Transforming Hedge Fund Fees?
One of Europe’s biggest hedge fund investors, Unigestion, is pushing hedge funds to scrap management fees in place of a bigger slice of profits as investors attempt to crack down on high charges.Institutional investors are finally openly discussing hedge fund fees and terms. Earlier this month, Ian Prideaux, CIO of the Grosvenor Family Investment Office, Marc Hendricks, CIO of Sandaire Investment Office and Simon Paul, Partner at Standhope Capital, wrote a letter to the FT on how the hurdle rate should apply to hedge fund industry as it does in private equity:
Nicolas Rousselet, head of hedge funds at the $16.7 billion investor, which has $1.9 billion invested in hedge funds, said that a zero management fee in exchange for a higher performance fee of 25% was “a great fee structure”. Hedge funds typically charge a 2% management fee and a 20% performance fee although better performing, more established managers can charge much higher fees. These top managers tend to attract investors easily, often having to turn away new ones, and can dictate terms to investors.
Mr. Rousselet said Swiss-based Unigestion had been pushing for a “transformation of fees”, that his team had successfully negotiated lower management fees with some hedge fund managers last year, and in two instances secured rates of lower than 1%.
Among those were both newer managers and more established ones that wanted to work with Unigestion on a new share class or fund.
Mr. Rousselet said: “If [a hedge fund manager] truly believes in his ability to perform, he should take my deal.” However, he acknowledged that low fees could pose a business issue for the hedge fund manager and conceded that the main challenge for investors was that the best-performing funds were oversubscribed.
He said that this transformed fee structure encouraged hedge fund managers to take on more risk, but that hedge fund investors like Unigestion needed to ensure that funds were prepared to take some risks. The aggressive stance is the latest development in a long-running fee debate between hedge funds and investors.
Data released earlier this month by Deutsche Bank Global Prime Finance showed that the success rate of fee negotiations was only gradually improving: some 37% of investors that negotiated fees were successful in one out of every two negotiations. This rate has increased from 35% a year ago, and 29% the year before that.
Investors are usually able to negotiate fees if they can commit a larger investment, and agree to invest for the longer term.
Deutsche Bank said that the most successful negotiators interviewed for its survey, which spanned 435 investors who have $1.8 trillion worth of investments in hedge funds, had an average of $5.6 billion invested in hedge funds. They agreed to invest on average $70 million for at least one year.
Sir, Sir John Ritblat makes a good point regarding hedge fund fees (Letters, March 2). Hedge fund managers should only be rewarded with an incentive fee for delivering performance that exceeds a “normal” hurdle.Good point, hurdles for hedge funds is something I discussed back in October, 2014. As far as fees, you know my thinking, it's about time a lot of overpaid hedge fund managers follow other wiser managers and chop fees in half.
For internal benchmarking purposes, many investors use an absolute return measure such as the return on short-dated Treasury bills plus 4 per cent. We should like to see a hurdle at a similar level adopted by the hedge fund industry generally, which by so doing would accept that it expected to deliver a “super return” in exchange for its incentive fee, as its highly talented managers no doubt consider themselves capable of producing. Otherwise investors can find themselves in the depressing position of paying an incentive fee on any positive performance however small.
If one assumes the “standard” — but by no means ubiquitous — 2 per cent plus 20 per cent fee structure, then a 5 per cent gross return to the fund is whittled down to a 2.4 per cent net return to the investor. A hurdle rate — typically of 8 per cent — is standard in the private equity fund sphere and only when the manager has delivered this return to the investor can he help himself to a share of the surplus. Why should the hedge fund industry not follow suit?
I know there is still plenty of dumb pension money piling into hedge funds, especially the larger ones all those useless investment consultants are in love with, but the gig is up. Hedge funds have been exposed by none other than Soros and Buffett as outrageously expensive money managers that typically underperform the market.
I can hear hedge fund managers protesting: "Leo, Leo, Leo, you don't understand! We have 'niche strategies' and mitigate against downside risk. We need to charge hefty fees to all those dumb pension and sovereign wealth funds you mention on your blog so we can maintain our lavish lifestyle and make it on the Forbes' list of the rich and famous. It's expensive competing with Russian oligarchs and royalty from the Emirates for prime real estate in London and Manhattan. Not to mention the cost of Ferraris, yachts, private jets, fine art, and plastic surgery for our vain trophy wives is skyrocketing up in a world of ZIRP and QE!!"
Oh, cry me a river! When I was investing in hedge funds at the Caisse, one of the running gags was if we had a dollar every time some hedge fund schmuck told us he had "a niche strategy that's uncorrelated to the market," we'd all be multi-millionaires!
