Putnam’s new crossover hits showrooms

27 May 2009

Yesterday we highlighted a series of media articles that described the ongoing skirmish between hedge funds and mutual funds as a “resistance” movement and a “turf war”.  Today, we examine one mutual fund that adopted several of the key weapons used by hedge funds without actually using the term “hedge fund.”

When asked to list the key differences between hedge funds and mutual funds, most point to the (potential) use of leverage, investment latitude and performance fees.  Indeed, these weapons have been banned by mutual fund regulators.

Leverage by any other name

Enter Putnam’s new “Equity Spectrum Fund”, listed as a “blend” fund on the firm’s website.  Like most mutual funds, this fund invests in equities without using any borrowed money.  But like many hedge funds, the Equity Spectrum Fund actually includes leverage – only this leverage exists within the holdings, not within the fund itself.  The fund invests in “leveraged companies”.  And according to the Putnam website

“Funds that invest in securities of leveraged companies involve the risk that the securities of leveraged companies will be more sensitive to issuer, political, market and economic developments than the market as a whole and the securities of other types of companies. Investments in securities of leveraged companies are likely to be more volatile than investments in companies that are not leveraged.”

But isn’t the holdings-level leverage more benign than the more traditional fund-level leverage we have come to associate with hedge funds?  Not really, say many experts who point to derivatives investments as examples of high leverage even though the hedge funds holding them use very little explicit leverage.

Leverage = Distress?

The fund’s prospectus refers to leveraged companies in vaguely positive terms, as if the companies actively chose to become highly-levered…

“Leveraged companies are companies that employ significant leverage in their capital structure through borrowing from banks or other lenders or through issuing fixed income, convertible or preferred equity securities.”

Of course, many companies simply become levered because their equity value has tanked.  So in a way, this high yield fund (or more accurately, its fixed income twin) might end up looking a lot like a distressed debt hedge fund.

Performance Fees, Sort of

But perhaps the most striking similarity between the Putnam Equity Spectrum Fund and a real hedge fund is the existence of a performance-based fee.  Mutual funds are barred from charging hedge fund-style asymmetrical fees (where the manager can win, but can’t lose).  So Putnam has adopted a “performance-based adjustment” to its management fee.  (You might miss it if you read the prospectus since, oddly, it’s described under “fund manager” not under “fees”).

Here’s how it works according to the prospectus…

“Commencing with each fund’s thirteenth whole calendar month of operation, the monthly management fee will consist of the monthly base fee plus, or minus, a performance adjustment for the month. The amount of the performance adjustment will be calculated monthly based on a performance adjustment rate that is equal to 0.04% multiplied by the difference, in percentage points, between the fund’s annualized performance (measured by the fund’s class A shares) and the annualized performance of the benchmark described below, over the performance period.”

Translation (as best we can decipher): If the fund beats the benchmark by 1%, the annual management fee will go up by 4 bps.  If the fund beats the benchmark by 10%, the annual management fee goes up 40 bps.  Unlike a hedge fund, however, the fee can also go down by 40 bps – which could mean a net fee of as low as 7bps in a worst case scenario.

Performance/Fee Convexity

When incremental performance has an increasing effect on fees, the performance/fee relationship is often said to be convex.

A lot of research has been conducted on the effects of traditional asymmetrical performance fees on manager behavior (see our entire section on fees or our dossier of white papers on fees for various examples).  But the effects of this kind of symmetrical fee on manager behavior is less researched.  As a result, questions remain.

For example, how does the added incentive from a “performance adjustment” compare with the existing incentive for managers to produce high returns in an effort to collect more assets (and, in turn, earn higher fees)?  After all, even mutual fund management fees are convex to some extent since higher returns lead to more assets, which leads to even higher fee revenue in future periods.  Beating the benchmark by 10%, for example, would surely lead to an increase in assets.  If assets doubled over the course of a stellar year on a fund with an 80bp fee, that would be analogous to a performance adjustment of +80bps on the same asset base (i.e. to an effective 160 bps).

The answer to this question might lie in the investment manager’s compensation agreement.  If the investment manager receives a higher proportion of the incremental performance fee adjustment than he/she does of the “base” management fee, then even a doubling of assets on an 80bp fund might not be as beneficial as an adjustment of 20 or 30 bps accruing mainly to the manager.  Since the management fee adjustment is listed in the “Fund’s Investment Manager” section of the prospectus, this may indeed be the case.

The investment manager, David Glancy, joined Putnam after running – you guessed it – a hedge fund that apparently charged the prototypical “2 and 20”.   That hedge fund pay-off structure could be approximated  (albeit at a lower quantum…but on higher potential assets) using the performance adjustment described above.

If You Can’t Beat ’em Join ’em

Most of the criticism of hedge funds has been focused on their legal structure and fee asymmetry.  Meanwhile most of the criticism of mutual funds has been focused on their lack of manager incentive alignment and investment flexibility.  By combining the torque, alpha potential and incentives of hedge funds with the legal structure and fee symmetry of mutual funds, we may see that these kinds of cross-over funds are the way forward for the fund management industry overall.

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