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Browse by CategoryHome » Category List » Fees
Researchers: If index funds are a commodity, why are their fees so divergent?2 July 2008
Although not directly examined by that particular paper, one category that makes no denials about its lack of active management is the S&P Index Mutual Fund category. These (almost) purely passive funds are the subject of another paper by the same authors available here. In “Institutional S&P 500 Index Mutual Funds as Financial Commodities: Fact or Fiction?” John Haslem, Kent Baker and David Smith examine whether index funds are really are all the same and whether they are truly “commodities”. They find a wide variation in the fees (and therefore the performance) of S&P index funds. This is counter-intuitive given their common Investment strategy, but even more counterintuitive when one considers that institutional investors should be less likely than retail investors to pay unwarranted fees. While the market for index funds isn’t homogenous, the researchers find that at least it’s a lot more competitive than other mutual fund categories. It turns out that the price of an index fund has a lot more to do with the economics of managing a fund, not the investment strategy itself. For example, large funds and funds with small minimum investments tend to charge larger fees. Comment the authors:
Since the underlying investment strategy is exactly the same across this category of fund, any difference in fees should translate directly into lower returns. Not surprisingly, this is what the authors found. So why on earth would you want to buy a fund that was virtually guaranteed to underperform? There are a number of reasons, say the authors:
The growing interest in portable alpha and alpha/beta bifurcation will likely bring these funds into more direct competition with products such as index futures, swaps and ETFs. So it will be interesting to see if fee deviations like the ones described in this paper become more closely linked to tangible attributes. In other words, will there eventually be a base (commodity) fee and a Chinese menu of other attributes (low minimum, an option to switch to another fund in the same family etc.)
Comments »Is the mutual fund industry competitive enough?25 June 2008
But price competition seems to have bypassed one particular fixed-cost business - the money management business. This, according to an article in the Journal of Investing that was made available for free recently. The paper by John Haslem of the University of Maryland, Kent Baker of the American University and David Smith of SUNY at Albany has the benign-sounding title “Identification and Performance of Equity Mutual Funds with High Management Fees and Expense Ratios”. But don’t be fooled. The authors rail against what they see as a lack of price competition in the US (and by extension the global-) mutual fund industry before examining the relationship between fees and performance. They even name names - highlighting the US mutual funds with the highest relative fees in the land. In their words:
Comments »When it comes to hedge fund compensation, “social usefulness” is a red-herring18 June 2008
We proposed a number of hypotheses to explain this apparent double-standard. One was that traditional entrepreneurs created a product or service of tangible value. However, the value created by hedge fund managers (provision of liquidity etc.) is intangible at best. As a result, hedge fund managers are often accused of simply “re-arranging the chairs”, not building them. But a letter in last Thuraday’s New York Times by John Berlau of the Competitive Enterprise Institute reminded us how traditional entrepreneurs shouldn’t be given a free ride since they create something tangible. Berlau was responding to a June 10 Times Op-Ed (IHT reprint here) that said:
Comments »Buffett’s horse race12 June 2008
Comments »Silos, flesh wounds, the “disintermediation” of poultry, and a call to action4 June 2008More from London (see yesterday’s posting for background)… A pension plan as a financial services firm
It turns out that this view of the hedge fund portfolio as a sort of arm’s length asset manager with only one client can also be applied to the pension fund as a whole. That’s how one major private pension fund described it to a gathering here in London today – as a “financial firm that produces pensions.” This view also has implications for “liability-driven investing” (LDI). Some said that the process of liability-matching and return-enhancing should be kept separate within this financial services firm. For example, one major pension fund here created a team focused on removing interest rate and inflation risk (via a “matching portfolio” designed to match the plan’s future liabilities to pensioners) and a separate team focused solely on trying to squeeze additional returns out of those assets. In true arm’s length fashion, the “return portfolio” is required to literally borrow assets from the matching portfolio – creating a real economic incentive to beat the short-term rates charged on this internal loan.
