Those of you in the hedge fund industry will recognize the name Alexander Ineichen. Ineichen has written several of the studies that form the foundation of today’s alpha-centric investing paradigm. Last month his new book, Asymmetric Returns hit book stores. We mentioned it on this blog and promptly reserved the first available copy to be delivered across the world’s longest (formerly) undefended border to Canada.

The book contains several useful lessons couched in an easy-to-read narrative that makes liberal use of colourful language  (more on that in a future post).  Ineichen spends a chapter discussing management fees – a topic that looks a lot simpler on the surface than it actually is. 

But first, a quick overview of Ineichen’s key message.

Like us, Alexander Ineichen believes a paradigm shift is occurring in asset management:

institutional investors (now) distinguish more carefully between alpha and beta, absolute returns and relative returns, and skill-based and market-based strategies. Quite early on, we referred to this change as a paradigm shift in the asset management industrywe continue to believe the asset management industry is going through structural change. (page 2)

The book’s thesis is that alpha is the result of downside risk mitigation, not security-selection or market-timing per se.

we could currently be witnessing the merger between what we referred to as the asset management industry and…the risk management business. (page 19)

As you might guess from the book’s title, Ineichen argues that the future of asset management rests with those managers who employ the best risk managers and therefore can create option-like return asymmetry at cheaper-than-option prices (i.e. in the form of hedge funds).  Somewhat ironically, Ineichen also advocates the use of derivatives themselves to create such cost-effective return asymmetry:

One amazing observation we make is the long and continuous aversion to derivatives among a large majority of investors and market observersBeing generally opposed to the use of derivatives in finance because its misuse has caused casualties is like opposing the use of morphine in medicine because of its misuse. (page 53)

Ineichen’s Triangle

Ineichen provides a useful rubric to understand management fees in both the hedge fund and long-only industries. He says investors have to pay the milkman thrice – once for skill, once for strategy complexity, and once for basic risk premiums.

We add that too often, (retail) long-only investors aim to pay for returns and hail their mutual fund manager as a hero if he simply produces positive returns – even if those returns are the result of easily replicable and extremely cheap market beta. To be sure, “exotic” beta returns may be a small part of the rationale to compensate managers. But we have advocated that investors should pay primarily for effort (as revealed by returns that do not simply track the index). Ineichen calls this effort complexity and also suggests it should be a major element of manager compensation. To beta returns and complexity, he adds skill as the third element that deserves compensation. Thus, he proposes the following triangle to understand the fee drivers of various investment strategies (page 76):

We like think about it this way: if your mutual fund guaranteed that it would have a 10% return when such a return is not actually guaranteed, you (and your national regulator) would surely consider suing the manager. So why should investors give money to an index-hugging mutual fund that alleges to use the latest complex investment techniques when the result is so clearly the same as the overall market?

But how much compensation does each fee element deserve?  Ineichen proposes that equal amounts of skill, complexity and (beta) risk premiums should be compensated in a 10:5:1 ratio. But different strategies rely on these factors to different degrees. For example, global macro hedge funds, says Ineichen, rely primarily on skill while long-only large cap strategies rely primarily on risk premium.  By comparing several strategies using this apples-to-apples model, he comes up with the following list ranked in order of descending value (page 78):

Ineichen uses this methodology to argue that there is “no skill involved” with long-only large cap mutual funds and that they should therefore charge the lowest fees.  This approach is very similar to the one we have proposed on this blog: that hedge funds and mutual funds must be normalized by removing market risk premiums from the equation.  Only then is an apples-to-apples fee comparison possible.