David Merkel: Investment Partnerships vs Hedge Funds
January 6, 2011
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An interesting piece today from David Merkel. David currently runs The Aleph Blog and is in the process of setting up his own firm. Previously he was the Chief Economist and Director of Research of Finacorp Securities, a senior investment analyst at Hovde Capital and leading commentator at the investment website RealMoney.com.
He has some excellent thoughts on aligning the interests of managers and clients and why hedge funds may not always do this. Also, very interesting comments on shorting as a source of alpha. From my understanding here – and reading some of his other writing – he is not talking about hedging via short positions but more-so a general short-biased strategy.
The entire post is below or you can click over to read it at David’s site. Reprinted with permission.
Incentives Matter, or, Why I Didn’t Set up as a Hedge Fund by David Merkel
I didn’t set as a hedge fund for a reason. First, I changed my mind from prior plans, and wanted to serve people below the top 1% of society, as well as those above, and institutions. But there is another set of reasons that is more fundamental.
My view is that requiring a manager invest almost all of his spare assets in his strategies is a far more effective means of aligning interests than a performance fee, because it discourages taking undue risk. It’s the same reason why Wall Street worked a lot better when the firms were all partnerships, and not offering performance incentives to employees. I’m with Buffett on this one, which is why I set up my firm the way I did – 80%+ of my liquid assets are in the strategy. Buffett started with more of a hedge fund structure, and ended up running a corporation where most of his assets were invested. That provides alignment of interests, while acting to limit the downside, which I think are the goals of most investors.
Beyond that, I think shorting is a difficult way to make money. Double alpha sounds wonderful in theory, but is really difficult to do in practice. Common risk control works for long investments — as investments rise, trimming them locks in gains and lowers risks. As investments fall, their ability to hurt diminishes. Downside is limited, and upside is unlimited.
With shorting, upside is limited and downside is unlimited. I can’t tell you how frustrating it is in working for a hedge fund when a large short moves against you. You might be right in the long run, but can you survive the short run? As a short goes wrong its impact gets larger, versus when a short goes right, its impact diminishes.
This is why I think alpha-is-the-goal shorting is very difficult to do. My suspicion is that the average hedge fund that tries it loses, which is why bear funds rarely attract assets, even over a decade as bad as the last one. Also, hedge fund fee structures encourage undue risk taking. I did not set up as a hedge fund partly out of my last hedge fund experience, where I saw that risk control is almost impossible to achieve on the short side in a concentrated portfolio.
Part of the problem rests in the concept of the credit cycle. The best time to be a short is when the negative phase of the credit cycle arrives. Aside from that, you are wasting your time being a short. But who can wait for that time? The optimal portfolio would be long during the boom phase of the credit cycle, and short during the bust phase. That is tough to do, but at least it helps to know what the goal should be. For me as a long only manager, it means taking more risk when credit spreads are tightening, and less when they are falling apart.
I am not out to make a fortune for myself, just enough to support my family. If more comes beyond that; that’s fine, but I am not aiming for that. Money for me is not my main goal, rather, I will not be happy at all if my clients do not do well. I abhor the idea of being a sponge off of the assets of others. I want to earn my own way for clients. Lord helping me, I will do that.
UPDATE: One more note. I say “I eat my own cooking.” Hedge funds might say (after the truth serum was administered): “We eat lots of our own cooking when we succeed, much less when we don’t.”
Incentives matter. Do you want asymmetric (but still positive) goals for your managers, or do you want them to genuinely lose money if they fail? The hedge fund structure offers a free-ish option to the managers — after all, much like mutual funds, they can start a new fund if the first one fails. Eventually some fund will achieve a performance incentive.