“Experience is a good school. But the fees are high.” -Heinrich Heine
As Mr. Heine points out, experience can be expensive, whether it’s earned via the school of hard knocks or obtained by paying others for the skillsets they bring to the table. One of the first topics that people tend to inquire about when discussing alternative investments is some reference to their charging “high fees” – especially as it relates to hedge funds or private equity funds. However, it is also vital to compare various fees of investments fairly, considering what experience/skillsets we are paying for, how the fee structure aligns managers’ interests with those of their investors, and what we should expect in return. As with many other purchases we make, the fee discussion surrounding alts is ultimately a weighing of cost vs. (expected) value. But to make an informed decision, we first need to understand typical fee structures and their application – a “feesibility” study, if you will. Here we go…
The GOAT
In case you aren’t familiar with the name Jim Simons, he is cited as the most successful investor of all time (if you’re interested in learning more, his story is told in the book The Man Who Solved the Market and is also outlined in this late-2019 WSJ article). Between 1988 and 2018, Mr. Simons and his team at Renaissance Technologies developed a strategy known as the Medallion Fund that generated 39 percent return per year – surpassing the next closest competitor, George Soros, by 7 percent annually. Importantly, these returns are net of all fees charged by Renaissance. But how much in fees would investors have been willing to pay for such incredible growth? Essentially whatever Renaissance decided to charge. And charge they did. The net performance of Renaissance was despite levying fees that were multiples higher than most of the investment industry – consisting of a 5 percent management fee and an additional 44 percent performance fee (concisely stated as “five and forty-four”)! That performance fee, where the fund manager shares in the gains of the fund, is one of the hallmarks of alternative investments. At the same time, it’s by no means required, so it’s worth considering why it even exists.
Why Do Funds Have Fees?
Let’s flip over to the traditional side of investing for a moment. If I would like to own the stock of a company, it could cost me money to acquire that stock (e.g., via transaction fees or commissions), but there is no internal cost to owning a stock; i.e., the company is not charging an investor money simply for owning its stock. The same is true of individual bonds. However, when stocks and bonds are then packaged into an investment fund, the manager of that fund will naturally charge a fee for the service they provide.
In some cases, that “service” looks more like convenience than actual investment management. For instance, rather than buying hundreds of individual stocks to achieve performance similar to that of the S&P 500, investors can buy a single fund that will provide such exposure. And one trade to have exposure to hundreds of stocks is convenience investors will pay for. In this case, the fund manager charges a small fraction of a percent of the assets under management (AUM) in exchange for performance that looks very much like the S&P 500. This is known as passive management because the goal is to largely replicate the widely-published holdings of the S&P 500 index, instead of making active “bets” on companies the manager believes will outperform the index. Internal costs can be kept low because the strategy is highly scalable and need not pay for investment talent in the form of a highly skilled fund manager or team of analysts. Typically these “index funds” come in the form of either an exchange-traded fund (ETF) or a mutual fund (MF).
Contrary to large index funds, some funds run more concentrated portfolios (e.g., between 20 and 50 stocks, instead of hundreds) and spend a very significant amount of time, effort, and intellectual capital on researching which companies the fund should own. The goal is to outperform some stated benchmark. Relative to an index fund, the talent pool needed to conduct active management – such as research, analysis, and portfolio construction – has additional costs associated with it. Also, the potential size of the fund (aka capacity) could be limited by the underlying companies it owns, especially if they are small companies; all else being equal, a smaller fund size requires higher fees to operate (as a percentage of assets), since it lacks economies of scale.
Instead of fees like 0.05 percent that we may see in some large ETFs, actively managed funds may charge 0.5 percent, 1 percent, or even more as their management fee. While investors don’t necessarily see these fees, as they are calculated in the fund’s daily net asset value (NAV), the impact on returns can be very substantial over time. Historically, actively managed strategies have commonly been found in mutual fund structures, although actively managed ETFs are on the rise.
Two and Twenty
Over to the alternative-investment side of the story, alt funds have management fees similar to their traditional counterparts. I do believe these fees are often (not always) higher than conventional funds because the strategies are typically more complex, more labor-intensive, and require a more specialized talent pool. But alts managers are not in business just to earn management fees. Instead, their goal is to make even more money by sharing in their investors’ profits, which comes in the form of performance fees.
Also known as an incentive fee or carried interest, managers understand that the real opportunity to make money lies in producing strong returns and sharing in gains with LPs. A typical fee structure is known as “two and twenty,” which means a fund has a 2 percent management fee and a 20 percent performance fee. Without getting into the weeds of the actual calculation, consider the following example: a 2-and-20 hedge fund produces a 10 percent return (net of the 2 percent management fee) and then takes 20 percent of that 10 percent gain – or another 2 percent of AUM, which effectively doubles the fees. At the same time, the LP’s gain is reduced to 8 percent from 10 percent.