Comments »Weekly Newsreel: Madrid, Stockholm, Maple Syrup and 130/3025 May 2008
Nervous alternatives managers could be leaving alpha on the table: P&I reports from ”AlphaMax” in Madrid that “Fees became a point of contention between pension fund executives and hedge fund managers…with the pension executives arguing that the typical hedge fund management fee of 2% and performance fee of 20% can be a deterrent…” 8 out of 10 managers fail to add value: Meanwhile in Stockholm, Watson Wyatt’s Roger Urwin tells another conference why pensions have an allergy to “2 and 20″.
Comments »How much would you pay for a free (McAlpha Meal) lunch?20 May 2008Imagine that financial markets were a McDonald’s restaurant. Now imagine that the Golden Arches was running a promotion on its $5 “McAlpha” sandwich meal deal. The sandwich, along with fries and a Coke was free while supplies last. But there’s a catch. As stocks of this tasty free lunch dwindle, you will be able to bid up the price to get your hands on the remaining supply. Of course, you could always just pay the $5 and get the meal at regular price, but you’d rather save a few bucks. How much are you willing to pay? You’d probably pay up to $4.99 for this free lunch. While most investors won’t agree to 99% performance fees, they face the same type of decision when buying pure alpha (assuming, for a moment that “pure alpha” exists in the form of a fund). The bottom line is that “pure alpha” is a free lunch and is therefore worth paying for. That’s essentially what Swedish pension plan AP2 (sister fund of AP7 - see posting above) told a meeting of investors in Stockholm today. According to IPE.com’s continuing coverage of this event, the plan’s head Tomas Franzen said that alpha was “in short supply, [and therefore] it should be very expensive”. He continues:
Apparently sister fund AP7 is in full agreement.
Comments »Study is first to examine the secondary market for stakes in hedge funds5 May 2008
But there is one rough approximation of such a market for hedge funds. And now one enterprising academic has used data from that market to determine how much investors value things like lock-ups and various other characteristics of hedge funds. That secondary hedge fund market is Bahamas-based “Hedgebay”. Every month, Hedgebay brings together buyers and sellers of stakes in (mostly closed) hedge funds. The funds trade at a discount or premium to their net asset value (NAV) depending on various factors. In a study published in March, Tarun Ramadorai of Oxford University used 10 years of Hedgebay trading data to determine the effect of those factors on the premium or discount for a stake in one of the funds traded on the market. Over the 10 year period analyzed, buyers have been paying a premium for these stakes in closed hedge funds. The chart below was crated using data from the study and shows the premia and commissions paid for about 870 hedge fund stakes (excludes about 70 blow-ups that generally sold at around a 50% discount).
Comments »Skeptics to hedge fund managers: Your alpha has been faked!3 April 2008
Now Wharton’s Dean Foster and Peyton Young of Oxford University and the Brookings Institution have added to the manager-as-scammer literature with a new paper entitled “The Hedge Fund Game: Incentives, Excess Returns and Piggybacking“. In it, they decry the proliferation of “fake alpha” (e.g. selling options and using the wrong benchmark to calculate alpha). The paper was published in January, but didn’t start making serious waves until mid-March when Martin Wolf, Chief Economics Commentator at the Financial Times wrote a column about it. Wolf points out the asymmetry inherent in any type of incentive fee and holds up the Foster/Peyton paper as a “beautiful” example of how incentive fees can be gamed. He says that such a structure bears a resemblance to the used car industry. Like the used car industry, he says the hedge fund industry “is bound to attract the unscrupulous and unskilled.” [Ed: We’re reminded of the famous Forbes cover story on hedge funds in May 2004 ”The Sleaziest Show on Earth“]
Comments »The End of (asset management) History?12 March 2008
To a great extent the history of investment management (at least, since Markowitz) can be described as similarly bipolar struggle - this one between active and passive management. Efficient market theorists would argue that the final pitched battles between the two sides are being fought in the mutual fund and ETF industries - with ETF’s destined to triumph. However, proponents of active management point to the hedge fund industry as proof that active management is not only alive and well, but is consolidating its forces. Are either of these the final epic battles in the history of asset management? A couple of news items yesterday suggest the balance of power is tilting toward the efficient market theorists. First, Mark Hulbert writes about Kenneth French’s latest paper, “The Cost of Active Management” in the New York Times. As far as we can see, the paper has not yet been released to the public. So Hulbert’s interpretation is all we have to go on for now.
