“Round-Tripping” Stocks and the Absurdity of Hedge Fund Fees

I think hedge fund performance fees are a scam to clients. Few phenomena illustrate this better than back-and-forth actions. These are stocks that, over the course of several years, for whatever reason, see huge price gains only to fall back to where they started.

During the era of COVID-19, many companies have experienced these back-and-forth trajectories. That’s not to say they were bad investments or that their stocks were overpriced—stocks go up and down for reasons that aren’t always tied to fundamentals. But the degree to which hedge funds profit from these round trips at the expense of their investors is surprising.

Consider the performance of online used car retailer Carvana.

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Carvana generated 87% annualized returns between January 1, 2018 and the end of 2021 (1112% cumulative returns), increasing its market cap from $2.8 billion to $40 billion in this period

But 2022 hasn’t been so kind. After reaching a high of $41 billion in 2021, Carvana’s market cap fell to $3.6 billion, with its stock down 91% in the calendar year since 1 of July That means the stock has returned a cumulative 9.7% since January 1, 2018, and has essentially “back and forth.”

Carvana’s 4.5 year round trip

chart showing the price movement of a hypothetical company a share

So what would this mean for hedge funds and their limited partners (LPs)?

Near Carvana’s Q2 2021 peak, using data from WhaleWisdom, we estimate that hedge funds owned about 21% of the company’s stock. These include such well-respected outfits as 683 Capital, Tiger Global, D1 Capital, Lone Pine, Whale Rock, Sands Capital and many others with excellent long-term trajectories.

Assume that over the 4.5 years in question, the hedge funds held an average of 20% of Carvana’s outstanding shares and charged an annual performance fee of 20% above a hurdle rate of 0% How much would the clients’ hedge funds have generated by owning Carvana over the time period? According to our calculations, they would have crystallized $1.2 billion in commissions in the three years between 2018 and 2020.

Confidence study sheet

This is simply stunning. Between January 1, 2018 and July 1, 2022, Carvana’s market cap grew from $2.8 billion to $3.6 billion. However, hedge funds would have crystallized 150% of that market capitalization gain in fees. This constitutes a pure transfer of wealth from the hands of allocators to those of hedge fund managers.

2018 2019 2020 2021 2022 Cum. current
Return price
71.1% 181.4% 160.2% -3.2% -91.0% 9.7%
Carvana market
None, from
January 1 (millions)
$2.8 $5.4 $12.0 $45.0 $40.1 $3.6
Percentage owned by
Hedge funds
20% 20% 20% 20% 20%
Hedge fund
Performance quota
20% 20% 20% 20% 20%
Implicit hedge fund
Performance fees
$79 $392 $771 $0 $0 $1,242
Note: 2022 returns to July 1st. Share price and market capitalization don’t add up perfectly, as Carvana issued shares most years.

Of course, this is only an estimate and may overstate the performance fees generated by these stocks. For example, negative-yielding stocks held by hedge funds mitigate the performance fees of positive-yielding stocks like Carvana. Also, different hedge funds have various performance fee crystallization requirements, such as high watermarks, hurdles, etc. However, ours is not an unreasonable approximation, and actually underestimates the overall impact given the large number of actions that have gone back and forth. .

Oh Snap! Another round trip*

Snap stock performance chart
Note: Instant performance from July 22, 2022.

In fact, Carvana’s performance is not very atypical. Over the past few years, shares of Facebook, Roku, Sea Limited, Shopify, Snapchat, and Zoom, among many others, have experienced similar “round trips.” The bottom line is simply that the annualized performance fees paid to hedge funds lead to absurd results always come at the expense and detriment of LPs.

Why wouldn’t hedge funds do that?

Hedge fund managers are incentivized to act in their own interest and to maximize their own wealth. They would be behaving rationally if they signed up for $1.2 billion in performance fees in exchange for offering -5.6% annualized net returns to clients. It’s an extremely attractive revenue stream for them, albeit a very poor one for their LPs.

2018 2019 2020 2021 2022 Cum. Ann.
Share price return
71.1% 181.4% 160.2% -3.2% -91.0% 9.7% 2.0%
Carvana as a
Hedge fund net return
56.9% 145.1% 128.2% -3.2% -91.0% -23.2% -5.6%
S&P 500 TR -4.4% 31.5% 18.4% 28.7% -19.8% 53.6% 9.8%
Carvana hedge fund
Excess return
61.2% 113.6% 109.8% -31.9% -71.1% -76.8% -15.4%
Note: 2022 returns to July 1st. Carvana’s net hedge fund returns assume a 20% performance fee on a 0% hurdle rate and that Carvana is the only hedge fund investment.

Although extreme, our example demonstrates how performance fees can create perverse incentives for hedge fund managers. Far from better aligning their interests, allocators who insist on paying for performance may be making a bad situation worse.

With stocks like Carvana, hedge funds received a round trip ticket for the past 4.5 years, with all expenses paid by their LPs.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images/BogdanV

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Jonathan Cornish, CFA

Jonathan Cornish, CFA, is the founder and portfolio manager of 38x Holdings, a long-biased investment firm based in Miami, Florida. 38x Holdings invests in high quality publicly traded companies with monopoly characteristics. Prior to founding 38x Holdings, Cornish worked for UNC Management Company, a $10 billion endowment fund, in North Carolina. He graduated in 2016 from the McIntire School of Commerce at the University of Virginia, where he played on the men’s tennis team that won three NCAA Team Tennis Championships during his four years. Cornish is from the UK and is a CFA holder. He can be contacted at [email protected]

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