Thank god I'm no longer in that business because I'd be the biggest pension prick grilling these grossly self-entitled hedge fund prima donnas charging alpha fees for leveraged beta. And most hedge funds are still underperforming the market! No wonder hedge funds saw their worst year in closures since 2009 last year and a few top funds don't want to be called hedge funds anymore. Most hedge fund managers absolutely stink and should follow Goldman's fallen stars and pump away!
Alright, enough ranting on crappy hedge funds. Let's get serious. I think it's high time we critically examine what hedge funds and private equity funds offer pensions and other institutional investors. And by critically examine, I don't mean some puffy article written in Hedgeweek, extolling the virtues of hedge funds using sophisticated and (mostly) irrelevant mumbo jumbo. I mean "where's the beef baby?" and why should we pay these guys (it's still an industry dominated by testosterone) all these hefty alpha fees so they become nothing more than glorified asset gatherers on their way to becoming part of the world's rich and famous?
As far as fees are concerned, I don't fully agree with Unigestion's Nicolas Rousselet. I don't want hedge funds to be compensated for taking bigger risks, I want them to be properly compensated for taking on smarter risks. There's a huge difference and incentives have to be properly aligned with those of investors looking to consistently achieve some bogey, however illusory it might be.
As I've stated, there's a bifurcation going on in the hedge fund and private equity industry. The world's biggest investors are looking for "scalability" which is why they're increasingly focusing on the larger funds and using their size to lower fees. But they're still paying huge fees, which takes a big bite out of performance over the long-term.
As far as the smaller funds, they typically (but not always) focus on performance but they need to charge 2 & 20 to survive. Big pension and sovereign wealth funds aren't interested in seeding or investing in them, which is a shame but very understandable given their limited resources to cover the hedge fund universe. Typically, smaller endowment or family offices or a former hedge fund billionaire boss are their source of funding.
If I can make one recommendation to the Institutional Limited Partners' Association (ILPA) as well as the newer Alignment of Interests Association (AOI) is to stop schmoozing when you all meet and get down to business and come up with solid recommendations on hedge fund and private equity fees and terms.
What do I recommend? I think hedge funds and private equity funds managing multi billions shouldn't be charging any management fee -- or they should charge a nominal one of 25 basis points, which is plenty to pay big salaries -- and the focus should instead be on risk-adjusted performance. The alternatives industry will whine but the power isn't with them, or at least it shouldn't be. It should be with big investors that have a fiduciary duty to manage assets in the best interests of their stakeholders and beneficiaries.
I still maintain that most U.S. public pension funds are better off following CalPERS, nuking their hedge fund program. They will save big on fees and avoid huge headaches along the way. And forgive my bluntness but most pensions don't have a clue of the risks they're taking with hedge funds, but they're all following the herd, hoping for the best, managing career risk even if it's to the detriment of their plan's beneficiaries.
On that note, I leave you with something else to chew on. Neil Simons, Managing Director of Northwater Capital's Fluid Strategies sent me a comment on operational risk, A Hedge Fund Manager, an Astronaut and Homer Simpson walk into a bar…:
We would like to propose a question to you: Is it possible for an investment management firm to operate with the same level of precision and reliability found in industries where failure is simply not an option?Neil followed up with these comments for my blog readers:
To answer this question, we looked at operational practices in industries such as nuclear power, space travel, aviation and healthcare, which face the prospect of catastrophic failure on a daily basis and have the highest standards for reliability and quality – after all, failure in these industries is a matter of life or death. While the consequences of success or failure in the investment management industry may not be quite as extreme, we do believe that investment managers must treat their investors’ dollars with the same level of respect and thus operate to the same standards.
In this post, we explore what investment management would look if we applied the same level of operational excellence found in these industries. Investment management is a business of precision, yet far too often you hear rumours of ‘fat-finger’ execution errors, or other more serious issues due to operational failures. And these are only the failures that you hear about – what about the failures that go unreported to clients, or even worse, failures that the investment manager itself is not aware of? What it all comes down to is that errors in investment management, no matter how small, are a sign of a lack of quality, and with a lack of quality there is a potential for loss and deviation from strategy.
Are Current Best Practices Sufficient?
Most major operational deficiencies (lack of proper oversight and separation of duties, for example) can often be uncovered by traditional manager due diligence activities. However, many approaches to manager due diligence are conducted through the use of questionnaires which are often built around a series of “check boxes” to ensure that nothing large falls through the cracks. This process places little attention to the quality and repeatability of investment operations. Third party due diligence firms conduct more detailed reviews, but can only see so far into the manager’s processes.
Most practitioners would agree that the intricacies of processes are a potential source of operational risk. For example, frequent small errors could be a reason why a fund might deviate from its benchmark or intended strategy. These errors may also reflect a general lack of attention to detail in the manager’s organization. But most importantly, they conspire to provide the investor with something other than what they are paying for – quality service and predictability of returns.
