The following is an extract from chapter 19 of Lars Kroijer’s new book, Money Mavericks: Confessions of a Hedge Fund Manager.
An Expensive Acquaintance
In early 2006, I was at the wedding of a good friend in the hometown of his bride outside Chicago. At the reception I sat next to the bride’s charming aunt, Mrs Straw. Mrs Straw had lived in the small town all her life and her husband was a couple of years from retiring from work at the local sub-supplier for one of the Detroit auto companies. She had not been working for about a decade. Soon the conversation turned to what I did for a living.
“I work at an investment management company,” I said.
“Oh, interesting. Like a mutual fund?” she asked.
“Sort of. It’s called a hedge fund but it is quite similar in many ways.”
“I know what a hedge fund is,” she said, slightly offended that I had assumed she would not. “We’re invested in them through my husband’s pension plan at the plant. They’re great. He is so close to retiring and the pension manager told the folks that hedge funds were like a guarantee against markets going down.”
“Sort of like a sure thing,” I suggested. “Which funds are you invested with?”
“I think they invest in a couple of what are called funds of funds who are then able to pick the best hedge funds,” she said.
“That’s great,” I said, before moving the conversation on to other things.
The brother of the groom who had given up investment banking earlier that year had observed our conversation from across the table. “Dude,” he said later, “everyone’s in hedge funds these days. It’s the way of saying “I am a sophisticated investor” even if many people don’t have a clue what hedge funds actually do.”
The following morning, as I was waiting for Puk to get ready for the post-wedding brunch, I absentmindedly jotted down some figures on the notepad by the bed while watching basketball highlights. These were numbers I had known about for a long time, but never really focused on or added up from the perspective of the ultimate end investor. They went like this: pension-fund advisor 0.25%, pension-fund fees and expenses 0.75%, fund-of-funds management fee 1%, and so on.
“There are a lot of people who need to get paid here before my friends from last night see a penny,” I thought, increasingly aware of the staggering aggregation of fees. I would cross many of the fee numbers and make them lower so that the aggregate fees would be more reasonable.
“Surely external pension fund advisors only charge 0.15% per year,” I would mutter to myself.
Still, the conclusions were troubling, and I began to think the only way the numbers made sense for them would be if the hedge funds all performed brilliantly every year – which clearly wasn’t the case.
Typically, Mr Straw’s pension fund would have its own set of expenses and fees on top of the external advisor they would often hire to assess what to do with their hedge fund allocation. With the help of this advisor, Mr Straw’s pension fund would typically make an allocation to one or a couple of the larger funds of funds, depending on their risk appetite and their views on which fund of funds showed greatest promise. The fund of funds selected would then go about its work and decide which hedge fund to invest in, including funds like Holte Capital. That is a lot of mouths to feed, particularly when you consider that the hedge funds on top of their typical fees have expenses associated with trading and administration. Below is a summary list of all the annual fees and expenses Mr Straw could incur before seeing a return from his hedge fund investment:
Note that in this zero interest rate environment Mr. Smith is down more than 5% (before incentive fees) on his investment every year on fixed costs alone. He would be well advised to question if the hedge fund investment business can consistently provide opportunities to justify this?
The trading expenses clearly depend on the type of hedge fund. In this case I assumed a typical long/short equity fund with 150% long and 75% short exposure – somewhat different from Holte Capital which aimed to be more equally long and short, although the math is fairly similar for other types of funds. In order to generate its investment returns this fund will typically incur trading expenses as summarized below.
At Holte Capital our administrative expenses were less than 0.2% per year, but for smaller funds that could easily be several percent annually. Even adding the 0.2% to trading expenses listed above, the fund has spent nearly 2% (0.2% + 1.64%) of its assets yearly before the hedge-fund manager gets his management fee. And the list goes on. In some cases at least until a couple of years ago, hedge-fund managers also engaged in “softing”. This is when a broker charges you more than the going rate for at trade (say 0.2% instead of 0.1%) and gives part of this difference back to you in the form of things like a Bloomberg terminal, computers, etc. This effectively causes the hedge fund to charge its investors higher fees. In line with Holte Capital, this example assumes there is no “softing” going on (as if we did not charge people enough already!).
