What is an investor to do? On the one hand, they want the best of breed managers and HIGH performance. Heck, they’ll settle for just good performance, it doesn’t even have to be high. On the other hand, all you hear about these days is the never-ending drumbeat of lower fees, lower fees. We’ve been told over the past few years that these two things aren’t necessarily mutually exclusive. And it sure seems more than possible that you can have good performance AND low fees. Vanguard topping $5 Trillion might go a little way to proving that.
But super low-cost stock index replication is not the same as replicating more complex hedge fund strategies, and a few recent articles are pointing out that the low fee experiment in alternative investments might not be working so well.
First up, Wealth Management with an article talking about how one of the most simple hedge fund strategies to replicate – trend following – haven’t done so great in a low-cost risk premia approach.
One approach promulgated over the past few years has been to build simple “trend” models: the notion of capturing excess returns by buying securities that have risen and shorting those that have declined. Banks create indices and offer over-the-counter swaps that track their performance; some asset managers, including those in managed futures, offer static trend-following models. The thesis is that “trend” is a key driver of managed futures’ performance: if you can access this key driver cheaply, you’ll get most of the value of managed futures.
But has this approach worked? The unsatisfying answer is: not really.
They go on to show that the small sample size they pulled has underperformed full fee products inside the index by about half, and with a quite wide dispersion of returns:
The four “trend” products with live 5-year track records returned 1.6 percent per annum, about half the net of fee returns of the SocGen CTA index, and the standard deviation of the products varies widely, further complicating the comparison of the reported performance to the SocGen CTA index.
And next, an institutional investor piece talking about this performance/fee conundrum:
…a large institutional investor spent months alongside a half dozen important allocators creating a wish list of best practices for structuring hedge fund investments. The list included a management fee that covered the cost of business, a performance fee that rewarded alpha and carried a multi-year clawback, and term structure that matched the liquidity of underlying investments.
But is that institutional investor actually invested with funds in this manner, they ask? Not so much:
“Well, no, the managers we want in our portfolio won’t accept these terms.”
This is the conundrum laid out plain for all to see. There’s lots of money chasing fewer talented managers out there. As Ray Dalio famously said a few years ago, there are about 8,000 planes in the air and 100 really good pilots. The answer for some has been to punt, in a way, saying if they can’t identify those top managers, they may as well just pay the lowest fees and just invest in the ‘beta’ component of these hedge fund strategies – in what we call risk premia. But the previous article mentioned with its graphs give a glimpse into how that’s been going. All of this adds up to fees not coming down that much. There’s still demand for top talent, and as a result – that top talent can charge a higher fee in a simple supply/demand equation straight out of Econ 101.
The disconnect between the wishes and actions of hedge fund investors makes the industry appear stuck in the mud. In theory, allocators want….cheaper fees and a better alignment of incentives….
In practice, however, almost nothing is different. Back in early 2009, The Economist suggested “two and twenty” might become “one and ten.” A look at the data reveals a very different future than that predicted. Industry assets are at an all-time high, topping $3 trillion, and fees have barely budged. The average hedge fund charged a 1.6 percent management fee and 20 percent incentive fee ten years ago, according to industry tracker Preqin. Today, the average fund charges 1.5 percent and 17 percent, a recent Goldman Sachs survey found. Fees are directionally lower, but not by much in the scheme of things.
All of this is to say – investors are smarter than they look. Yes, they want low cost, but they also want cost efficiency. It’s something we covered back in April covering Resolve Asset Management’s great post: Three Alternative Funds Walk Into a Bar.
…. a cheaper price tag doesn’t mean you’re getting the cheaper price. Turns out, when buying milk or just about anything else – you can pay less (per unit) by paying more for a larger quantity. Jumping back into the investment world, Resolve is basically saying the quantity, or ounces, in the investment product world is the volatility of the investment. We’re often taught volatility is bad, but when considering costs – you want more volatility per unit of cost, all else being equal. The question Resolve asks, is what’s the better price per unit value up there on the investing supermarket shelf, where there are no Unit Prices: