We recently told you about the decision to steer clear of regulating investment management fees by the UK’s Financial Services Authority (FSA).  After entertaining the notion of being a de facto “price regulator”, the FSA ran for the hills when it felt that it was taking on a sort of consumer protection role.   Wrote the FSA in a 2007 ruling (p. 43):

“We do not act as a price regulator, and we do not consider it appropriate for us to take such a role.”

You may also recall this November 2009 post about the US Supreme Court’s decision to steer equally clear of the question of “fairness” in mutual fund pricing.  A 2008 judicial ruling upheld the so-called “Gartenberg Standard” to determine whether an investment management fee was fair.  The Gartenberg Standard (created in 1982) essentially rejects the argument that a fee is unfair just because competing fees are lower.  The 2008 decision affirmed the Gartenberg Standard by ruling in favor of a fund company (Harris Associates) that charged retail investors way more than it did institutional ones.   The chief judge in that case echoed the FSA’s 2007 ruling above when he said:

“…The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth.”

In other words, caveat emptor.

This case and others are contained in a new paper by Ross Miller of the State University of New York (Albany).  Miller has been a long-time critic of mutual fund fees.  Regular readers may recall his earlier seminal work on calculating the “active cost” of mutual funds (read paper here – highly recommended).  Miller revisits the idea of active cost in the context of the ongoing regulatory debate concerning mutual fund fees.  He also makes a direct comparison between mutual fund fees and hedge fund fees.

By upholding Harris Associates’ court victory, Miller argues that the US Supreme Court “has done retail investors no favors.”  He adds that in any case,

“…fees that might appear reasonable by any standard can still have a devastating effect on investors that will not be realized until they actually need the money.”

This is especially true in defined contribution plans and retirement programs such as the 401(k) in the United States.  Since investors in these plans are likely to remain invested for 30 or more years, the cumulative effect of management fees is often larger than the (deferred) income tax paid when funds are eventually withdrawn.

With the growing trend toward switching defined benefit (DB) plans with defined contribution (DC) plans, more employees are now, in Miller’s words, “…held captive by the mutual funds chosen by their employers.”

He points a finger at some DC plans that effectively have a “revenue share” with the mutual funds they provide in their plans.  In these cases, high-fee mutual funds can basically cover the sponsor’s costs to administer the DC plan out of its own revenues, leaving “employees with the impression that they are getting something (the administration of the plan) for nothing”,  when they are actually paying for these services in the from of higher management fees.

Hedge funds are “less expensive”

Attacks on mutual fund fees are nothing new.   But where does that leave hedge funds with their “2 and 20″ fees.  After all, even a hedge fund fee of 2% dwarfs those of many US mutual funds.  Those unfamiliar with Miller’s previous work may be surprised by his answer:

“…high-priced active management that hedge fund managers provide tends to be considerably less expensive than that provided by mutual funds.”  (our emphasis)

In a reprise of his 2005 paper, he suggests the following rule of thumb when comparing funds (of either the hedge or mutual varieties):

1. Determine the ratio of passive risk to active risk.  For example, a 98% r-squared to the S&P 500 is a 49-to-1 passive to active risk ratio.
2. Take the square root of both sides of this ratio (i.e. 7-to-1).  This is the amount of purely passive and purely active investment dollars needed to replicate the fund in question.  This particular fund is therefore seven parts (87.5%) passive and one part (12.5%) active.
3. Assume a cost for the purely passive component is, say, 20 bps per annum.  Multiply the active proportion by 20 bps to determine the share of costs resulting directly from the passive component (87.5% x 0.20% = 0.175%).
4. Subtract that passive cost from the overall cost of the fund (say, 0.75%).  This means that the active component of the fund is responsible for (0.075-0.175%=0.575%) of the overall 0.75% management fee.
5. Finally gross this cost up by  factor of 8 since the active portion of the fund only represents one-eighth of the value of the fund (remember it’s 7 parts passive and 1 part active).  This is 4.6% per annum.

A market neutral ” 2 and 20″ hedge fund with a return of 12% would still charge less than this mutual fund for active management (4.4% vs. 4.6% for the mutual fund above).

Granted, many hedge funds are not market neutral.  In fact, a hedge fund with a 4.4% total fee and a relatively benign r-squared of 50% would be charging a whopping 8.6% for its purely active proportion.  But that only underscores the importance of not making a summary judgment about hedge fund fees without first thinking through this analysis.

Hedge funds: lower volatility

Making matter worse for our mutual fund above, the volatility of its active component is significantly higher than that of a typical market neutral hedge fund.  A loss of 1.46%, for example, would translate into a loss of (1.46% x 8 = 10.28%) if one were to make an “apples-to-apples” comparison with a market neutral hedge fund.  But as Miller points out, “A market-neutral hedge fund with such a poor showing over a three-year period would likely either be forced or choose to close up shop and return its investor’s money.”

Is a 4.6% cost for active management in this example typical?  The short is “yes” according to Miller.  He analyzes over 700 large cap US mutual funds and finds that the mean is actually 6.44% per annum (see chart below from paper – click to enlarge).

He concludes by lamenting the slow pace of legislative reform that would help investors understand calculus like this.  For example, he argues that pension plan administrators should be required to provide the dollar amount of fees paid by plan participants.

Remember the “Unemployment Compensation Extension Act” signed into law a couple of months ago to keep unemployed Americans afloat?  The initial version of the bill contained a section on DC plan fee reporting that mandated plan administrators to provide employees with:

“…A statement of the total fees and expenses which were directly deducted from the participant’s or beneficiary’s account during the quarter and an itemization of such fees and expenses.”

But the mutual fund industry “slammed” this section of the bill, arguing that it could conflict with existing government efforts in this area.  Alas, this section was missing in action by the time the bill hit the President’s desk.  Looks like hedge funds aren’t the only ones being attacked for their fees.

The battle for the hearts and minds of investors has raged for over a decade now.  On one side, hedge funds have argued that a boutique, alpha-centric approach is best while on the other side, mutual funds have used their considerable marketing and distribution skills to make the case for the tried and true (read: less idiosyncratic) approach of long-only investing.  The central front in the battle is often the alignment between manager and investor.  Hedge funds’ weapon of choice has been the performance fee.  But as students of the industry are well aware, these weapons often backfire, leaving some investors with a feeling that they have just been the victim of friendly fire.

In the US, the SEC has always allowed performance-based fees for mutual funds as long as their effect is symmetrical.  In other words, as long as the manager can lose, as well as win (see the related post “Long-Only Mutual Funds with Performance Fees…”).  By 2001, researchers found that only about 2% of US mutual funds had the chutzpah to take that bet (see Elton, Gruber and Blake’s seminal paper on the topic).

An Armistice in Europe?

Meanwhile, in the UK, regulators have made no such stipulation.  In it’s “Policy Statement 04/7″, the FSA cleared the way for performance fees – even dropping its earlier concerns about charging performance fees over a hurdle rate when that hurdle rate was based on a benchmark that lost money on the year (see page 17 of the FSA’s statement here).

Three years later, in December 2007, fund analytic firm Lipper penned a report concluding that UK mutual funds would eventually adopt the weapon.  Reported Reuters at the time:

“As part of the wider industry phenomenon of differentiating between premium priced actively managed funds and lower cost index trackers, Lipper said the performance fee levels of UK collective funds could become increasingly influenced by the ‘two and twenty’ fee structure employed by hedge funds.”

Now a new report by Lipper examines the use of this weapon and reaches some interesting conclusions (available here with free registration).  It has now been been six years since the FSA’s change of heart and only about 5% of mutual funds have instituted performance fees (remember, these are the traditional asymmetrical kind that some have called a “free option” for the manager).

Today, two-thirds of performance fee charging UK mutual funds charge a performance fee whenever they beat heir benchmark – even when their benchmark loses money.  (A fifth of funds avoid this issue altogether by choosing a cash benchmark.)

Laissez-Faire = Lesser Fare?

Lipper reports that the FSA ultimately dropped it’s proposal that all funds have a high water mark.  In addition, the firm writes that the FSA also backed off any suggestion that fees should be capped when, in 2007, it arguing it did not want to “act as a price regulator.” (see page 43 of the FSA’s statement here).

So how has the UK’s laissez-faire approach to performance fees helped investors?  Curiously, Lipper finds that:

“Over the past decade, of the funds where fund expenses have been analysed and a performance fee is in place, the average performance fee charged is just over 0.4% of fund assets, although the median (or middle value) is zero. The latter finding highlights that in the majority of cases funds with performance fees do not achieve the performance fee targets set.”

We’re not suggesting that the lack of ability for the median UK mutual funds to beat their hurdle rate was a result of regulatory issues, but it does beg the question “Why all the ruckus then?”  (The report itself refers to the performance fees of true hedge funds “which can often double the level of annual fees...”.   But that suggests that hedge funds are producing excess returns while mutual funds are not.)