But back to Mr Straw’s pension. Let us for simplicity’s sake assume that all the hedge-fund managers the fund of funds had invested in returned 10% before any fees and trading and other expenses. How much does Mr Straw get to bring home to Mrs Straw to help them enjoy their golden years? Not a lot, as it turns out. In the table below you can see that in this simple example Mr Straw gets around 3% return per year even as the hedge-fund managers do quite respectably with a 10% gross return. Hold that thought. Every time Mr Straw’s money generated a return of $10, he got to keep less than $3.
Heaven forbid that Mr Straw would have to pay tax on his gains. Instead of enriching the many layers of financial advisors and principals, Mr Straw should just have put his money in treasury bonds, and slept easily at night (particularly as his retirement date was fast approaching) or a stock-market index fund if he wanted market exposure.
But wouldn’t Mr Straw be quite upset with the company canteen folks if they forced him to pay this kind of price premium for a slightly more exotic sounding and tasting fruit as part of his standard company lunch?
*Normally gross performance is quoted after trading expenses.
The example above needs one further explanation. Namely, how did the hedge fund generate its 10% return? If the hedge fund was just long the S&P500 index and that index was up 10% for the year, Mr Straw would have paid large fees for very little additional value. He could just have bought a Vanguard index fund and paid 0.2% in total fees, not 7% (although he might not be able to avoid some pension-fund costs to gain tax advantages). The directional funds are still charging the fees, but do not add as much value (they just owned something that went up) as those with 10% pure alpha (value generation). As the events of the fall of 2008 suggests, a large number of hedge funds are indeed long the markets and the value they generate was thus lower. Investors were paying for beta – paying for being long the market, rather than true alpha. It is no coincidence that the surge of growth in hedge-fund assets has occurred at the same time as a historic bull-market run in equities and other asset classes. There has been a lot of beta sold as alpha, yet how much is perhaps not readily apparent to the end-investor until the market starts going down, and even then there are ways to disguise it.
Speaking from personal experience, it is incredibly hard to generate 10% gross “alpha” every year. If you did, funds of funds would love you and invest lots of money with you and simply gear their investment in your fund to fit their risk profile. The holy grail of funds-of-funds investing is to create a portfolio of hedge funds with no correlation to markets or each other, thus almost guaranteeing continued positive performance. Unfortunately there is very little doubt that we as an industry don’t create an average of 10% alpha per year; we create far less and correlate quite highly with each other, particularly in bad markets. In the good years healthily rising markets might disguise the fact that it is not 10% alpha, but rather 3% alpha and 7% being long the market that generated the returns. Mr Straw may not know the difference and happily pay his fees. But in the long run the fees will undoubtedly catch up with Mr Straw and the hedge-fund industry and reveal that it is not generating nearly enough value for the fees it charges. Something will have to give: the hedge-fund industry will either have to start charging lower fees, generally decline in size, or only charge fees when it can demonstrate actual out-performance. As the fallout from the turmoil of 2008 start to emerge, there seems to be a good deal of evidence of at least the first two points.
To get an idea of the magnitude of fees, imagine Mr Straw invested $100 in the type of fund used in the example above, while Mrs Straw takes $100 from her savings and put them in a Vanguard Fund. Now suppose that both those investments return 10% per year before any fees over the ten-year period of the investment until Mr and Mrs Straw are ready for retirement. The results are both obvious and staggering.
A simplistic example, but the fees to the hedge fund and fund of funds are ten times larger than to Vanguard, and this is before pension fund costs, expenses, or trading costs. This is obviously not to say that hedge funds never make sense, but rather that the bar Mr. Straw has to clear for it to make sense for him to have money with a hedge fund is very high indeed.
I was still working through the math when Puk was finally ready to head out for the wedding brunch. As we took the short walk down the street to the aunt’s house, I tried to explain my re-discovered revelation about the multiple fee structure and how it probably did not make sense for the Mr and Mrs Straw or even pension funds generally to be invested in hedge funds but Puk was oddly casual about it. “Don’t you think the rest of the world knows that finance guys are not worth what they are getting paid?” she said with a smile before continuing “and are you and Holte not a part of the problem rather than solution?” I gave Puk the usual song and dance about uncorrelated risk adjusted returns at Holte Capital, but her mind was already elsewhere.