The Next Level: Systematic and Detailed Examination
Passing a due-diligence audit is a good first step, but managers have the ability to hold themselves to a higher standard. When we at Northwater think about operational deficiencies, we look at all potential failures that can occur throughout the investment process, e.g., inside the details of reconciliation processes, trade execution and model updates. It is only at the finest level of granularity that one can assess errors that may go unnoticed. A systematic method is needed in order to investigate, prioritize and the resolve potential failures.
Failure Mode and Effects Analysis (FMEA) is one technique that we have implemented to assess quality and to reduce the probability of smaller errors, not just to prevent large, obvious ones. FMEA was originally developed by reliability engineers and is widely used today in many non-financial industries. To implement FMEA concepts, we have taken an in-depth look at our own processes to identify areas that can be improved, examine the potential results of errors that can occur, develop highly-documented processes to ensure accuracy and consistency, and continually review and improve these processes.
Nuclear power plants, airlines and hospitals have all adopted strict and well-documented quality control processes that prevent not just large errors, but the potential for a small error to propagate through a system with the potential to push a system beyond its tipping point.
Acknowledge the Human Element
Other industries explicitly acknowledge and manage the human factor and acknowledge that human error rates are not zero even for the simplest task. Consider a study conducted by NASA to understand human error rates when performing relatively simple tasks; cognitive scientists have found that humans have base error rates in performing even the simplest tasks such as the classification of even vs. odd numbers or identification of triangles.
Despite the best intentions of employees, an underlying issue in investment management is that firms are made up of people and people make mistakes – it is inevitable. Even if the average employee isn’t Homer Simpson, the pilots from “Airplane!”, or the cast from TV’s “Scrubs”, the staff at these organizations face legitimate challenges such as time availability, stress levels, distractions, and even ergonomics and office culture. As such, a lot can be assessed from a review of the processes in place to manage the ‘human factor.’
At Northwater, we have explicitly acknowledged the human element within our processes as well as the performance shaping factors that can impact human performance. Automating processes is a standard method for minimizing the probability of an operational error. It is also possible to redesign processes to reduce complexity. This reduction in complexity helps to minimize the probability of error when a human is involved with a process. We believe that this is an important aspect of our approach to the minimization of operational risk.
By looking to other industries, investment managers can achieve a higher operational standard. If you are interested in learning more about our novel approach to understanding and minimizing operational risk, please contact us.
As discussed, we probably didn't go into sufficient detail in the post. We did quite a few things in our opinion to reduce operational risk.Those of you who are interested in finding out more about the FMEA process and Northwater Capital's Fluid Strategies should contact Neil directly at nsimons@northwatercapital.com. As someone who has invested in many hedge funds, I can unequivocally tell you human mistakes happen more often than investors and funds want to acknowledge and there should be a lot more rigorous industry standards to mitigate against operational risk.
One, as mentioned, was the implementation of the FMEA methodology. Requires all the people involved in daily trading (PM's, ops people, model people) to systematically map all processes and then brainstorm on how processes can fail. Then rank how failures can cause problems by severity and ultimately prioritize and implement changes to processes to eliminate or significantly reduce the probability of those failures.
FMEA is a standard practice in many other industries to assess operations but you don't seem to hear about it in finance.
We believe that standard op risk practices are important and useful for finding issues associated with investment management firms. They play an important role in helping investors. This topic is more about assessing quality and repeatability of operations. And achieving the highest possible quality, resulting in minimizing the probability of an operational issue associated with day to day portfolio management.
We believe that the third party operational risk firms can't ever go into as much detail as the management firm itself. It is only the people involved in the actual processes that can really understand how processes could fail. Benchmarking and big picture best practices are done well by the third party people but I don't believe they can do a good job at assessing the real quality of the processes.
Financial firms typically strive to implement industry best systems. However, at times, these systems require workarounds and spreadsheets. As well, many of these workaround can be operated by junior people and we believe they are accidents waiting to happen. It is just assumed that these people won't make mistakes or it is up to these people to show sufficient "attention to detail" to never make a mistake. But to us, that is an unrealistic assumption.
Humans make mistakes.
The next aspect that helped us was acknowledgement of the human side. Once you read some of the literature on how humans screw up simple things, you realize it is just a matter of time until someone makes a mistake while operating a process. Humans have small, but non zero error rates for even the simplest tasks. As task complexity increases, the error rate increases.
If a diligent person does 20 simple tasks per day and they do that every day for a year, then you should consider the potential error rate of those tasks. A 1 in 1,000 error rate will cause errors to become a reality for the case of 20 tasks per day for an entire year. If the potential consequences of one of those errors is severe then you have a real problem.
When humans are involved in a process, make their tasks as simple as possible. This accounts for increasing error rates that occur as task complexity increases.