Hedge funds’ Gold-Plated Back Offices?

The report calculates that the average back office costs of a retail European cross-border mutual fund amounts to 34 bps (on an asset-weighted basis).  By contrast, the average back office costs of an “off-shore domiciled” hedge fund is only 31 bps.  But these are asset-weighted averages, and mega-funds are able to spread those costs across a larger pool of assets – thus dropping the fee per dollar of invested capital.  The fund-weighted average back-office cost for mutual funds and hedge funds is 41 bps and 87 bps – reflecting the tiny size (and therefore high expenses per dollar) of the average hedge fund.

Or does it?  Lipper acknowledges that the average mutual fund is larger than the average hedge fund in the US.  But in Europe, it says that they are “more likely to be of similar size to hedge funds.” This means that the difference between the typical mutual fund’s back office costs and the typical hedge fund’s back office cost is attributable to something other than AUM.  Lipper writes that because of this, current HFSB guidelines on the disclosure of back-office related fees should be more “robust.”

In fact, Lipper says that pretty much every aspect of performance fee disclosure should be more robust.  So it suggests a set of 10 “Fee Standards for Hedge Funds” in the spirit of those previously tabled by mega-investors CalPERS and the Utah Retirement Systems (see related posts).  Most are standard fare in hedge fund due diligence questionnaires, but they are probably useful for mutual fund investors unfamiliar with the surprising intricacy of performance fees.

At the end of the day, performance fees aren’t so much a new weapon, as they are a refurbished weapon drawn from the early days of asset management (see related post).  Even though the median UK mutual fund hasn’t exactly cashed in on performance fees, the FSA’s approach to this issue has accelerated the convergence of traditional and alternative investing and given retail investors access to investment strategies they may not have otherwise had.

If there are two sins that mix extremely well together, it is booze and gambling. While the odds certainly favor the house on the gambling side of things, they increase even more once alcohol is thrown in, as many can certainly attest. Indeed, while hardly empirical, most pit bosses can certainly vouch that the more alcohol consumed, the greater the amount of risk that gets tossed onto the table.

A revised version of a paper published not too long ago by HEC Montreal PhD student Serge Patrick Amvella Motaze entitled, Managerial Incentives and the Risk-Taking Behavior of Hedge Fund Managers (click here to download from SSRN) considers roughly the same concept: Do hedge fund managers take greater risks when “drunk” off the potential of pulling in a greater reward for their efforts?

Using mathematical and statistical models, Motaze argues that even if a hedge fund manager wanted to maximize his or her fees, he or she still has the mandate to provide absolute returns; otherwise investors can withdraw their money which will lower the asset under management and in turn the manager’s future payouts.

In other words, even after a couple of drinks at the craps table, only a measured amount of caution is going to be thrown to the wind before the deterrent of spouse, kids, mortgage and job security kicks in  (at least for the majority of managers).

Motaze focuses on what he refers to as the “optimization problem,” where he includes the constraint of a minimum net-of-fees return to be delivered by the manager in order to renew his or her contract at the end of the year or to avoid asset outflows due to poor performance.

His results link the optimal volatility of the fund to the management fee rate, the incentive fee rate, the minimum net-of-fees return required by the investor, the expected return of the fund, the size of the fund and the so-called moneyness of the option contract – deemed as the spread between the high water mark and the fund value. The chart below contrasts critical and optimal volatility according to the level of moneyness.

His findings? That the first three parameters – management fee rate, incentive fee rate and minimum net-of-fees return – are negatively related to the optimal volatility – good news for investors, because they can act on these contractual parameters to moderate the risk-taking of the manager. Indeed, contrary to taking on more risk with more booze, in Motaze’s findings the opposite occurs: that a higher incentive fee rate actually contributes to reduce the optimal volatility for the manager.

“Not only does it constitute an incentive for superior performance, it is also a means of reducing the manager’s appetite for risk,” concludes the paper.

“As for the minimum net-of-fees return required by the investor, it is important to keep in mind that it cannot be superior to the expected return of the fund, otherwise the manager will not be able to meet investor expectations.”

Motaze recommends investors set a reasonable net-of-fees return as an explicit term of the contract, which in turn may contribute to moderating the risk-taking behavior of the manager. Another key factor that can reduce a manager’s optimal volatility is a liquidation boundary – the threat of pulling out, which in Motaze’s findings represents “a powerful tool for reducing the agency problem.”