Comments »January turmoil has “sharpened the argument for the convergence of traditional and alternative asset management”: Report19 February 2008Putnam Lovell released its annual survey of asset management M&A this month. This 45 page document is packed with useful information and is a must-read if you follow the paradigm-shifting going on in this industry. Here are some highlights… When you were a kid, did you ever say you wouldn’t do something “for all the money in the world?” Well, we now you know exactly how much that is. According to the report, there was $68 trillion in major capital pools worldwide in 2006, and Putnam Lovell’s “most conservative forecast” shows this amount rising to almost $110 trillion by 2012.
The report shows that last year saw another leap in M&A transactions involving alternative asset managers. There were 76 transactions - up from 60 in 2006. However, alternative managers’ proportion of all asset management transactions remained stable at around one-third.
Comments »2007 data suggests 130/30 outperforms29 January 2008Our friends over at eVestment Alliance, a major database of institutional money managers, recently provided us with some interesting 130/30 data hot off the presses for a presentation Alpha Male delivered in Europe. Firstly, check this out. Back-testing has shown that 130/30 funds would have performed better than their long-only analogs over the past several years (see related posting). But does this match reality? Unfortunately, there simply haven’t been enough funds around long enough to paint a complete picture. However, eVestment Alliance has been collecting data from managers of institutional funds for some time now. While the pre-2006 numbers are a little thin, annual return data shows that 130/30 funds have indeed outperformed the S&P 500 every year since they started tracking such funds (the white number shows the number of 130/30 funds tracked by eVestment Alliance).
Comments »New research illustrates wide-ranging implications of the ubiquitous “high water mark”21 January 2008
Now a new academic study by Sugata Ray and Indraneel Chakraborty at Wharton reveals that messing around with performance fees can have a material impact on the manager’s effort, the fund’s volatility and even the manager’s propensity to “walk away” from the fund altogether. As the authors acknowledge, their findings support common intuition - that managers are more likely to buckle down when the high water mark (”HWM”) is in sight, more likely to swing for the fences when it’s not, and more likely to walk away when they feel it’s totally out of reach. We’ll get into these effects below. But first, here is the authors’ take on the Goldman situation we discussed in August. It clearly illustrates the mechanics by which a seemingly benign metric can have such wide-ranging implications:
Comments »New paper explains “muted demand” for portable alpha3 January 2008
By this standard, Larry Gorman is a name to watch. The Cal Poly professor has a unique ability to come down from the ivory tower to help the rest of us get our head around the pressing academic issues of the day - the Fundamental Law of Active Management, 1X0/X0, and the true meaning of alpha, for example. But don’t take our word for it, Gorman has been named “Most Outstanding Faculty” in the Cal Poly finance department each of the past fours years. Gorman recently teamed up with professor Robert Weigand of Washburn University to write this relatively easy to digest paper covering some of the roadblocks on the path to alpha-centric investing (called “Measuring Alpha Based Performance. Implications for Alpha Focused, Structured Products”). Warn the duo:
Comments »A closer look at Bear’s new 130/30 mutual fund19 December 2007
But sensing the vast potential, a large US financial services firm filed their own 130/30 mutual fund prospectus on Monday. That firm is none other than Bear Stearns. As Morningstar’s Marta Norton tells the Wall Street Journal this is surprising since Bear doesn’t have many mutual funds. Says Norton:
The preliminary prospectus, filed with the SEC on Monday, reveals the following about the “Bear Stearns Multifactor 130/30 US Core Equity Fund“:
Comments »Fifth birthday of bull run making mutual funds look better than they are12 December 2007
The last few years have provided mutual fund investors with a unique opportunity to compare their funds to a full market cycle, not just to a bull market (where levered or growth funds are likely outperform) or a bull market (where unlevered or conservative funds are likely to outperform). The chart below shows the rolling 5 year (weekly) returns of the S&P 500 beginning in January 2005. The section of this chart shaded in blue represents the future 5-year rolling returns of the S&P 500 (not annualized) assuming - for the purposes of this argument - that the index flatlines at Tuesday’s close until the end of the decade.
