Are Hedge Funds Worth the Price?
AIMA Canada debate: are you paying for alpha … or beta?
BY Scot Blythe | April 25, 2010
Proponents of index investing don’t normally try to tackle hedge fund managers in their own den. But Som Seif, founder and CEO of Claymore Investments, which provides a suite of ETFs based on indexes developed by the likes of Rob Arnott among others, did just that yesterday. However, he came to praise hedge funds – at least in theory – but also to bury them over their fees.
He took the Opposition side in AIMA-Canada’s annual parliamentary-style debate on the motion: “Be it resolved that hedge funds are worth the price.”
Arguing the Government side was Jim McGovern, founder and CEO of Arrow Hedge Partners. The opening argument wasn’t pretty. “I stand before this house, for the second time in the past five years, to debate, or rather to justify my existence and my sustenance, the lifeblood of all financial institutions, my fees,” quipped McGovern. “My esteemed colleague, the member from Index Valley East, will tell you that hedge funds are nothing more than a fee grab masquerading as an asset class … [E]very year we have to suffer the slings and arrows, or at least the arrows, from those envious backbenchers and party hacks who, like small children, demand to be told the same story over and over again.”
The real story? Hedge funds attempt to mitigate risk, not – and that is key – to eliminate it, McGovern argued. Fees are the price of admission. Typically, hedge funds charge a 2% management fee and a 20% incentive fee – 20% of profits over a benchmark. Not that all funds hedge.
“A levered long resource fund, charging 2 and 20, of which there were many going into 2008, is not a hedge fund. They’re not worth 2 and 20, they’re not even worth 2,” said McGovern.
So did hedging work in the Great Bear of 2008 and 2009? Hedge funds had an annualized return of 6.5% from 2000 to March 2010. The MSCI World had a negative 1% return. On the risk side, hedge funds had a drawdown of 21.4% – almost all fully recovered, McGovern said. The MSCI World is still working through a drawdown of more than double that size.
“What would you pay for not losing 52.7% peak to trough; what would you pay for not having a near-death experience?” he asked. “Hedge fund managers earned their management fee, but they collected no performance fees during the period. Great performance – for 2 and nothing.”
In rebuttal, Seif said: “I’m not here to tell a room full of hedge fund managers that hedge funds are not valuable. In fact, I believe the exact opposite.” But hedge funds and the hedge fund industry are two different matters. “Stated broadly, this industry has abused the term hedge fund to hide behind the 2 and 20, while masking beta as alpha,” he charged.
Given that hedge funds cover a variety of strategies, with different return streams, risk profiles and correlations to other securities, he argued that what hedge funds have in common is their compensation structure. He took particular aim at the “2” in 2 and 20.
“The base fee, generally or traditionally ranges around 1.5 to 2.5%. Now these base management fees were set up to cover the operational, back office and other overhead costs of running the business. They were not meant to be used as a profit incentive and that’s instead what the performance fee was meant to be,” Seif argued. The break-even for running most small fund management companies would be in the $1 million to $2 million range, growing with the scale and size of the operations. But any hedge fund with assets of over $100 million should be able to pass on economies of scale on its base fees to clients. This is not happening. In fact, the base fee has become a significant part of the overall compensation structure for many managers. Two percent of 1$ billion is equal to $20 million per annum, regardless of the value provided by the manager.”
Seif’s arguments revolve around whether hedge fund managers offered alpha. If they didn’t they shouldn’t be collecting asset-gathering fees higher than industry norms simply for providing beta.
“So let me ask you this: if a managers doesn’t add any value above the market or his peers, why should they be be charging this traditional type of fee or a beta-type of fee or at minimum, the standard industry fee of 1%. Shouldn’t the choice of industry free structures be for pure beta, beta-type fees and for active money management, either a structure of low base fees and incentive performance fees, or higher fixed fees?”
With an influx of capital, base fees mean that managers don’t have to rely on compensation for performance.
“In a good year, a manager brings in stunning amounts of money; in a bad year, they still do very well.”
He didn’t manage to persuade the House, however.