Institutional Investor’s Daily ii reports today on a story at Financial News Online about hedge funds that charge more than the regular 2% management fee and 20% performance fee. According to Financial News Online, over half of these premium-priced hedge funds underperformed the average of “their cheaper peers” and most underperformed the S&P. Reports Daily ii:
“Calling such behavior ‘irrational,’ one private banker told FN that well-heeled investors take a certain amount of pride being associated to big name funds, regardless of performance. ‘They use the word â€˜vintage’ to describe the year in which they became an investor,’ said the banker. ‘It is just as they have bought a fine wine.'”
The unstated conclusion of this article is that investors should avoid high priced funds. We’re not saying hedge fund managers are altruistic with regard to pricing, but before the flood of new “hedge funds charge too much” stories, we wanted to make a few observations:
1. First of all, the conclusion that most high prices funds underperform the rest is a bit of a stretch. Financial News reached its conclusion from a sample of 13 “expensive” funds. Five (5) beat the average and 2 others were on track to beat it by the end of November. If they did end up beating the average, we might easily conclude that “expensive” hedge funds are no better or worse than the rest of them.
2. In any event, like all participants in a market economy, hedge fund managers charge the highest price they can. The result is an equilibrium between supply and demand for which no one – not the manager nor the investor – is to blame. That’s why no one blames gold miners for the high price of gold. Financial News Online (the story’s source) even quotes one manager who says:
Investors are not forced to put their money in. There is excess demand for funds over supply, we live in a capitalist world and, if investors are clamouring to get into a particular manager’s fund, I don’t begrudge him charging high fees.
3. The link between price and objective value has always been weak for premium products. Does a Gucci handbag perform 30 times better than a Kmart handbag? Probably not. But people pay for more esoteric reasons (brand). Even services generally considered to be a commodity can charge premium prices based on perceptions of safety and quality (e.g. long distance telephone services, bottled water, airline flights).
4. The willingness to bet on a higher priced fund reflects an investor’s belief in the expected value of that bet (tempered, of course, by the investor’s own utility curve and risk appetite). To investors in these funds, these prices are a fair bet. Asset management may look like a commodity where success is measured along one dimension: returns. But the expectation of performance (risk & returns) is apparently a critical, if “irrational”, part of the buying decision.
5. Finally, if we had a nickel for every time someone played “gotcha” by pointing out that hedge funds didn’t beat the S&P last year, we’d be running our own fund. Had hedge funds beaten the index in a bull market, we would be the first to lambaste the industry for selling a “hedged” fund while actually delivering a levered long-only fund.
In conclusion, it’s somewhat ironic that those who believe market efficiency makes “premium” hedge funds an impossibility, are so quick to blame high management fees on “irrationality” in the market for asset management services itself. With several premium-priced funds posting high returns in 2006 (Moore, Tudor etc.) and several others flat or down on the year, we propose a better way to invest your money than to shop around for the lowest possible fee: don’t pick bad funds.