Opinion and Investing Column

Skarbeck: Hedge fund fees pile up despite bad performance

June 14, 2014

Ken SkarbeckInvestors continue to pour money into hedge funds, even though their performance has been downright awful.

The only explanation for this has to be the persuasive prowess of the entrenched army of advisers and consultants convincing investors they need hedge funds.

Their popularity explains one of the reasons hedge fund returns have suffered. Two or three decades ago, a handful of smart managers produced results by investing in undervalued corners of the market that mainstream investors would not touch.

Scooping up those undiscovered bargains led to outsized performance. Today, the ability of hedge funds to consistently outperform has largely been arbitraged away by too much money and too many managers chasing the same ideas.

Last year, the average hedge fund returned about 9 percent while the stock market, as measured by the S&P 500, rose 32 percent. Hedge funds haven’t beaten the S&P 500 return for five years running.

A few rational observers have pointed out the absurdity of hedge funds collecting high fees while delivering poor performance, but industry apologists have surfaced to defend them. Consultants now counsel investors that these investment vehicles shouldn’t be held to such “lofty goals” like beating the stock market.

One hedge fund-of-fund manager (a hedge fund that constructs a portfolio of several other hedge funds) argues hedge funds shouldn’t be judged against the stock market’s return, but instead be compared to the old 60/40 pension fund allocation model (a portfolio of 60 percent stocks and 40 percent bonds). We would counter with asking him to explain why a vehicle like a fund-of-fund should even exist!

So now their message is that hedge funds weren’t meant to outperform, but instead deliver mediocre “risk-adjusted” returns—albeit they still want to charge you “2 and 20” (a 2-percent management fee and 20-percent incentive fee on profits). Talk about moving the goalposts in the middle of the game!

To be sure, a few managers have excellent long-term records. David Tepper’s $20 billion Appaloosa Management hedge fund returned 42 percent last year, earning him $3.5 billion. On the other hand, Ray Dalio’s Bridgewater group of hedge funds has returned only 3 percent to 5 percent. Yet Dalio still collected $600 million in fees.

On a local level, the hedge fund allocation at the Indiana Public Retirement System is typical of most pensions. In the fiscal year ending June 30, 2013, INPRS had 8.6 percent of total pension assets, or $1.8 billion invested in 17 hedge funds. For 2013, INPRS paid $35.8 million in fees to hedge fund managers, or a whopping 29.2 percent of the pension fund’s total investment fees of $122.5 million.

With nearly one-third of its total management fee expense in 2013 going to hedge funds, INPRS received a net 6.9 percent return, while the S&P 500 index rose 20.6 percent over the same period.

Surely investors will eventually wise up and demand significantly reduced fee structures from their hedge fund managers. The fund-of-fund manager did have one thing right: A 60-percent stock and 40-percent bond portfolio would have delivered better results than hedge funds over the past five years, at a fraction of the cost and complexity.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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