Comments »Lipper predicts British mutual funds will be “increasingly influenced” by hedge fund fees10 December 2007Thomson News reports today on a Lipper study of UK mutual funds that shows many have not implemented performance fees in the wake of regulatory liberalisation. The following observation from Lipper illustrates why the seemingly benign and boring topic of fees is central to alpha-centric investing.
Comments »Is the 130/30 price right?28 November 2007
Institutional investors are probably feeling the same confusion about 130/30 fees. There are so many moving parts, no common standards and a lot on the line. With hybrid investment products such as 1X0/XO, concentrated funds, and alternative beta funds blurring the lines between alpha and beta, comparing prices (fees) between funds is becoming more complex than ever. Earlier this week, we covered a new academic study that attempted to back-up performance fees to analyze the behavior of hedge funds’ gross returns. We’ve discussed how temporary fee cuts during rough spots may be nice for investors, but can provide managers with a much needed tail-wind on returns. And not long ago, we suggested that it was feast and famine in the investment management industry, depending on whether you were a provider of alpha or beta.
Comments »Unscrambling the performance fee egg yields new insights into hedge fund returns25 November 2007
For example, a performance fee reduces return volatility. In an up-month, the fee reduces the size of the return that might otherwise have been realized. But in a down-month, the unrealized performance fee is essentially “paid back” to the fund – as if a negative performance fee had been charged. Of course, after the fee is paid out at the end of the year, its gone for good and the worst a manager can do is to earn no performance fee the next year (see related posting for more discussion on intra-year negative performance fees). Accounting for a performance fee can be a difficult task when conducting a back-test of a new trading model since the accrued performance fee in, say, December, would more than likely have impacted the manager’s strategy at that point. So applying the same trading rules across the board and ignoring downside risk for the manager is unrealistic.
Comments »Hedge Fund Fee Cuts: Benevolence or Conflict of Interest?29 August 2007
As we’ve discussed a few times on these pages, fees are quite literally the corollary to alpha. Management fees amount to a charge against the alpha bottom line, if you will. So, like cutting any expense on an income statement, the benefits of fee reductions accrue right to the bottom line. Fees (like alpha) are uncorrelated and consistent sources of returns - in this case though, they’re negative returns. Mutual funds are aware of this. That’s how some of them manage to charge a stealth performance fee under the guise of benevolence (or at least fairness). In a posting last winter, we told you about a family of Fidelity funds that offered a “fee adjustment to management fees”. Essentially, Fidelity would charge a higher fee if the rolling 36 month performance beat a benchmark and would give back fees when performance stank (note: at least it’s symmetrical). The effect of this is strategy, aside from adding volatility to the fund manager’s revenue stream, is to dampen volatility of the fund itself - particularly its alpha. It’s the fund management equivalent of earnings management by CEOs.
Comments »Short-bias hedge funds: Masochists or Yeomen?17 July 2007
As passers-by gawk at the spectacle, some have marveled at the display of resilience and determination while others have scoffed at these managers - as they often do at Blaine - saying things like, “What a loser. Why doesn’t he get a real job!”. But everyone wonders what could possibly motivate such apparently irrational behavior.
Comments »Fee Squeeze: A Tale of Two Greeks10 July 2007
The Financial Times provides a good overview of this phenomenon in a story last Monday. We haven’t always agreed with the FT’s view of the hedge fund industry (see related posting). But Alphaville, FT’s excellent blog-esque news service, has made up for it by enthusiastically welcoming opposing views. Says the recent FT piece:
The article comes to a dire conclusion for hedge funds:
Comments »Hedge funds’ next fee challenge: skimming the consumer surplus2 July 2007
But P&I also cites sources that tell them the story is different for single-managers.
