Last week both Ford and Delta got off their deathbeds to hand out goodies to many of their employees. Response was swift as bloggers and columnists asked why a company like Ford that lost $12.7 billion last year was in a position to hand out anything at all. “What a waste!”, bloggers wrote. “It’s all so hopeless”, “Nothing ever changes!”.
Hedge funds of funds face a similar problem nearly every year. Typically, a single hedge fund charges a 2% management fee and a 20% performance fee. A fund of funds then adds a further 1% management fee and often a 10% performance fee of their own. So on the surface, the nickname “fees of fees” may seem appropriate to some.
But the effect of dual fee layers is more complex than it looks on the surface. An article by Mark Hulbert in last weekend’s New York Times (reprinted here in Friday’s IHT) fees refers to an MIT study on the “deadweight” fees paid by hedge fund of funds investors. The paper explains that an end-investor in a fund of funds often ends up paying performance fees even if their fund loses money because some underlying managers are always bound to produce positive returns. Ironically, the source of this problem is the very reason funds of funds exist: diversification.
“Deadweight” refers to the actual performance fee paid above and beyond that which would have been paid on the average return of all underlying funds. If all underlying funds moved in unison (ie. with a correlaion of 1.0), then you’d never end up paying performance fees during losing years. But if your underlying funds had a zero correlation, then there would be a good chance some would be up and some would be down. And as a result, you’d be paying the winners a performance fee in a losing year for your overall fund of funds. In other words, you’d be paying a price for the very diversification you sought when you invested in the fund of funds.
The study says that given the same level of correlation between funds in the portfolio, the deadweight costs will rise with a higher volatility. This makes intuitive sense when you consider that dramatic ups and downs will naturally amplify any differences between actual performance fees paid and the fees that would have been paid on the average return. The following chart from the MIT study summarizes these findings.
The study goes on to show that increasing the number of funds will increase the deadweight costs – but at a decreasing rate (note that this chart assumes a standard deviation of 10% shown by the green dots above):
The authors of the study propose a few solutions to this deadweight issue. Firstly, they point out that multi-strategy funds don’t face the same arm’s length issues and can therefore put the kibosh on all performance fees in losing years:
“…a multi-strategy fund structure possesses its own set of problems resulting from a unique set of agency issues. Unlike a typical FOF, a multi-strategy fund does not take an arms-length approach to its underlying managers. Each manager belongs to the same organization, which tends to create problems of political nature when it comes to manager termination, compensation and capital allocation.”
But where underlying funds operate at arm’s length, the authors side with a proposal where funds of funds absorb performance fees in losing years by charging higher management fees every year. In other words, just let the fund of funds pay the deadweight costs inherent in their business model:
“Brown, Goetzmann and Liang propose an alternative to the traditional FOF fee arrangement wherein a FOF fully absorbs the individual HF incentive fees. The FOF manager could then hedge the underlying incentive fee exposure. The arrangement could be made revenue-neutral for the FOF manager if this additional cost is reimbursed either in a form of a higher asset-based expense or through a larger incentive fee. We also argue that for investors, compensating the FOF manager with a higher asset-based fee is superior to the ramped-up incentive fee because it avoids increasing the FOF’s desire for volatility. Also, such a compensation arrangement would provide substantial benefit to the investor by making the cost structure more transparent. Additionally, the desire to minimize the cost of hedging would encourage a FOF to better understand the underlying HF strategies resulting in an increased effort to perform due-diligence on the underlying funds.”
Ford and Delta have the ability to quash all performance fees (like a multi-strategy fund). But obviously, they elect not to do so. Instead, these firms effectively pursue the strategy laid out above – charge enough each day (to customers and shareholders) so they can eat the bonus costs without having to jack-up prices. Shareholders can only hope these companies have effectively “hedged the underlying incentive fee exposure”.