Yes, non-dumb people give this man their money. Photographer: George Gojkovich/Getty Images
Yes, non-dumb people give this man their money. Photographer: George Gojkovich/Getty Images

There's been a lot of discussion recently about why hedge fund managers get paid so much money.1 Curiously little of this discussion has involved asking the people who pay hedge funds all that money what they're paying hedge funds all that money for. Presumably they have some thoughts. This week Citi released a report on hedge funds in which they interviewed 138 investors, hedge fund managers, consultants and others, and -- well, they didn't quite ask that question, but they got some answers to it anyway. Those answers -- and much else in this report -- are fascinating.2

Why invest in hedge funds? Citi says, "since the [global financial crisis], confidence that hedge funds can outperform the underlying markets has been strained and that more emphasis has been placed on their role in controlling volatility." But investors are happy enough to pay for that. An endowment manager quoted by Citi:

The return expectation for hedge funds is really much lower than it used to be. We are overall pretty happy with the past five years of performance in our absolute return program even though it didn’t come close to outperforming the S&P. We really like the downside protection. The old days of always thinking about double digit returns from your hedge funds have gone.”

A private pension manager:

Sometimes to compound your returns, you have to implement a strategy where it is only going to be a fraction of the S&P returns but it gives downside protection.

Another:

The only thing that’s really changed for us in our hedge fund program is our need for downside protection. Upside is pretty easy to get, even in an equity market neutral strategy, but we are in need of downside protection to offset our beta risk.

Now you can find people who will dispute those claims, noting that hedge funds had some rough drawdowns themselves during the financial crisis, and that academic studies are not especially conclusive about how much protection hedge funds provide and whether it's worth what they cost.

But don't be too smug that these investors have just been tricked into paying for downside protection that they're not getting. Much of the Citi report is about how institutional investors -- pensions, endowments, etc. -- are no longer willing to treat hedge funds as black boxes, instead demanding the ability to measure performance against risk factors. They do this by demanding more transparency, and also by setting up separately managed accounts and "funds of one" that they control more directly, with the hedge fund manager acting as a sub-advisor for the institution's own assets. A private pension manager:

In co-mingled accounts, they are always like, ‘trust me.’ When I ask for an SMA and I turn it around on them and say, ‘Trust me. I’m not going to run stops on you. I just want to see how much the P&L moves on a risk factor basis.’ I just want to see if these guys are doing what they say they are going to do.”

And in fact many institutions "have built out their own toolsets" to examine risks and performance. Citi:

Having the ability to run better risk scenarios and perform factor analysis on hedge fund positions side-by-side with their broader set of portfolio holdings has been a key contributor to these investors being able to assess sources of beta and alpha across their hedge fund allocation. This has facilitated their expanded use in institutional portfolios under the risk-aligned portfolio model, helping to explain why hedge fund allocations have been spiking in recent quarters despite disappointing performance.

And a public pension manager:

We’ve been doing a lot of work building out our technology platform. We have built a CRM system tailored to hedge funds or plan sponsors. This should help us maintain our organizational knowledge in case of turnover. We have built our risk systems that help us run our portfolio. We look at the marginal contributions to risk and return. We look at the exposure overlaps as well as the position overlaps. We look at each manager’s return stream and determine how differentiated those return streams are.

The point is that (some) institutions don't just hand hedge funds money and hope for the best. They actually measure them -- sometimes on a position-by-position basis -- to see if they're performing as advertised. "Performing as advertised" doesn't mean "beating the S&P 500." It means correlating with the things they're supposed to correlate with, not correlating with the things they're not supposed to correlate with, and enhancing the institution's overall portfolio in a way that the institution can't (easily) replicate on its own.

Of course the institutions could be wrong, but they're not blindly wrong. They know what they're getting, and they know what they're paying, which ought to create at least a presumption that they're getting what they pay for.

