Category: Economy & Markets

Where are hedge fund fees headed? As a (careful and selective) investor in hedge funds, I frequently find myself grappling with how to justify their fees. And the answer is most times, I cannot. Indeed, we routinely screen out 2% and 20% funds. What is a fair level? My feeling is that 1% and 10% does not sound like a bad answer. But it sounds unrealistic.

Did you know, however, that in the early days of hedge funds, the General Partner paid itself 20% of profits full stop. That’s right, no management fee, just a share of profits. And the General Partner was often a significant Limited Partner as well. So, the General Partner’s payoff was simple. In a profitable year, he took 20% of profits. In an unprofitable year, he lost money as Limited Partner. That sounds aligned.

I discovered this reading Carol J Loomis’s January 1970 article in Fortune magazine, “Hard Times Come to the Hedge Funds”. She was reflecting on the impact on the nascent hedge fund industry of its poor performance in 1969. She described the shock felt by investors who had thought that hedge funds hedged.

As well as talking about the impact on investors, she also described the impact on General Partners who had made no money. Some of them had started talking about paying themselves a salary as well as taking the 20% profit share in order to deal with years when the profit share was zero. Now, to a twenty-first century investor paying 2% and 20%, a salary and 20% sounds a better deal.

Indeed, the idea of paying the reasonable costs of a hedge fund manager and then letting them take a profit share sounds the best bet. But having looked at projects that were based on passing through cost, I know how tricky it becomes. As an investor, you become embroiled in questions of what is and what is not a reasonable cost. Better to keep it simple and go for a modest and sensible 1% management fee. In exchange for this, however, the performance share should be closer to 10%.

Will we get there? It is certainly possible. Is it probable? Well, I don’t think it is improbable.

Going back to Loomis’s article, she notes that Warren Buffett was closing his Buffett Partnership despite having had a profitable 1969. She says that he had “a strong feeling that his time and wealth (he is a millionaire many times over) should now be directed toward other goals than simply the making of more money.” Despite being close to Buffett, she got this wrong or was, at least, premature.

Since 2008, policy-makers in the OECD have consciously decided that they prefer to have bank stability even if this means instability in capital markets. They have concentrated regulation on stabilising financial institutions by curtailing their participation in capital markets whether as long-term owner or trader. They have not explicitly said that they are willing to accept greater instability in capital markets. Instead, their message is that they want capital market participants really to bear the risks implicit in the returns they hope to make and not to lay those off, via the banks, to the public purse the moment the risk looks like serious downside, rather than upside, risk. But the result is that capital markets will be less stable at moments of stress.

You might argue that 2008 showed that you could have both unstable banks and unstable capital markets, which is true enough. The damage endured by capital markets would, however, have been worse had the banks not absorbed significant losses, which were, through state guarantees, transferred to taxpayers. Defenders of the bank bailouts will point out that, overall, realised losses on the rescue were modest and even negative. Regulators retort that this was true ex post but was not evident ex ante and makes no allowance for the reputational damage of bailing out capitalists. And, anyway, if it ended so well and was such a good trade, why don’t you, the capital markets, next time carry the temporary losses.

They want banks to avoid risk of loss in the first place – less involvement in capital markets. And, in the event of loss, they want shareholders and creditors of financial institutions – capitals markets – to take as much loss as they can. They have tried to make sure that taxpayers only have to intervene at the very last resort when the reserves of the capitalists have been seriously depleted or exhausted. It is just harder for institutions to trade or and hold some types of securities, particularly those with greater risk of loss.

Capital markets participants are warning regulators that the diminished liquidity seen in markets is a result of the re-regulation of financial institutions, which implies that regulators are unaware of the consequences of their actions. They are aware. Prior to 2008, regulators and policy makers did not think there was a trade-off between the stability of capital markets and the stability of institutions. Now that they know there is, they have opted to ensure bank and insurance company stability by curbing their activity in capital markets. The other option available to policy-makers was to withdraw or water down the state guarantee. They did not do this. Indeed, they have rather reinforced it by their evident pre-occupation with the consequences of it.

