, but the effective pricing of investment strategies is likely to disperse dramatically, through the use of separate accounts, co-investment rights, and advisory contracts, as well as through simple fee rebates.”

Douglas is suggesting that the industry will move beyond the one dimensional view of compensation (low to high) and begin to trade off certain aspects of fees with other factors such as co-investment rights.

Last weekend, the FT quoted a hedge fund administrator who seemed to share Douglas’ view.  John McCann of Trinity Fund Administrators told the paper:

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Cynics often describe the hedge funds not as a unique asset class or investment strategy, but as a unique “fee structure“.  To some extent, they are correct.  After all, mutual funds now use hedge fund strategies (long/short, 130/30 etc.) and yet we still call them mutual funds.  Conversely, many hedge funds pursue high-beta long bias (a.k.a. mutual fund) strategies, yet we still refer to them as hedge funds.  And indeed, one of the main regulatory differences between the two types of funds is the ability to charge a performance fee.

Hedge fund fees are generally viewed by the media with a jaundiced eye.  Many people have expressed frustration that hedge fund fees don’t seem to budge - even as hedge funds have been producing lackluster absolute returns.

Take 2008 for example.   A recent study by Eurekahedge recently found that 90% of hedge funds are currently below their hurdle rates or high water marks and are therefore at risk of earning no performance fee this year.  And that was only as of July 31.

As Financial News reports:

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