Now, this trend toward careful performance measurement isn't universal, and other investors are less sophisticated. Citi also discusses the rise of hedge fund consultants: Many less sophisticated institutional investors outsource their hedge-fund allocation decisions entirely to consultants, who are good at due diligence but who tend to favor huge established hedge funds.3 And at the other extreme, hedge funds are creeping into retail, with "liquid alternatives" and other mutual-fund-y platforms to raise money from smaller and less sophisticated individual investors, who presumably don't have great analytics for measuring alpha.

Really, Citi's report paints a picture of an industry serving a bunch of different purposes, including small pure-alpha funds appealing to aggressive investors, medium-sized "boutique" funds that can appeal to institutions, big institutions with the infrastructure to support less sophisticated consultant-driven investors, and giant asset gatherers that are also set up to take retail money and essentially operate as general-purpose money managers:4

Never mind the fact that "hedge funds" have very different investment strategies; these are very different businesses. Two guys running $20 million of high-net-worth, levered-pure-alpha money out of their apartment have very little in common with a thousand-person institution seeking to minimize volatility on its $20 billion stable of hedge funds, institutional separately managed accounts and retail "liquid alternatives." Other than the fact that they can both call themselves "hedge fund managers."

Actually wait they have one other thing in common:

For all the diversification in business models, tiny funds and medium-size funds and big funds and giant funds all charge pretty much the same fees.5 The famous line is that "hedge funds are a compensation scheme masquerading as an asset class," and as the investing strategies and business models of hedge funds get ever more diverse, the compensation scheme still holds up as the one thing they have in common.

Last week my colleague Noah Smith said, "People often seem to treat the term 'hedge fund' as if it’s a shorthand for 'money manager of unusual skill.' " He objected: "'Hedge fund,' after all, is just a legal category." But one important lesson of this Citi report is that it's not. I mean, it is -- a hedge fund is, roughly, a pooled investment vehicle not subject to mutual-fund registration requirements -- but increasingly "hedge fund managers" are moving beyond that legal category, managing separate accounts for institutions and public mutual funds for retail investors. The hedge fund industry is not all that closely tied to the hedge fund legal category. It's just a bunch of money managers of unusual skill. Or, at least, a bunch of money managers who all charge similar fees.

1 The latest round kicked off with Institutional Investor's ranking of 2013's top-earning hedge fund managers, and this DealBook article noting that the top 25 managers made $21.15 billion and that they "earned that hefty sum in a year when most hedge fund managers fell short of the market’s returns." I pointed out that a lot of those earnings were just the managers' return on capital in their own funds. John Cassidy professed to be mystified by hedge fund manager compensation, and proposed eight theories for how they "get away with it." And my new Bloomberg View colleague Noah Smith suggested that high-performing early hedge funds may have encouraged lower-performing, but similar-fee-charging, imitators. There's a lot more but you get the idea.

2 Seriously, I am barely scratching the surface of stuff in this report; I recommend it. And it's just Part I of II; Part II "will explore the regulations reshaping the banks and revamping the industry’s financial plumbing." Here is a BuzzFeed story, and a Pensions & Investing story, about the report, particularly about its (rather optimistic sounding?) headline estimate that hedge fund assets under management are going to double by 2018.

3 Citi:

One criticism that has emerged about the industry's increased reliance on consultants is that too frequently these players equate "big" with "safe" and will push investors toward the industry's largest hedge fund managers. According to HFR, hedge fund firms with >$5.0 billion AUM have grown from accounting for 59.5% of the industry's total assets at the end of 2008 to 68.6% of the industry's assets at the end of 2013.

4 That's their picture. I kind of have no idea what the squiggly lines are up to. Also the "Gen 2" thing is an interesting digression about star employees of giant, closed-to-new-investors hedge funds who strike off on their own and quickly raise money from investors in the old firm who are excited to have a chance to put more money in.

5 I mean. Citi doesn't report performance fees, though it says "most in the industry would be quick to defend the 2% management fee and 20% performance fee structure as remaining in force." And it quotes a couple of investors saying things like, "We are not averse to using our substantial allocation size as a negotiating point on fees."

To contact the writer of this article: Matt Levine at mlevine51@bloomberg.net.

To contact the editor responsible for this article: Tobin Harshaw at tharshaw@bloomberg.net.