Obviously automation is a well-known solution. Some tasks can’t be automated or at times, systems require some human intervention, and at times a human must intervene in the instance of an exception. These are the instances when the human element should be considered.
We have implemented many more checklists and improved existing checklists for clarity. Implemented many more double checks for tasks involving humans and have also strived to make the independent double checks truly independent. i.e., two people sitting beside each other looking at the same information at the same time is not an independent test since they will potentially influence one another and reduce effectiveness of what is supposed to be an independent check.
We have also implemented a daily pre-trading huddle with people involved with trading, model updates, operations in order to understand the portfolio management tasks for the day. This mirrors the huddles that are more frequently used in operation rooms before a procedure starts (see “Checklist Manifesto”, book by Gawande below).
Again other industries recognize some of these human elements and try mitigate. Finance doesn't seem to do that, most just assume that humans involved in processes perform their tasks perfectly.
We intentionally also modified our working environment. During portfolio management model updates and trading times we do not permit any interruptions of the portfolio management team. We place an indicator in the office that says tells other people in the office that the portfolio management process is taking place and to stay away and do not interrupt the portfolio management team (operations, model updates, reconciliation, trading). An open office (most trading rooms) is great for communication, sharing ideas, etc. but a disaster waiting to happen if you consider how humans perform when they are interrupted or bothered while performing tasks. Again, other industries are aware of these issues.
The FMEA process changes need to be considered within that context. Obviously automation is key, but humans are involved in most processes at some point along the line. Making the human involvements as simple as possible and having safety modes that can catch failures is also key. FMEA is a manner for understanding all of that.
Implementing FMEA and also reading all about how humans make errors changes our way of thinking. We believe we have improved operational efficiency and minimization of operational risk.
As always, feel free to contact yours truly (LKolivakis@gmail.com) if you have any insights you want to share on transforming hedge fund fees and mitigating operational risks. I don't pretend to have the monopoly of wisdom on these important topics and even though I come off as an arrogant cynical prick, I'm a lot nicer in person (just don't piss me off with your bogus niche strategy and if you ever want to meet me, the least you can do is subscribe or donate to my blog!).
One astute hedge fund investor shared his insights with me after reading my comment:
The challenge is that the managers who know they can deliver sustainable alpha (ie the only ones it is worth investing in under the current fee structure paradigm), are still not negotiable today unless you are prepared to write 10 figure tickets and underwrite business risk yourself. There is a considerable capacity shortage for quality alpha generators. In rare instances, 2% and 20% might not be enough!Below, CNBC's Kate Kelly reports on the new players in hedge funds leading corporate activism. I've got a great young activist fund manager looking to get seeded in a world where everyone is hot and horny for big hedge funds. If you're interested, contact me directly (LKolivakis@gmail.com).
However, in many instances, 0% and 25% is too much if you factor in all the operational risks that you face.
Unfortunately, the biggest problem brought by high fees is borne by managers as a whole in the form of abnormal attrition rates. High attrition rates exist partly because investors cannot tolerate drawdowns from high management expense ratio operation. That triggers a window dressing exercise, whether it is voluntary or policy driven.
I think if managers rewarded long-term investors by reducing the fee paid by an investor by a notch on each of its investment anniversary, attrition rates would stabilize. It would be less psychologically painful to re-underwrite a losing fund if the fee structure comes down every year. The only risk from the manager view point is that if he is really successful, after a few years, every investor stuck around and now its entire capital base is charged below market rates. But there are ways to circumvent that second order problem.
That's one approach we have tried to implement without success due to existing MFNs but we never lose an occasion to talk about that.
Ironically, MFNs signed by large investors who are members of high profile investor associations that supposedly promote better alignment of interest is what makes it almost impossible for managers to consider alternative fee structures where the economics are less skewed in favor of the manager.
Second, a discussion on alternative investing strategies amid changing trends in interest rates, with Colbert Narcisse, Morgan Stanley Wealth Management head of Alternative Investments Group.
As my friend Brian Romanchuk points out in his blog, investors are making mountains out of molehills on the Fed lift-off. In his latest comment, Brian critically examines why the Fed is keeping rates low looking at former Fed Chairman Bernanke's first blog comment (for me, it's simple, raising rates now would be a monumental mistake but don't ever discount huge policy blunders!).
Lastly, Jamie Dinan, York Capital founder and CEO, shares his global economic forecast for Europe, Japan and China. He's a lot more optimistic than I am on Europe, Japan and China but I'm still playing the mother of all carry trades fueling the buyback and biotech bubbles everyone is fretting about.
As always, I work extremely hard to provide you with the very best insights on pensions and investments. The least you can do is show your financial support by donating any amount or by subscribing via the PayPal buttons on the top right-hand side (under click my ads pic). I thank those of you who have contributed and ask others to follow suit.
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