Red flag pay day for hedge funds

Financial Review

PUBLISHED: 05 Apr 2012

Anna Bernasek, New York

The sums are staggering. The highest-paid hedge fund manager in the United States hauled in $US3.9 billion in 2011. That’s right, billion. The runner-up made $2.5 billion and third place raked in a mere $2.1 billion. Those figures approach the kind of numbers major US corporations employing tens of thousands of people can earn in a good year.

Yet 2011 was a bad year for hedge funds. In fact, it was the worst year since 2008, when financial panic spread across global markets. Although the S&P market index rose 2 per cent in 2011, the average hedge fund lost about 5 per cent, according to Hedge Fund Research.

That’s not supposed to happen. In theory, at least, hedge fund managers are entitled to get paid eye-popping fees because they don’t just beat the market, they are expected to trounce it.

To be fair, as a group the highest-paid hedge fund managers’ earnings dropped by about 35 per cent last year, according to a survey by AR magazine. But that means the top 25 hedge fund managers still earned a collective $14.4 billion, averaging $576 million each.

Are they really worth all that?

Hedge fund pay seems strangely out of line with that of the rest of finance, and that’s saying something. Wall Street’s bankers are not typically shy about claiming big bonuses.

Jamie Dimon, chief executive of JPMorgan Chase, is among the most powerful and respected of America’s bankers. In 2010 his total compensation was $23 million and he’s expected to earn about the same for 2011.

Compare that with chief executive pay across all industries. The average CEO of a top-100 company in the US is worth about $12 million, according to pay consultants. That includes everything: salary, bonuses and the value of stock and stock option grants at the time of the grant.

Of course, corporate America can afford to pay its top performers a lot more than the average worker. But no mere chief executive gets anything near the pay hedge fund managers earn. Take Ford, which posted a $20.2 billion profit last year. It recently announced that its chief executive, Alan Mulally, earned $29.5 million in total compensation for the year.

However, it’s tricky to compare hedge fund pay with executive pay more broadly. For a start, hedge fund figures include not only the fees managers earn from running the fund but also gains from their own holdings in funds they manage. Since fees are not broken out separately from fund gains, it’s a matter of guesswork to figure out how much pay comes from outside investors. As well, the data on hedge fund pay is not consistently available. Hedge fund managers are not required to disclose pay details, so there is no industry-wide metric.

We are left to look at each hedge fund case by case. One might ask, how did the highest-paid hedge fund manager last year, Ray Dalio, earn $3.9 billion? With about $120 billion under management, the firm Dalio helped found and now runs achieved a 16 per cent gain in its main fund last year. Remember, the broader market returned only 2 per cent last year, so a 14 per cent outperformance is a very good result. The question is whether, adjusted for risk, that return deserves a payday measured in billions.

There are other managers who performed in line with the market. Take Paul Tudor Jones. While his main fund did no better than the S&P, he got $175 million.With that kind of performance, it doesn’t make sense to pay a premium fee.

None of that would matter if investors reaped rewards over the long haul. Yet the latest evidence suggests that might not be the case. A New York Times analysis of public pension fund investment in hedge funds shows that over a five-year period, hedge fund investors did not fare very well.

The study looked at the public pension funds with the largest proportion of their portfolios in alternative investments and compared the results with funds with the smallest stakes.

The 10 funds with the highest share of alternative investments returned 4.1 per cent on average over five years. That’s more than a full percentage point less than the 5.3 per cent average gain for the 10 with the lowest share of alternative investments. All their efforts to get into non-traditional pension investments didn’t pay off.

But just because it didn’t pay off doesn’t mean the funds didn’t pay for the “help”. Fees paid by the funds in the group that plunged into alternative investments were four times those paid by the funds that steered clear.

The New York Times analysis highlights that there’s a lot we don’t know about the details of hedge fund performance and pay. So long as funds are not required to report their details, the public, and perhaps even hedge fund investors, will be left to guess whether compensation is way out of line. But even without all the details, you can see red flags. In fact, you can see billions of them.