Despite markets that, um, aren’t exactly surging, we personally know of five new hedge funds that are supposed to be starting up this fall in Canada.

Why would one want to start up a new hedge fund right now, even as existing funds are struggling both in performance and in raising money? Well, for the cash of course.

Hedge funds, because of their business model, are an exceptionally profitable businesses, especially if things go well in your investment selection. For example, a typical new hedge fund might be able to gather $20 million in assets on start up. At a 2% management fee and a 20% performance fee, a fund that size that generates a 20% investment return can generate $1.2 million in combined investment management and performance fees the first year. That’s a stunning first-year accomplish for any sort of business. Considering a start up might have, at most, three employees, it starts to look fairly attractive for portfolio managers considering heading out on their own.

Why would investors take a chance, though, on an unknown hedge-fund company? Well, many won’t, thanks to Bernie Madoff and other scams in the business. But many investors, especially those on Bay Street, will gladly fork over some money for a new hedge fund to manage. Why? Two reasons. First, it has been proven that new hedge funds tend to do fairly well in their first two-to-three years of business. Employees in a start-up typically have lots of money invested in their own fund, and watch it extremely closely. Partners know, also, that a good couple of years will make it far easier to attract new assets, so their start-up might not stay small for long if they can hunker down and pick some winners. Of course, a smaller fund is very nimble, and can take advantage of almost any opportunity that comes along.

Second, many Bay Street types will support a new fund to garner future goodwill. If the new start up becomes a behemoth one day, maybe the partners will remember those that supported it in the early days, and spin lots of business to certain brokers because of it. One of the start-ups I worked at got free commissions from a broker for two years, while we were in start-up mode.

Nothing wrong with any of this. We wish the new firms luck. What we fail to understand, though, is why customers continue to flock to hedge funds in general. In the early days of the industry, funds were supposed to be ‘exclusive’ and only available to very wealthy types looking to diversify their other assets. Now, of course, pretty much any accredited investor can buy a fund, and those that don’t qualify can buy one of the many closed-end funds that have been set up to get around this restriction.

In addition, we know of no other industry where giant clients actually have to pay more than smaller clients. If you have $10 million invested in a fund that earns 20% (net) in a year, your reward as a giant client is the payment of $600,000 in fees. A client that barely qualifies as an accredited investor and ponies up $100,000 will pay $6,000 in fees. Clearly, the client who is a ‘whale’ should be given a break on fees. Admittedly, some funds do that. But most do not. Despite almost 30 years in the business now, we still don’t know why large clients accept that. Nor do we understand why competition hasn’t driven down fees dramatically.

In ANY other business that has high profit margins, very low barriers to entry, exceptionally low start-up costs and very low capital requirements, competition would force down fees dramatically. It just hasn’t happened in the fund industry.

Why not? Well, the industry has been very good at massaging its image, with ‘proprietary trading’, ‘risk control models’, and terms that many investors don’t understand, like Alpha, Sortino Ratios and Sharpe Ratios. If you look at any fund presentation, they all sound like they have an exclusive license to print money, and are exceptionally good at controlling risk.

Except…….they are not. We saw in 2008 that many hedge funds just didn’t hedge that well. Some did though, and many have recovered strongly since then, but then so have all investments.

Nope, it’s likely not the ‘hedge’ in hedge funds that attracts investors. It is likely greed. Stories of how John Paulson’s hedge fund had a three-year annualized return of 122% in 2010 is likely what continues to attract investors to funds. Who cares about fees if you are doubling your money every year?

The problem, of course, is you never hear about the ones that go down. They don’t make the news. Unless, on the other hand, they were famous on the way up: Paulson’s Advantage Plus Fund fell 35% in 2011, and was down 18% in the first half of 2012. Suddenly, the fees, the ‘exclusivity’, and the ‘proprietary models’ don’t really look so attractive, anymore.