Finally, Motaze throws a bit of a curve ball, particularly in light of recent negative focus on hedge fund compensation (click here for our synopsis of an AIMA-sponsored debate on whether hedge funds are worth the price). In contrast to the rest of the world, Motaze suggests the broader business world could actually learn a trick or two from the hedge fund compensation model when it comes to paying their executives reams of cash.

How? Very simply, since high water mark provisions typically contribute to lowering a manager’s appetite for risk, because he or she earns incentive fees only after recovering past losses, a high water mark on executive compensation could in effect accomplish the same thing.

“With the absence of a high water mark provision, as is generally the case in the compensation contracts of corporate executives, the option is at the money at the beginning of each year which does not help reduce the agency problem. Nowadays, where the compensation of corporate executives is increasingly called into question, hedge fund compensation contracts, although not perfect, could be a good source of inspiration.”

While not delving into the perennial “fee debate” nor analyzing corporate compensation practices, it would seem that a high-water-mark-style of remuneration might not be a bad idea.  You’d be excused for wondering if many corporate executives would likely have to be both three “sheets to the wind” and throwing dice on green felt before ever agreeing to being paid like hedge fund managers.

Since the birth of the hedge fund performance fee over 60 years ago (see our “Performance fees as old as portfolio management itself”), this form of compensation has drawn fire from some investors and professional jealousy from asset managers who did not use it. At the heart of the problem is the “free option” that upside participation with no downside represents. Making matters worse, this option – like all others – is worth more when volatility is high. And since the managers themselves influence the volatility of their funds, this represents a serious moral hazard. Needless to say, creating an effective performance fee contract can be a complicated and mathematically ugly process.

In an article for the Spring edition of the Rotman International Journal of Pension Management, Jan Bertus Molenkamp of Vrije University Amsterdam proposes a few modifications to the traditional performance fee arrangement. Getting right to the heart of the matter, Molenkamp says something that won’t come as a shock to some hedge fund investors:

“Option-like contracts may even induce uninformed managers to enter into the business.”

But “option-like contracts” also provide a measure of alignment between the interests of manager and investor. It’s just that a performance fee also introduces new mis-alignments. That’s why hurdle rates and highwater marks exist (the latter called “Negative Carry Forward (NCF)” by Molenkamp.)  In order to compare apples to apples, he uses the concept of “Equivalent Base Fee (EBF)” developed by Mark Kritzman (see our “Fees six of one or half dozen of the other). As you can probably guess, the EBF is the guaranteed fee rate (% of AUM) that matches a given performance fee when a fund has a certain volatility, hurdle rate etc. In other words, it’s the management fee level that should make the manager indifferent between receiving a performance fee or a management fee.

This is a critical question because, as Molenkamp suggests, management fees incentivize managers to do more marketing (and increase AUM) while performance fee incentivize performance.

Equivalent Base Fee

As Molenkamp shows, the period during which the fund must exceed its highwater mark can influence the value of the option for managers. In the chart below from the article, you can see the EBF for a 20% performance fee at various levels of investment success (i.e. information ratio). When the manager is paid a percent of that return, but has to pay it back if performance is negative, the payoff is said to be linear. When there is no downside, the payoff is said to be an “option”. The chart also shows the payoff when the highwater mark is 3 years old, returns over an infinitely small time (theoretical as the shortest time period we’ve seen for performance fees is a quarter), and the payoff for something between the two: a 3 year old highwater mark with 1/3 of the performance fee paid out in each year.

Molenkamp points out that investors can use this kind of chart when negotiating fees with their managers:

“Suppose that a manager has an observed tracking error of four percent and expects to generate an information ratio of 0.5. The manager offers the investor a choice between twenty basis points base fee plus twenty percent outperformance fee (i.e., an option-like structure) or a total fixed fee of forty basis points. This implies the manager is indifferent between a twenty percent performance fee and a base fee of twenty basis points. Under a risk neutral assumption, this implies the manager has an information ratio of -0.35 as shown in Figure 1. If we see this fee proposal a skill signaling tool for a manager who is indeed risk neutral, then the investor should walk away from this offer.”

Still, as Molenkamp writes in the appendix, the manager may just have a thing about volatility (i.e. have a different utility function) and want to simply avoid volatility at all costs.

Co-investment

Another way to address the deficiencies in performance fee arrangements is to ensure the manager has skin in the game. By co-investing alongside their investors, the benefit of a positive management fee can be mitigated by losses to the managers own capital. That way, if the manager wants to play fast and loose with the fund’s assets, he’s strapped into the same roller-coaster with his clients. Assuming the client and the manager get equally sick from riding the roller coaster (i.e. that they have the same utility function when it comes to volatility), then they will both end up turning green at the same time.

