2 and 20?

2 and 20? A friend ate at a top restaurant recently. As she related the soup to nuts gourmet experience, I wondered if economists would argue she was ripped off. There was an even more famous eatery nearby, that satisfied hunger just as well, served more customers and whose track record was much longer. A meal there cost a few dollars compared to hundreds where she ate. I asked about her "irrational" decision and the "cheaper" food elsewhere but she said that, while aware of those "lower" fees, the difference in QUALITY and VALUE was fairly reflected in comparing prices at three star Michelin restaurants with McDonalds.

Good hedge fund = three Michelin stars, passive index fund = cheap fast food. 2 and 20 has become the industry mode for many reasons but the main one is due to investors. Rightly or wrongly lower fees get associated with lower quality products. I have heard "fees are too high and will decrease" for many years but they never happen. Why should they? You can always find lower cost INFERIOR products. In my experience hedge funds">hedge funds that reduce fees aren't top tier or are usually just selling repackaged beta. Check out the abysmal risk-adjusted returns from "low cost" index funds. Get what you pay for.

2 and 20 fees for REAL absolute returns is a great deal. Demand outstrips supply but some investors still balk at paying for skill. It makes sense that those with the rare ability to generate alpha charge a fair rate for access to that technology. Alpha is like oil in requiring specialist expertise and equipment to locate and extract. Oil fuels airplanes and alpha fuels portfolios not beta if you are risk averse like me.

Investors need alpha because "cheap" beta is TOO risky. "Passive" index funds are very expensive in bear markets. If you don't like the "high" fees then please DON'T invest in hedge funds">hedge funds. It leaves more room for investors that prefer absolute returns more than relative returns because they have trillions in absolute liabilities to meet. The capacity for a quality hedge fund is limited like getting a reservation at a popular restaurant.

I once asked a group of experienced institutional investors which of the following fee structures they would prefer for an otherwise identical hedge fund. A) 2 and 20 B) 0 and 25 or C) 0 and 50 above a 10% hurdle. All, yes ALL 100%, said they would choose A). They feared B and C might induce a manager to take too much risk. I've also seen two similar strategy hedge funds">hedge funds make it to a final selection "beauty parade" with the first charging 1 and 20 and the other 3 and 30. Guess who got the mandate? Quality rarely competes on price. Take a look at the "performance" of funds with no incentive fees!

It would be great to have a stock market that went up 10% each and every year but we don't. It would be even better to buy a risk free bond yielding 5% above the inflation rate and be certain to receive back interest and principal but we don't have that either. It would be nice to live in a world where car and home insurance weren't necessary but they are. People pay insurance premiums to cover against bad events. Investors pay hedge fund fees to those FEW managers able to make money for them in tough economic conditions.

A listed hedge fund called Berkshire Hathaway recently issued a shareholder letter saying the 2 and 20 crowd is not worth it. That is obvious since talent is rare. The "crowd" cannot have skill, by definition. BRKA made "hundreds of millions" trading those apparent weapons of mass destruction called DERIVATIVES. Do as I do not as I say? The fee "debate" throws the baby out with the bathwater. As the hedge fund's manager Warren Buffett correctly wrote, "derivatives, just like stocks and bonds, are sometimes wildly mispriced". Surely those able to identify such anomalies can charge whatever fees clients are freely willing to pay. The crowd exists so that the best managers can arbitrage it.

If Warren Buffett can subsist on cherry coke and hamburgers that is his right and privilege but most people need more sophisticated fare in their diets AND their portfolios. No-one is forced to invest in hedge funds">hedge funds anymore than forced to eat at a good restaurant. People do because the after fee product is superior. It takes great skill to become a top chef and great skill to become a top money manager. Just like good food, alpha and outstanding risk-adjusted returns are worth paying for.

Hedge funds might appear to be portfolio deadweight during strong bull markets. It could even temporarily seem like an investor does not need them. The fees are "higher" and the performance will generally be "lower" comparatively when stocks are doing well. Hedging has a cost. Sophisticated strategies are also more expensive to implement. But such contentions fail to take account of the role of good hedge funds">hedge funds in achieving portfolio diversification, reducing volatility and monetizing true investment skill.

The fees for alpha stem from widespread investor demand but limited supply. Good hedge funds">hedge funds are rare but there are trillions of dollars of global money looking for a RELIABLE return higher than government bonds but with LESS risk than long only equity. Competent hedge funds">hedge funds more than justify their fees. Fund of hedge funds">hedge funds and other intermediary allocators charge a second layer of fees to those investors without the resources, time and expertise to do it themselves. Multistrategy is NOT multimanager.

There has been renewed attack on hedge fund fees recently. Some think they are too high so they avoid "expensive" hedge funds">hedge funds and take their chances with the enormous risk of long only equity. That is good for sophisticated investors since it leaves more room for those that understand the diversification value of SKILLED strategies. In a recent paper Mark Kritzman concludes that after fee performance of "all" hedge funds">hedge funds reduces their value to investors. So? We already knew the AVERAGE hedge fund isn't any good and does not merit its fees just like the AVERAGE restaurant.

Reliable alpha producers, after fees, CAN be identified ahead of time and that performance IS of great value to investors. However, it usually takes a bear market for investors to realise this. Mark Kritzman would have reached a very different conclusion had he used solely 2000-2002 or 1970s data. No-one disputes that if a fund makes 22% gross, the client would be better off if the fees were zero instead of 2 and 20. Next time you go shopping insist on paying only what it cost to manufacture what you bought. Good luck with that. And index funds don't seem so "cheap" when they squander 50% of YOUR money.

It surely does not take an empirical study to determine that 16% to the investor is not as good as 22%. What matters is that the 16% performance offers a new, diversifying source of return. 80% of mutual funds are likely to underperform their index and, likewise, 80% of hedge funds">hedge funds are unlikely to be alpha generators. There is no doubt paying 2 and 20 for repackaged beta is unnecessary but 2 and 20 for alpha is a bargain.

The fee structure of hedge funds">hedge funds will not change because there is no incentive to change and professional investors, unlike the mainstream media, look at the after fee RISK ADJUSTED returns. Whatever the critics and hedge fund replicators think, 2 and 20 is here to stay. Warren Buffett was able to charge 0 and 25 in his hedge fund because he was the sole employee and markets were less complex and competitive in the 50s and 60s. The "2" nowadays goes towards the higher strategy development costs in today's markets and paying the deep benches of employees now required by investors. I'd be the first to concede that the "20" should only be charged on the alpha, not the beta.

The AVERAGE gold miner probably won't find gold and the AVERAGE fund manager won't find alpha. Those who figure out a way to generate alpha deserve the higher fees since it is worth more than gold. Alpha is theoretically in vast supply but the research costs are high. This is where these "limited supply of alpha" people get it so wrong. Gold is also considered "rare" because no-one, yet, has invented a way to economically isolate gold dissolved in sea water, but the world's oceans contain billions of tons. There is lots of alpha out there.

Alpha is rare and expensive because very few will ever reliably find a rich supply or develop a sustainable way to mine that seam. But plenty of alpha is out there and investors will ALWAYS be prepared to pay a premium for the highest quality money managers. Just because alpha, oil and gold are DIFFICULT to produce does not mean they are not abundant. It's the extraction costs that merit that 2 and 20. "Cheap" beta won't do it and is too risky anyway.

by Veryan Allen. Copyright

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