Mystery solved: Why hedge funds earn for mediocre performance

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    Institutional investors, including pensions and endowments, willingly pay top prices for mediocre performance at hedge funds while the money managers earn large paychecks. Despite talk of fee concerns, the disconnect continues.

    Over the last five years, ending in April, an index of equity hedge funds returned 4.83% compared to the S&P 500, which earned 14.31%, Fortune reports. At the same time, the managers of the top 25 hedge funds were paid $11.62 billion, almost $500 million each — even though they didn’t all outperform the market. So where’s the beef?

    The fault may be with the institutional investors. Fees, while softening a bit, have stayed relatively close to the 2% management fee plus 20% of profits the hedge fund industry was able to demand in its early life, while the number of diverse, competing hedge funds has boomed. Hedge funds may be able to continue to charge outlandish prices for poorer performance because they’re not dealing as much with wealthy individuals any more. Institutional investors aren’t risking their own money, they’re risking their jobs. Not quite the same, is it?

    Institutions will also err towards strategies that will lose less in bad year, even if it means earning less in good years. Underperforming for consecutive years doesn’t mean their deaths. Writes Fortune: To paraphrase Warren Buffett, if anyone should prefer a lumpy 12% to a smooth 8%, it is an institution.

    Granted, small hedge funds are going to bring down the performance average, and some hedge funds do particularly well. But even weighted for size, hedge funds still fall well behind the S&P 500. The stock market has also been doing particularly well on this lengthy bull run, making hedge fund returns look relatively weak. But over the last 10 years, which includes the financial crisis, equity hedge funds continued to trail the market as a whole.

    Institutions may need to look again at why CalPERS exited the hedge fund world.

    Photo: iStockPhoto.com.