The chart below from the article shows that, in the absence of co-investment, the manager’s utility (dark blue line) keeps going up as volatility increases (who cares, it’s not his money). Naturally, the investor’s (black line) utility falls as volatility rises. The mis-alignment of interests occurs when the manager’s utility rises – and the investor’s falls – as the manager ramps up volatility. In other words, the slopes of each line have to have the same sign. But if the manager co-invests, then his net worth takes huge swoons and his utility drops after a point (grey line).

So some extent, this elegant analysis served to confirm a piece of common sense employed by hedge fund and venture capital investors for years. As Molenkamp concludes:

“Eat your own cooking should be the motto in the construction of investment fees.”

Just about the only folks who don’t seem to appreciate the ongoing banter and debate regarding hedge fund fees are those that have to pay them. Since Alfred Winslow Jones first introduced the concept of a hedge fund in the 1950s, the argument over whether paying a premium for alpha is worth it has raged on.

AllAboutAlpha.com touched on this in our “Dazed and Confused” piece last week, highlighting a recently updated survey from Ernst & Young showing that more than half of hedge fund professionals have either already made changes or plan to make changes to their redemption terms and / or fees. And we’ve certainly covered it in the past (click here for a recent newsreel of  “fee”-related articles on AllAboutAlpha.com) More…

We are broadcasting live today from Sao Paulo, having dodged volcanic ash clouds to get here from Hong Kong.  While the mainstream media was in “all ash cloud – all the time” mode (at least in Europe and Asia), the hedge fund media seemed to have had a thing for hedge fund fees in the past few weeks.

Fee clawbacks: The Co-CIO of London-based Hermes HBK tells Top1000funds.com about the firm’s new fee model.  Said Barker, “We are working on a fee model that will allow investors to claw back fees over a three-year period if we are under our high water mark at the end of three years…It is a very complex administrative issue that can’t be done inside the fund.” More…

Earlier this week, The Telegraph reported that pension funds were fed up with “high fees” and planned to “tell hedge funds to drop fees.”

Fees are never far from the top of the list of institutional investors’ concerns about asset managers (of all stripes).  The Telegraph’s claim was backed up by an interesting duo of surveys conducted by consultancy bfinance.  Our reading of the results suggests that last year’s frustration over fees may actually be subsiding.  Can we be on the verge of a detente between pensions and asset managers when it comes to fees?  You decide… More…

The fable of The Wind and Sun tells the story of how the Wind and Sun argued over who was more powerful.  Seeing a passerby wearing a coat, the Wind blew as hard as he could to blow it off the man – to no avail.  The Sun, on the other hand, shone on the man, lifted his spirits (and his body temperature) – and basically cajoled him to remove his own coat. More…

If you could simply backspace and delete all the red racked up in 2008, 2009 would be seen as one of the best years ever for the hedge fund industry.

Yet despite the great returns, most hedge fund managers are still “substantially” below their high water marks, with little likelihood of rising above them this year, according to the latest Bank of America / Merrill Lynch Hedge Fund Monitor.   In others words, they’re building up quite an appetite for performance fees.

“Based on a very optimistic scenario (greater of the rate at the 90th percentile of monthly historical returns or their 2Q09-3Q09 monthly pace) we estimate most strategies will take four to eight months to get back to their high water marks,” noted report authors Mary Ann Bartels and Shan Hasnat. More…

Like Democrat versus Republican, Communism versus Capitalism or Yankees versus Phillies, discussion and debate over fees, their justification and their pending demise is perennial and never-ending. With each market downturn and never-again wave of investor revolt, the banter over whether alternatives managers can and should be exorbitantly charging for their services inevitably heats up.

Certainly AllAboutAlpha.com is just as guilty when it comes to focusing on and feeding the fee frenzy. Only a few weeks ago we published this post about the yet-again demise of 2 and 20 in light of the new era of reduced returns – and reduced interest – in hedge funds.

So it caught our attention when Tabb Group published a report last week noting that while they too expect management and performance fees to steadily decline over the next couple of years, that according to their poll of hedge fund managers 1.75 and 21.93 are actually the new 2 and 20.

“Many wouldn’t be surprised to know that ‘2 and 20’ is still alive and well,” Matt Simon, TABB research analyst and author of the new study, “US Hedge Funds 2009: Fees, Redemptions and Managed Accounts,” noted in a statement accompanying the release of his report. “When weighted by assets under management, the reality is ‘1.75% and 21.93%’.” More…