Comments »“Operational Alpha”20 June 2007As the hedge fund industry matures and becomes more process-oriented, more and more hedge fund managers figure that if they can run their own back offices, why not run other peoples’ back offices? For example, Highbridge spun out Harmonic Fund Services in 2003 and Oak Hill spun out its back office into OpHedge in 2005. As various other managers enter this industry by spinning off their own administration functions, they bring with them a new language. Nowhere is this more evident than in the recent announcement that hedge fund behemoth Citadel is launching an arm’s length hedge fund administrator, Citadel Solutions. Hedgeco.Net reports that Citadel caused a stir at SIFMA’s Annual “Technology Management Conference & Exhibit“ in New York on Tuesday with news of their new initiative (which is slated to go live July 1):
Whoa. Hold the phone. “Operational Alpha“? At first blush, this term smacks of marketing schlock. But then we recalled a presentation given by a BGI executive to a gathering of AIMA (The Alternative Investment Management Association) last fall that could give credence to this claim. It turns out that the BGI executive, Ananth Madhavan, has since published his research in the form of an article last month called “Transaction Costs Analysis as a Source of Alpha“. While Madhavan’s paper pertains to transaction costs - not administration costs - the same lesson still applies: every dollar of expenses is a dollar is taken directly from alpha.
Comments »An Inconvenient Truth19 June 2007
This is a nuanced argument. The magazine calls only for greater transparency - however fees are earned. But an open dialogue with clients regarding the actual commissions received by the adviser on each recommended product would surely end in the client viewing his adviser as a salesman, not an advocate (largely negating the benefits of such candor for the commissioned adviser). The current situation is pretty grim. Recent research cited by the magazine suggests less than half of investors said they understood their adviser’s fees “completely” or “fairly well”. (Faced with a direct comparison between mutual funds and ETFs, we would suggest investors also do not understand the fees charged by mutual funds either.) Meanwhile across the pond, the head of one purely fee-based advisory firm is calling on the FSA to ban all forms of trailers and commissions. Money Marketing reports that the CEO of Towry Law, Andrew Fisher, is calling on a “total abolition” of all commission fees to avoid complication:
Comments »What do Fiduciaries, ETFs and 12b-1 Fees Have in Common?5 June 2007
Three separate stories published today by Investment News illustrate the complex inter-relationship between the regulatory landscape and alpha-centric portfolio construction. Seemingly disparate stories about fiduciaries, ETFs, and 12b-1 fees have roots in the same underlying phenomena.
Comments »How an 8 (or 10) figure income can make sense24 May 2007
For a supposedly liberal news outlet, the NYT has approached this topic with refreshing clarity. In New York Magazine’s feature on the industry last month, economist Tim Harford said:
Comments »Business Week hedge fund story is so “2005″26 April 2007
As the article itself points out, BW itself published a piece nearly two years ago called “A Fee Frenzy at Hedge Funds”. So we’re not sure what the “sudden” realization is. But more importantly, the article seems to take greater issue with private equity than it does with hedge funds anyway.
Comments »Alpha-centric Investing on Main Street25 April 2007
So to determine how these ideas are playing on “Main Street”, we look to Columbus, Ohio and Matthew Brandeburg a planner with John E. Sestina and Company, a fee-only planning firm. He writes in Financial Advisor that financial advisors can’t just look to the mutual funds they recommend to produce all the alpha. They too must produce the good stuff:
Comments »Bridgewater: Hedge fund leverage now at levels not seen since LTCM19 April 2007
The following excerpt succinctly sums up the philosophy shared by $100b+ Bridgewater and the somewhat smaller, but no less enthusiastic, AllAboutAlpha.com:
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Last week, we told you about a paper that suggested price competition in the mutual fund industry was somewhat less than robust. Rather than lopping all mutual funds into one pot and comparing their fees, the authors of that report examined the fees of individual funds relative to their Morningstar category average. While not as ideal as examining the active management delivered by each fund, this approach loosely categorizes funds by their level of active management (e.g. the small cap growth category has a higher level of active management than the large cap value category).
