Criticism of hedge fund fees misses the point

Hedge fund fees are a joke. Often, so is the criticism of hedge fund fees. Take the faux outrage that greeted last week's Institutional Investor announcement that the world's top 25 hedge fund managers took home $11.6 billion in 2014.

An average pay packet of $467 million certainly seems crazy, especially as half the group actually underperformed the S&P 500.

However, it misses the point. The top earners were already enormously rich men managing huge fortunes.

"If you start with a $5 billion fortune and make 10 per cent on your money, you just earned $500 million according to this list," said hedge fund manager Cliff Asness.

Additionally, many managers were investing their own money. Looking at the top 10 investors, more than two-thirds of their gains came because their own investments grew. Fees were of secondary importance.

The same managers will be on next year’s list – they’re bound to be, as even minor percentage gains equate to huge dollar gains when you’re a billionaire.

In other words, the 2014 rich list doesn’t prove hedge fund managers are scandalously overpaid (even though they are).

It simply proves that “one way to make a lot of money is to start out with a very large fortune and make any non-trivial positive return on it”, as Asness quipped.

Thinking otherwise is “a triumph of sensationalism and bad math over sobriety”.

Fear expensive markets?

Federal Reserve

chief

Janet Yellen

last week cautioned that stock valuations were “quite high” and pose “potential dangers”. She’s right, but that doesn’t mean a market peak is near.

It's true that overvalued markets in 2000 and 2007 were followed by crashes. However, former Fed chairman Alan Greenspan famously warned in 1996 of investors' "irrational exuberance", only for stocks to continue soaring for another four years.

Money manager and blogger Ben Carlson recently looked at the 12 major market peaks since 1961.

No obvious pattern emerges: stocks were expensive when they peaked in 2007, extremely expensive at the 2000 market top, dirt cheap when they cratered in late 1980 and fairly valued at various other cyclical tops. Dividend yields ranged from 1.2 per cent to 4.5 per cent.

High valuations indicate future long-term returns will be subdued.

Calling a top on the basis of valuations, however, is another matter entirely.

Oil and the magazine indicator

Investors have been taken by surprise by surging crude oil prices, which have risen 50 per cent in recent months.

Contrarians, however, saw this one coming. Time magazine’s January 22nd cover story – ‘Cheap gas: How long can it last? How low can it go?’ – was a perfect example of the magazine cover indicator, the idea a major investment trend may be ending if it starts featuring on the cover of popular magazines.

Time has form in this regard.

Its June 2005 cover, 'Home sweet home: Why we're going gaga over real estate', marked the top of the US housing bubble. 'Will you ever be able to retire?', it asked in mid-2002, near the bottom of the worst bear market since the Great Depression. It named Amazon's Jeff Bezos 'man of the year' in December 1999, months before the dotcom crash.

It’s not just Time: research confirms that contrarians are right to be suspicious of mainstream magazine covers in general.

That's why the latest Barron's cover – 'China: The world's hottest stock market' – is worth noting.

Sell!

More bubble trouble in China

Talking of China, nothing exemplifies the recent market madness better than the case of online video stock Beijing Baofeng Technology.

The company debuted on the Chinese stock exchange in late March.

It immediately jumped by 44 per cent from its offer price, the maximum allowed by Chinese regulators.

On the next day, it rose by the daily limit of 10 per cent. Another 10 per cent rise followed the next day. In fact, shares rose by the daily maximum of 10 per cent for 29 consecutive days.

Last Wednesday, the unthinkable happened: a single-digit share price rise. Normal service resumed on Thursday, the stock jumping another 10 per cent. It’s now worth almost €3 billion, having soared some 1,600 per cent in little over a month.

The madness of crowds is a sight to behold.

Return-chasing kills investors Everyone knows the line about past performance being no guide to future results. Do investors heed this warning? Should they?

According to a new study examining Italian investor behaviour over the 1999-2014 period, investors ignore the disclaimer, investing more when stocks have risen and less when returns have been poor.

Such behaviour is disastrous. The study found return-chasing underperformed buy-and-hold investments in Europe and the US by up to five percentage points annually.

Add in transaction costs as well as funds’ entry and exit fees, and the real difference is likely even larger. See http://goo.gl/Y1qgOL