In the example of Renaissance, investors gave up 5 percent of their assets each year just for the opportunity to have been invested, and then also rewarded the fund with nearly one-half (44 percent) of all profits! As a numerical example, consider an investor with $1 million in Renaissance in a year when gross returns (i.e., before fees) are 15.79%. Before fees, the million turns into $1,157,900 (a gain of $157k – pretty good). We then deduct the 5 percent management fee, and the investment declines to $1.1 million (I’m rounding down 5 dollars). Then subtract 44 percent of the gain for the performance fee, and the investor is left with a $56k profit (5.6 percent), while Renaissance keeps over $100k for their efforts ($101,900-ish to be more exact) – nearly a 2-to-1 ratio in favor of the fund manager! Seemingly not a great deal, but the 39 percent net return each year probably limited the complaints.
Come Hell or High Watermarks
Performance fees are usually subject to a high watermark, which essentially means that the fund must be making new highs for the incentive fee to apply. If your investment is down 20 percent in year one but then makes back 10 percent in year two, you don’t have to pay the performance fee on that 10 percent increase because it’s not a gain – it’s still below the high watermark, and your investment is at a loss. The watermark can be calculated at either the investor level or the overall fund level. In cases with a fund-level watermark, when the fund has declined in value, some savvy investors will use that as an entry point because they get to avoid the performance fee until the fund exceeds the previous highs – therefore benefiting from the negative experience of other LPs whose investments are underwater.
In private equity or drawdown fund structures, the watermark concept doesn’t really make sense. As those funds are frequently calling capital from and distributing money to LPs, the value of one’s investment at a given time is a poor indicator of whether the fund is making money or not. So, instead of a high watermark, these funds use a hurdle rate or preferred return. It means that – until the investors receive their investment plus a stated level of net return (e.g., 8 percent annualized) – the GP does not share in the fund’s gains. However, once the hurdle rate has been met, the GP starts to share in profits according to a distribution waterfall and carried interest provisions. Just like with hedge funds, when you hear “carried interest” or “the carry,” you should be thinking “profit-sharing” because that’s what it is.
There are different approaches for calculating the returns and sharing the profits. In many cases, once LPs receive the preferred return, the GP may retroactively share in the gains going back to the first dollar of profits – known as a full catch-up provision. The GP then receives every dollar of fund profits until it “catches up” on the share of profits to which it is entitled. For returns above the hurdle rate, the split of profits between the GP and LP may change. For instance, it may be an 80/20 split (80% to LPs, 20% to the GP) up to the hurdle rate, but then a 50/50 split after that. All of these elements can vary significantly from fund to fund.
One other note: GPs really like to be paid via carried interest because it has historically been taxed at long-term capital gains rates – NOT ordinary income rates. So it’s not only the incentive structure, but also the taxation of the carry that has contributed to the fortunes of hedge fund managers. You may hear this come up in the political arena from time to time, and if capital gains rates were ever to be taxed at ordinary income rates instead of the currently more favorable rates, it would greatly diminish the value of the incentive fee to GPs.
Malignant or Alignment?
Did you just start to mispronounce “alignment” in your head? That’s not important, but it is important to consider whether performance fees are a bad thing or a good thing. Arguably, incentive fees are designed to do precisely what their name implies: incentivize managers to generate better returns for investors. If so, they may genuinely create better alignment between the interests of LPs and GPs.
However, work by the Harvard Law School Forum on Corporate Governance indicates that the aggregate effect of the performance fee structure over a 22-year period has been to create a losing proposition for investors, as the fees are applied assymetrically (charged when performance is good, but not returned when performance is poor). Importantly, this study/conclusion was done only for hedge funds (not Private Equity) at the industry level. Remember, private equity fee structures are different because investors have to first receive the promised return before the performance fee is charged, and those positive returns are locked in because the fund ultimately ceases to exist. One of the main issues cited in the above study is where hedge fund performance is good early in a fund’s life, incentive fees are charged, and then performance suffers – thus LPs can potentially have paid incentive fees for little or even negative return over time. While there are ways of helping to combat this issue (e.g., “clawbacks,” where the GP may have to give back some of the previously earned performance fee in periods of negative performance), in my experience, they are far from the norm. For a manager with consistently good performance over time, the actual result of the 2-and-20 structure will be much more aligned with investor expectations. At the same time, those who are determined to avoid higher fees at any cost may view the higher expenses of alternatives – and especially performance fees – as malignant detractors from investment returns over time.
In my experience, incentive fees seem useful in attracting talent to the Alts space (and making their oft-arduous work schedules more acceptable/tolerated), and the right team is an important component for successful execution of given strategy. If the end investor feels they are receiving attractive risk/return/income characteristics net of all fees, then those fees will not be of concern. It’s merely a question of cost vs. value. Just ask Jim Simons or anyone who invested with him during the heyday of the Renaissance Medallion fund.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
