The battle for the hearts and minds of investors has raged for over a decade now. On one side, hedge funds have argued that a boutique, alpha-centric approach is best while on the other side, mutual funds have used their considerable marketing and distribution skills to make the case for the tried and true (read: less idiosyncratic) approach of long-only investing. The central front in the battle is often the alignment between manager and investor. Hedge funds’ weapon of choice has been the performance fee. But as students of the industry are well aware, these weapons often backfire, leaving some investors with a feeling that they have just been the victim of friendly fire.
In the US, the SEC has always allowed performance-based fees for mutual funds as long as their effect is symmetrical. In other words, as long as the manager can lose, as well as win (see the related post “Long-Only Mutual Funds with Performance Fees…”). By 2001, researchers found that only about 2% of US mutual funds had the chutzpah to take that bet (see Elton, Gruber and Blake’s seminal paper on the topic).
An Armistice in Europe?
Meanwhile, in the UK, regulators have made no such stipulation. In it’s “Policy Statement 04/7”, the FSA cleared the way for performance fees – even dropping its earlier concerns about charging performance fees over a hurdle rate when that hurdle rate was based on a benchmark that lost money on the year (see page 17 of the FSA’s statement here).
Three years later, in December 2007, fund analytic firm Lipper penned a report concluding that UK mutual funds would eventually adopt the weapon. Reported Reuters at the time:
“As part of the wider industry phenomenon of differentiating between premium priced actively managed funds and lower cost index trackers, Lipper said the performance fee levels of UK collective funds could become increasingly influenced by the ‘two and twenty’ fee structure employed by hedge funds.”
Now a new report by Lipper examines the use of this weapon and reaches some interesting conclusions (available here with free registration). It has now been been six years since the FSA’s change of heart and only about 5% of mutual funds have instituted performance fees (remember, these are the traditional symmetrical kind that some have called a “free option” for the manager).
Today, two-thirds of performance fee charging UK mutual funds charge a performance fee whenever they beat heir benchmark – even when their benchmark loses money. (A fifth of funds avoid this issue altogether by choosing a cash benchmark.)
Laissez-Faire = Lesser Fare?
Lipper reports that the FSA ultimately dropped it’s proposal that all funds have a high water mark. In addition, the firm writes that the FSA also backed off any suggestion that fees should be capped when, in 2007, it arguing it did not want to “act as a price regulator.” (see page 43 of the FSA’s statement here).
So how has the UK’s laissez-faire approach to performance fees helped investors? Curiously, Lipper finds that:
“Over the past decade, of the funds where fund expenses have been analysed and a performance fee is in place, the average performance fee charged is just over 0.4% of fund assets, although the median (or middle value) is zero. The latter finding highlights that in the majority of cases funds with performance fees do not achieve the performance fee targets set.”
We’re not suggesting that the lack of ability for the median UK mutual funds to beat their hurdle rate was a result of regulatory issues, but it does beg the question “Why all the ruckus then?” (The report itself refers to the performance fees of true hedge funds “which can often double the level of annual fees...”. But that suggests that hedge funds are producing excess returns while mutual funds are not.)
Hedge funds’ Gold-Plated Back Offices?
The report calculates that the average back office costs of a retail European cross-border mutual fund amounts to 34 bps (on an asset-weighted basis). By contrast, the average back office costs of an “off-shore domiciled” hedge fund is only 31 bps. But these are asset-weighted averages, and mega-funds are able to spread those costs across a larger pool of assets – thus dropping the fee per dollar of invested capital. The fund-weighted average back-office cost for mutual funds and hedge funds is 41 bps and 87 bps – reflecting the tiny size (and therefore high expenses per dollar) of the average hedge fund.
Or does it? Lipper acknowledges that the average mutual fund is larger than the average hedge fund in the US. But in Europe, it says that they are “more likely to be of similar size to hedge funds.” This means that the difference between the typical mutual fund’s back office costs and the typical hedge fund’s back office cost is attributable to something other than AUM. Lipper writes that because of this, current HFSB guidelines on the disclosure of back-office related fees should be more “robust.”
In fact, Lipper says that pretty much every aspect of performance fee disclosure should be more robust. So it suggests a set of 10 “Fee Standards for Hedge Funds” in the spirit of those previously tabled by mega-investors CalPERS and the Utah Retirement Systems (see related posts). Most are standard fare in hedge fund due diligence questionnaires, but they are probably useful for mutual fund investors unfamiliar with the surprising intricacy of performance fees.
At the end of the day, performance fees aren’t so much a new weapon, as they are a refurbished weapon drawn from the early days of asset management (see related post). Even though the median UK mutual fund hasn’t exactly cashed in on performance fees, the FSA’s approach to this issue has accelerated the convergence of traditional and alternative investing and given retail investors access to investment strategies they may not have otherwise had.