Policy-makers are telling us they care about retail financial services. They do not want the payment system, retail and corporate credit or private and business insurance damaged by capital market losses. They also care about their own sovereign credit markets although, given the central banks have had such practice with QE, they should find it easy to maintain liquidity in those markets. Spot fx and commodity trading may also fall into activities that can be defended as necessary for the “real” economy. But, thereafter, I wonder. Futures, corporate bonds and structured credit, equities, derivatives: would policy-makers be able to make a case to save such speculators?

This is probably right from a first principles public policy point of view. Capital markets are there to underwrite risk. Why should state guaranteed financial intermediaries reinsure the risks of the risk underwriters? There are those who disagree and feel that the price of stable financial markets – periodic losses to the taxpayer and unequal income distributions – are worth paying for the broader economic benefit. But, regardless, to me, it is clearly politically necessary. One of the many causes of the apparently global current of anti-establishment sentiment (along with social media, less hierarchical culture and and) is the sense that the establishment is an accomplished player of heads I win, tails you lose.

So what? There is a trade-off between the stability of financial institutions and the stability of financial markets. Regulators know this and have made their choice. In the event of crisis, investors should be prepared to expect little intervention except in areas that relate directly to the real economy.

Thomas Piketty worries that levels of private wealth are high, rising and unequally distributed, and public wealth is low. This voice from the left says that public policy is needed to curb this growing inequality. At the same time, voices from the right worry about the still very high levels of debt in the global economy and in individual countries; we are borrowing our way to ruin. But aren’t these things the two sides of the same balance sheet? Is not debt high because wealth is high?

Piketty measures private wealth as a multiple of GDP. We are at present around five times GDP in the big Western economies. His summary of the historical time series suggests that this is high and in line with previous historic peaks, such as the late nineteenth century when private wealth reached five to six times. The European catastrophe of the first half of the twentieth century saw it fall sharply. His concern is that since returns on wealth (or investment returns) are larger than GDP growth, so private wealth as a multiple of GDP will grow. And, what’s more, it will be concentrated in fewer hands.

Yet, every quarter, I look at tables of the total stock of debt of certain countries compared to GDP. Generally, levels have fallen since the crisis but, compared to the long term, are higher than they have ever been. Those of a conservative economic disposition fear that these remain unsustainable levels of debt, which, one day, will ignite and blow up the global economy. Piketty worries we are getting too rich, conservatives worry that we shall soon be poor.

Putting aside who is right and which is the most worrisome, they are both the same problem. Gross levels of wealth in the global economy have risen enormously – relative peace, technology based productivity gains, end of command economies. Debt levels have risen commensurately. But the net wealth position has also risen. We have a great deal of wealth, we have a lot of debt but the net position is, for the moment, good.

Lower petrol prices could well lead to higher insurance premiums: one example of how relative prices will change as oil prices fall. Consumers will enjoy more disposable income released by lower energy prices, be they at the petrol pump or in household heating or lower prices for goods, including food, with high energy content. One reasonable guess at what they will do with the spare cash is that they will use their cars more.

If you make the reasonable assumption that accidents are accidents, then if you drive more, you are more likely to have an accident. Moreover, if everyone else is driving more and car density, users on the road, goes up, you are yet more likely to have an accident. So, we are likely to see more accidents. More accidents means more claims on the car insurers who, having to pay out more to drivers, will start making less money, and perhaps losing money, on their car insurance businesses. So, insurance premiums will have to rise simply to cover the cost of more accidents and more repairs.

There may be an additional element. if there are more accidents, there will be greater demand on garages and body shops for repairs. In the short term, at least, they are likely to put up prices to deal with demand. It is possible, at the same time, that these garages will anyway be busier because more driving will also mean more repair work arising from greater wear and tear. So the car insurers will not only be facing more insurance claims but possibly more expensive individual bills from the garages.

