With the fees investors pay becoming much more transparent, the hedge fund industry is slowly but surely moving towards a new performance-based model.
Head of Investment Solutions for Hedge Funds at Unigestion, Brian Johnson recently released a report entitled Investing in hedge funds does not have to be expensive
. The text concentrated on the area of fees and how they could be restructured to better align the interests of clients and fund managers. In his opinion, a system where managers receive their cut whatever the performance is antiquated and in need of change.
“Investors in hedge funds have been frustrated by the lack of returns they were accustomed to prior to the financial crisis,” he says. “At the institutional investor level, trustees say that they are making 10–15 per cent in their equities, and it costs next to nothing if they are doing passive investing. So they asking why they are paying upwards on 4–5% in total expenses to hedge fund managers that are delivering 3–4% return if they are lucky.”
It is not an unreasonable question to ask, so Johnson and his team at the Geneva-based asset manager have moved to change the way hedge funds and those that manage them operate. It’s true that returns on hedge funds have been pretty stagnant in recent times, but as Johnson explains, an investor should look at much longer trends when assessing their value.
“The first thing we wanted to highlight in our report was that the types of returns you get from hedge funds are unique,” he says. “The returns are not delivered by the market – they are supposed to be idiosyncratic. So when one market underperforms, you have a return source that is different and can act as an anchor when things go wrong in your traditional portfolio.”
The choice between hedge funds and equities famously came to the fore when the world’s most esteemed investor decided to wager against the ten-year performance of hedge funds against equities. Warren Buffet and Protégé Partners’ $1 million bet will be settled on December 31, 2017, with current trends looking like Berkshire Hathaway CEO will take home the winner’s purse. Unigestion’s head of Investment Solutions believes outside circumstances have favoured Buffet just as much as his much-lauded vision. “Warren Buffet and Protégé Partners big bet – if they made that bet in 1998, hedge funds would have performed much better, as you had dotcom crash and then the 2008 crisis. It depends on the timeframe you use to look at a track record. Long term, hedge funds have performed quite well.”
In addition, the returns offered by hedge funds are smaller for good reason, he posits.
“Looking at the types of returns individual hedge funds deliver, when I talk about idiosyncratic returns, I’m taking about alpha – what returns a manager generates over the market, says Johnson. “The ones that have a lot of equity returns are beta-heavy, so that’s not all that valuable to investors. We need to remind investors that alpha is hard to get and that is why it is expensive.”
When clients are asked to stump up these fees, then a reasonable return on their investment is the least they can ask for. If a manager doesn’t achieve that, then their fees should reflect it, as Johnson explains.
“With the inclusion of a performance fee we are telling managers that they should not receive high fees if they are not delivering returns,” he says. “That seems like a pretty sensible statement to make. When you are doing due diligence on a manager, one of the things you will ask is what sort of return you can expect from your strategy. Performance fees will be a useful tool for investors to see if managers are telling the truth about their return projections. We are not trying to reduce what managers are earning – we want to pay the ones producing returns a good fee.”