Industries dominated by fixed costs tend to experience a lot of price competition. You don’t have to look any further than the airline industry to find evidence of this economic axiom. In fact, price competition is often even more fierce in growth industries where price cuts are enabled by economies of scale. For example, the Model T Ford had a price tag of $850 when it was launched - blowing away most rivals priced in the $2000-$3000 range. Within a few years, the Model T MSRP was around $300 - illustrating to the world the new economics of scale.
After the release of Alpha Magazine’s rankings of the highest-paid hedge fund managers (e.g. 
A lot has been written in the past few days about Warren Buffett’s bet with hedge fund firm Protege Partners that the firm couldn’t beat the S&P 500 over 10 years. We’ve taken an interest in this story because it hits at the heart of the active/passive (alpha/beta) debate. After reading various media interpretations of the bet and the resulting comments from readers at several websites, we offer the following observations:
As some pension funds begin to shift from funds of funds to single-manager hedge funds, they usually create what amounts to their own internal fund of funds. The only difference between this fund of funds and a “real” fund of funds is that the pension has only one client: its own pension plan. 
Several commentators on these pages have wriiten about the hedge fund liquidity premium. While it makes intuitive sense that investors demand compensation for locking in their money, it can be notoriously difficult to put a price on hedge fund attributes such as this. When the only decision facing an investor is binary - to invest or not to invest - it is difficult to get a picture of the full demand curve for a particular fund. Unlike in most other markets, investors don’t bid up or bid down the price of a hedge fund in an open market.
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In his famous 1989 essay “The End of History?” (
Remember when Goldman Sachs, smarting from mega-losses in its quant hedge funds, offered new investors a one-time opportunity to invest at a reduced fee (1% management fee plus 10% of profits, instead of 2% and 20%)? At the time, we suggested that such a fire sale can have unintended consequences (
As outside observers of the academic literature surrounding alpha-centric investing, we always find it curious that the easiest-to-read, most accessible papers and presentations are usually written by some of the field’s most accomplished and technically sophisticated members. William Sharpe, Eugene Fama, Andrew Lo, Jacobs & Levy…each seems to be able to cast aside the trappings of academia and present cogent arguments in laymen’s terms.
130/30 investing is still generally considered to be for institutions only, even though its simplicity and ”hedge fund light” characteristics make it well suited for the retail mutual fund world. Only a handful of 130/30 mutual funds are tracked by Morningstar so far and one Canadian 130/30 fund prospectus was actually pulled from the market (for reasons unrelated to the strategy itself). 
With the recent 5th birthday of the latest bull market, it’s getting hard to find a mutual fund that hasn’t produced great 5-year returns. Apparently this fact is not lost on Morningstar, which is 
For decades, the climax of the US game show The Price is Right has pitted two contestants against each other as they try to guess the value of a large package of prizes. It’s called the “
Performance fees. No other words in the hedge fund lexicon seem to generate so much passion among both managers and investors. But while the concept seems simple enough, it actually has implications well beyond the size of the manager’s bonus.
What’s the quickest way to goose the alpha of any fund - mutual or hedge? Easy. Slash fees. Sure it hurts revenues, but it can also provide a desperately needed boost to alpha. 
For the past 20 years, managing a short-bias or short-only hedge fund has been a little like one of the stunts performed by street magician and certified masochist 
When it comes to fees, it’s the best of times and the worst of times for hedge funds - depending on their alpha and beta. 
Some said it was bound to happen. 
Adding to the relentless attacks on the opacity of financial advisory fees, Investment News took a major stand yesterday. In an editorial entitled “
A few days ago, we wrote 
Kudos to the New York Times’ 
Warning to those colleagues sitting around my desk: my head will likely explode if I read another media story about high hedge fund fees. But thankfully for our cleaning staff, Business Week’s 
While we argue that alpha/beta separation will have a broad-ranging impact on the world of asset management, we are often hard-pressed to find articles or papers written by or for financial advisors. However, 
As regular readers know, we are big fans of Bridgewater Associates. Their quintessentially “alpha-centric” view of the world amounts to a case study in modern portoflio management. The firm put out an interesting note in January that was recently brought to our attention by blog wonderkid Yaser Anwar over at