Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [34]
In finance, the good do not die young and they do not go on the lam. Like Warren Buffett, the good are usually long-term investors and live to a contented ripe old age.
Hedge fund managers may invest their own money in their funds thereby claiming their interests are aligned with their investors.Yet are they really aligned? Many managers and employees of smaller hedge funds are not as wealthy as the investors, but they would very much like to be. After all, they reason, if they are taking the risk of working for a hedge fund, they should get paid for it.
How much should hedge fund employees get paid? Senior risk managers at investment banks get paid in the high six figures. A well-known bank hired a second-tier compliance officer for $800,000 per year. Structured credit researchers got paid anywhere from the high six figures to $2 million per year. A mediocre senior investment banker will earn around $2 million per year, and a good one can earn much more. But many beginning hedge fund managers can only aspire to this compensation.
Many hedge funds are small, undercapitalized shops that have an “investors only” Web site. If a fund rents offices, purchases computers, phone systems, reporting systems, trading systems, hires staff and retains accountants, it may not break even on the 2 percent annual fee unless it has several hundred million dollars under management. The trouble is, if a manager’s results are not good, investors will run for the exits.
The strategy reminds me of a bridge saying I sent Warren about having a 50-50 chance your play will win while expecting it to work out 9 times out of 10.
The temptation is to lever up just for the sake of making a lucky bet so that the 20 percent fee on the upside kicks in to keep the fund solvent and keep investors happy. But can you trust that leverage is employed for the right reasons when the fund is feeling a cash crunch? Is it any wonder they want a waiting period to return your money?
Overcrowding makes most hedge fund strategies look very unattractive. Many hedge funds are merely shorting (selling) volatility to earn risk premiums, selling options in a low implied volatility environment and selling credit default protection in a skinny credit spread environment, or using investment banks’ financing to make a bet on the market. In other words, underperforming hedge funds often resort to leverage in a gamble to inflate returns.
It is as if they are the young boy in D. H. Lawrence’s story “The Rocking-Horse Winner,” who gets visions of the winners of Ascot’s horse races while madly riding his rocking horse. At first he wins enough money to pay off the family debts, but that is not enough, the household goes mad with greed and he must keep riding to produce winners until he dies of exhaustion. “Although they lived in style, they felt always an anxiety in the house. There was never enough money.” After the boy’s initial bet wins, the house seems to say: “There must be more money, there must be more money.” When the boy wins even bigger, the voices become louder and more urgent: “There must be more money! There must be more money!” The boy asks his emotionally bankrupt yet greedy mother about luck and she responds: “I don’t know. Nobody ever knows why one person is lucky and another unlucky.” The boy manically rides the rocking horse “Now! Now take me to where there is luck! Now take me!”The voices in the house rise to a frantic pitch: “There must be more money! Oh-h-h; there must be more money. Oh, now, now-w! Now-w-w—there must be more money!—more than ever! More than ever!” The boy eventually dies of nervous exhaustion and his uncle mourns: “eighty-odd thousand to the good . . . But, poor devil, poor devil, he’s best gone out of a life where he rides his rocking-horse to find a winner.”32
Warren avoids leverage.