High Sharpe Ratios and High Leverage Help Hedge Funds Survive
Irene Aldridge, Managing Partner
Able Alpha Trading Ltd
May 2009
In an article dated 24 January, Newsweek estimates that of the 8,000 hedge funds that existed in January 2008, 2,000 went out of business by January 2009 and another 2,000 will disappear by January 2010. What determines which funds stay in business and which funds will go by the wayside?
For business to remain viable, revenues must be sufficient to cover expenses of running the business. The business of hedge funds is no exception. Once accounted for trading costs, a portion of revenues (80% on average) is paid out to investors in the fund, leaving the fund managers with performance fees. In addition, hedge fund managers may collect management fees: a fixed percentage of assets designated to cover administrative expenses of the fund regardless of performance.
Even the most cost effective hedge fund operation faces employee salaries, costs of administrative services, trading costs, as well as legal and compliance expenses. The expenses easily run to US$100,000 per average employee in base salaries and benefits plus negotiated incentive structure; in addition to the fixed cost overhead of office space and related expenses.
To compensate for these expenses, what is the minimum level of return on capital that an investment manager should generate each year to remain a going concern? The answer to this question depends on the leverage of the fund. Consider a fund with five employees. Fixed expenses of such a fund may total US$600,000 per year, including salaries and office expenses. Suppose further that the fund charges 0.5% management fee on its capital equity and 20% incentive fee on returns it produces above the previous high value, or watermark. The minimum capital/return conditions for breaking even for such a fund under different leverage situations are shown in Figure 1.
