You asked about hedge funds. Columbia University professor Wei Jiang has delivered, with a first round of answers. We'll be posting more questions and answers in the days to come. For now....

In the last few years a number of the new names to Fortune's "Richest people" list were hedge fund managers. All of the people on the list had over $1 billion net worth. Why/how are the hedge fund managers raking in so much money? Are their earnings stable/permanent, or might they evaporate like so much other "wealth" has lately?

Prof. Jiang writes: A hedge fund manager is compensated with both management fees (as a percentage of assets under management, 70 percent of the hedge funds charge between 1 percent and 2 percent), and a performance fee (as a percentage of returns in excess of benchmarks -- more than 60 percent of the hedge funds charge between 20 percent and 25 percent). The 10 largest hedge funds managed more than $20 billion dollars in 2007, and in a good return year, these people indeed can be loaded.

However, there are more than 10,000 hedge funds in the U.S. , and only a handful of the hedge fund managers made to Fortune's list. The median hedge fund managed less than $100 million in early 2007 (before the trouble started), and the median hedge fund barely beats the benchmark (because it cannot be that everybody is above the average, which is the market return). A median hedge fund would earn a total fee close to $2 million, with which it would have to cover system cost, research, and salaries (of a whole team), etc.

Personally, I don't believe the exorbitant earnings of some hedge fund managers are permanent or sustainable. Early this year, Warren Buffett challenged hedge funds to bet on their beating the S&P500 over the next 10 years. I am betting with Warren Buffett (I am mostly investing with Vanguard index funds). Of course, in any given year, out of 10,000 hedge funds, even just by sheer luck some of them will yield phenomenal returns, making investors happy even after the handsome fees.

Would you please address the tax implications for the investors both who make money and are defrauded? This sounds more like a blind trust than a rational investment strategy. Are most people in hedge funds individuals? Can there be public retirement funds tied up there, too?

Profesor Jiang writes: If you were asking about the alleged Madoff Ponzi scheme, it would be bad news for investors who thought that they made money by investing with Madoff and who might already have consumed the "profits" they received from the fund. If it could be proved that their "profits" were actually coming out of later investors' principal, they could be asked to return the money! Of course, they could file amended returns and get back the tax they paid on those gains.

Hedge funds are open both to institutions and "high net-worth" individuals. The larger the hedge funds, the higher percentage of institutional money. Among the 10 largest hedge funds, institutional money makes up between 75 percent and 100 percent of the total. Smaller hedge funds and funds that are part of hedge funds are more likely to court individuals. The minimum investment requirement is a good indication of whether the fund is primarily targeting institutions or individuals.

In recent years, it has been common for public retirement funds to allocate money to "alternative investment." Some pension funds (one employee pension fund from a Connecticut town and a state pension fund in Massachusetts) are caught up in the Madoff case.

categories: Questions from You

1:04 - December 22, 2008

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