Diminutive Nature of Net Returns
I began thinking about hedge fund returns. Since hedge funds need to maintain liquidity, let's assume a hedge fund only deploys about 85% of its AUM at once. Let's assume 0.2% for fund expenses, a 2% management fee and 20% carried interest:
AUM: $100
Cash Liquidity: 15%
Assets Invested: $85
Fees: 2%
Fund Exp: 0.2%
Carried Interest: 20%
Remember, funds need to maintain liquidity and cannot be fully invested. Let's assume a fund only invests ~85% of its assets. Let's assume a fund has $100MM of AUM. In order to make $20MM (i.e. a 20% return before any fees), it needs to hit a 23.5% return on the $85MM invested. After fees, that 23.5% gross return on invested capital (20% overall) only works out to a 14.24% net return. So in order to hit a 14.24% return, the fund needs their investments to generate returns of 23.5%.
Return on Invested Capital: 50% 40% 30% 20% 10% 5%
Net Return to Investor: 32.24% 25.44% 18.64% 11.84% 5.04% 1.64%
This also completely debunks efficient market hypothesis. This means that funds performing as well as the market are in fact significantly outperforming the market (considering all the fees they take) and the fact that they are never fully deployed.
I have two questions:
a) When you read that Abrams Capital or Baupost have 15% net returns; does this mean since they sit on like 40% cash and only deploy like 60% of AUM, that their returns on deployed cash are like ~40%?
b) For HF people, how much cash does the average hedge fund keep not deployed at all times?
LPs care A LOT about drawdowns and volatility. They use such metrics as measures of success of a fund's strategy.
If you make a value bet, there is a certain amount of risk that you are taking on when you make that bet. If you can find a way to reduce the risk of that investment via hedging/shorting/etc. in a way that reduces your volatility and average drawdowns even if you sacrifice some amount of expected return, that is often the right call to make.
I don't know anything about real estate but in public market strategies, 20-30% drawdowns can happen and they hurt. A lot. Finding ways to minimize those drawdowns even if it means sacrificing expected long-term return is quite valuable.
There's a reason that market neutral strategies exist. They will underperform the SP500 in the long run but if you're looking to minimize the volatility of your overall portfolio while still making $, they're a good place to be as they'll often make money or at least significantly outperform during crises. Hedge funds are generally just one aspect of an asset allocation strategy.
Huge pension funds, fund of funds, and even HNW investors often look to minimize their exposure to equity market risk without straight up holding cash. To do this, they will hand over $ to hedge funds who know how to do that.
Let's say you have two potential investment strategies.
Strategy A) 9% expected annualized return with 20% volatility. Strategy B) 10% expected annualized return with 40% volatility.
Strategy A is far, far superior. That 1% of additional return is simply not worth all the additional volatility that you experience along the way. If you are a pension fund, you want to be able to pay out to pensionees no matter what the market environment is.
It seems to me that your attitude is that volatility should not be an important factor when considering an investment strategy. If that is your attitude, I'm sorry but that is absurd.