This content is from: Portfolio

What Pirates Can Teach Us About Hedge Funds

With a little thoughtful analysis, investors would likely abandon the narrative that hedge funds are swashbuckling marauders. It might even lead them to treasure.

When I was 7 years old, I began having a recurring nightmare about pirates. In my dream, headless pirates sailed down the neighboring city-maintained swale and discussed how they were going to cut off and steal my family’s heads. Never mind that there was zero moving water, let alone enough to sail a ship, in said gully except in the roughly 25 minutes following a torrential downpour. And let’s ignore the fact that the drainage ditch originated a mere 20 yards away at the home of Mr. and Mrs. Hall — who were not, to the best of my knowledge now or then, pirates or sponsors thereof. We should also overlook the fact that the pirates were with no heads (and therefore no mouths) loudly discussing their head-swiping mission.

But none of that mattered to me at the time. I had that dream over and over again for years and eventually became terrified of pirates. Even while watching Pirates of the Caribbean years later at the ripe old age of 35, my sister paused the film to ask my mom if she thought it was okay for me to watch, given my well-known fear of swashbuckling.

It was. Decades older and in possession of facts that eluded my childhood self, for me pirates had morphed into eyeliner-wearing fictions, with the occasional Somali ransom demander thrown in for good measure. Isn’t it funny how a little data can transform something that seems so treacherous into something quite benign?

Which is why it seems like we all need a little fact-finding about hedge funds right about now. In recent weeks hedge funds have been repeatedly named as the bogeymen under our collective beds. Here to steal from the poor, make themselves rich, wreck companies, and single-handedly prevent the U.S. from balancing the budget, they are modern-day economic pirates, hellbent on destruction.

Or maybe not. For example, when Donald Trump released his single-page tax plan on April 26, it failed to mention closing the carried-interest tax loophole for hedge funds, an oft-repeated promise of his campaign. As per usual, his surrogates rushed the next day to ensure the public that carried interest was still on the chopping block. So how much does the U.S. stand to gain by closing the carried-interest tax loophole? Eighteen billion dollars. Over ten years. And yes, that was billion with a B. While this is certainly no small chunk of change, it’s less than 1 percent of the interest payments the government is projected to make over that decade. Carried-interest revenue is enough to pay for six out of ten years of community block grants, which one could morally argue is a good use of fund manager profits, but the bottom line is it isn’t going to eliminate the federal deficit or save Social Security. If those are the goals, tax reform will need to be more comprehensive than the type that generates budgetary sofa change.

In addition to driving the U.S. into bankruptcy, it seems hedge funds are after the average Joe too. For the amount of ink they get, you’d think that activist hedge funds encompass the bulk of the alternative investment universe, and that they spend their time fleecing poor retail stockholders left and right (at least according to a new paper by Leo Strine and recent remarks by Warren Buffett). But activist hedge funds comprised only 4 percent of hedge fund assets under management through the first half of 2016.

And retail shareholders? They’ve been on the decline since the 1950s, falling from more than 90 percent of all shareholders to about 30 percent in 2016. Oh, and the top institutional shareholders in 2016 (and in the four years prior)? Vanguard, Fidelity, State Street, and BlackRock. There’s nary a hedge fund name among them. Altogether there were about 300 publicly announced activist campaigns in 2015, with roughly 10 percent of those undertaken by the three most active of the activists, all hedge funds. Activist efforts included campaigns to boost shareholder value, as well as some targeting corporate governance, environmental, and other issues. So has no hedge fund ever pillaged and plundered at retail shareholder expense? Perhaps, but those kinds of forays may be significantly overstated.

Finally, hedge fund fees aren’t the oft-stated “2 and 20” and never have been. When I looked at fees for PerTrac in 2010, I found average management fees ranged from 1.35 percent to 1.65 percent, based on launch data between 2000 and 2009. Recent data suggests management fees fell from their 2009 high to an average of 1.39 percent in 2016. Performance fees are also lower than many might expect: My PerTrac research showed them topping out at just over 19 percent on average for funds launched in 2007, and newer data suggests they fell to an average of 16.7 percent in 2016. Sure, you can pay less for passive management, but I’d suggest that is more of an asset allocation discussion than a fee debate. I won’t even get into misconceptions about performance. As many times as I’ve written about it, that particular ship must have sailed.

So you see, as it was with the infamous drainage ditch buccaneers of my youth, sunshine is the best disinfectant for many of the horrors of hedge funds. But while my pirate phobia merely kept me from watching The Goonies until I was in my early 20s, the collective angst and misinformation about hedge funds could keep investors from making rational asset allocation decisions and cost us all some booty.

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