This is not to say that the disinflationary impact of lower energy prices will be balanced by price changes in other areas. More that the effects of the fall in the price of oil, if sustained, will reverberate for a while and may cause some upwards price changes in other areas. It will take a while for this to work through.

I also feel this illustrates, how the fall in energy prices might enhance economic velocity. In the high oil price world, consumer dollars were exported to the oil producing countries who would accumulate surpluses, deploy them into the international financial system whence they would eventually work their way back to deficit accumulators. It was all a bit cumbersome. In the new world, consumer dollars are instead spent on highway restaurants, car maintenance and insurance premiums, or other goods and services. These businesses will still accumulate surpluses – profits – but on smaller scale and more likely to be deployed through the local or regional financial system: a more nimble and reactive system.

If oil prices stay low, real interest rates should start to rise. If, indeed, real yields do start to rise, it matters for global investors since US government asset prices are a floor for many markets. In the round, it will tend to move capital from low yielding and carry-trading activities to high return ones. Why would you put up with a few percent yield on a real estate asset if the US government is paying the same return net of inflation and no risk?

A favourite chart of mine is the regression of oil prices against the yield on US TIPS. It shows a clear and significant inverse correlation. That is, real yields are high when oil prices are low and vice versa. Real yields were above 4% in the late ’90s, when oil was down towards US$10, and they started falling as oil prices rose through the early and mid noughties. During the financial crisis, oil prices fell as real yields rose and then this reversed when oil prices recovered while real yields became negative. It is noteworthy that yields started rising a little before oil prices started their recent fall.

(TIPS are US Treasury Inflation-Protected Securities, the equivalent of indexed linked gilts. If you own a TIP, the US government pays you inflation plus a yield. This yield is therefore a real yield since it comes on top of inflation.)

The question is how are oil prices and real yields linked. My view is that it is all about surpluses. If oil prices are high, it generally means that oil producers are accumulating surpluses – Russia, Gulf states etc are receiving dollars for this oil. They have to re-cycle this surplus back into the oil-consuming countries. The problem is that it is, for a bunch of reasons, very difficult efficiently to re-invest that capital back into productive activities in the oil-consumers.

First, the oil exporters worry that the good times will not last so they put some capital in central bank reserves, which tend to be invested in safe, low yielding US and European government debt. Second, it is just plain hard for a few people sitting in the Gulf, smart and well-intentioned though they be, to decide the best place to invest money. Third, some of the surplus anyway ends up in unproductive outlets, such as luxury assets. Finally, there are high transaction costs for oil exporters to re-invest in oil consumers. There are lot of intermediaries along the route travelled by the re-cycling dollars all of whom have to be paid.

Consider the alternative. If there were low oil prices, there would be no surpluses. Rather than lots of US dollars ending up in a few hands in the oil producers, they would end up in the oil-consuming nations spread among many hands. All other things being equal, these dollars are more likely, in this fashion, to be more efficiently deployed.

In fact, the oil surpluses are a subset of the wider surpluses that were accumulated by the big exporters, including Germany and China, during the 2000s. The Chinese and German trade surpluses had an energy component. The petrodollar surpluses were not just about Western demand. China was importing oil in order to manufacture goods to sell to the West and still accumulating huge net surpluses. The strong negative correlation between oil and real yields arises not just from the inefficiency generated by oil surpluses but from the inefficiency of the web of imbalances in the global economy. Just imagine how difficult it was for the central bank of China to re-invest the trillions of dollars of reserves that it had accumulated.

These global surpluses are in decline. China is restructuring of its economy from production to consumption and Germany is unable to sell as much as before to the Eurozone periphery. So, to some extent, the fall in oil prices is an aftershock of falling trade imbalances but it is a useful marker for this broader trend and what it means, in due course, for real yields.