Veryan Allen: Alpha and the 2 and 20 crowd

12.3.07

Alpha and the 2 and 20 crowd

A friend went to a famous restaurant recently. As she told me of the soup to nuts gourmet experience and enjoying the vintage Petrus and d'Yquem, I couldn't help wondering if some would argue she was ripped off. There was an even more famous restaurant nearby, that satisfied hunger pains just as well, served more people and whose track record was much longer. More importantly a typical meal tab there was approximately 1/100th of what the other restaurant charged. I informed her about the cheaper food elsewhere but she replied that, whilst aware of those lower food fees, the difference in quality was fairly reflected in the menu prices between 3 Star Michelin-rated and McDonalds restaurants.

No-one is forced to invest in hedge funds anymore than forced to eat at a top restaurant. People do so because the after-cost product is superior. It takes great skill to become a top chef and great skill to become a top money manager. Alpha and better risk-adjusted performance is worth paying for. The fees involved derive simply from widespread investor demand but limited fund supply. Good hedge funds are rare but there are decatrillions of global money looking for a reliable return higher than bonds but with LESS risk than long only equity. Competent hedge funds more than justify their fees. Competent fund of hedge funds and other intermediary allocators justify their second layer of fees for those investors without the time and expertise to do it themselves.

There has been renewed attack on hedge fund fees recently. In one paper Mark Kritzman concludes that after fee performance for hedge funds reduces their value to an investor. So what? We all know the AVERAGE hedge fund isn't very good and does not merit its fees. Even the new Berkshire Hathaway annual letter makes a jibe about 2 and 20 crowd not being worth it. The accusatory paragraph comes a few pages after revealing they made hundreds of millions trading those apparent weapons of mass destruction called DERIVATIVES. But these fee arguments throw the baby out with the bathwater. As Warren Buffett correctly wrote last week, "derivatives, just like stocks and bonds, are sometimes wildly mispriced". Surely those able to identify those mispricings should be able to charge whatever fees the market will bare and investors are freely willing to pay. I would have omitted "sometimes" though or changed it to "always".

Reliable alpha producers, after fees, CAN be identified ahead of time and that performance IS of great value to investors. It usually takes a bear market for investors to realise this. No-one disputes that if a fund makes 22% gross, the client would be better off if the fees were 0 and 0 instead of 2 and 20. It surely does not take an empirical study to determine that 16% to the investor is not as good as 22%. Surely what matters is that the 16% performance offers a new, diversified excess source of return. 80% of mutual funds are likely to underperform their index and, likewise, 80% of hedge funds are unlikely to be alpha generators. There is also no doubt paying 2 and 20 for asset or strategy beta is a waste of money, BUT 2 and 20 for alpha is a bargain.

2 and 20 has become the industry standard for many reasons but the main one is due to investors. Rightly or wrongly, lower fees get associated with lower quality fund products. I have heard these "fees are too high and are bound to drop" forecasts for years but they never pan out. I once asked a group of experienced institutional investors in hedge funds which of the following fee structures they would prefer for an otherwise identical fund. A) 2 and 20 B) 0 and 25 or C) 0 and 50 above a 10% hurdle. Most said they would choose A. They feared B and C would make a fund take too much risk and not correctly compensate a high quality investment team. The fee structure of hedge funds will not change because there is no incentive to change and professional investors look at the after fee returns. Whatever the critics and hedge fund replicators think, 2 and 20 (and above) is here to stay.

Alpha is like gold. There is lots of it out there but is hard to extract. The AVERAGE gold miner probably won't find much gold and the AVERAGE fund manager won't find much alpha. Those who figure out a way to mine alpha deserve the higher fees since it is worth its weight in gold. Alpha is theoretically in vast supply but the extraction costs are expensive. This is where these "limited supply of alpha" people get it so wrong. Gold is rare because no-one, yet, has invented a way to economically extract gold from sea water. Alpha is rare and expensive because very few will ever reliably find a rich seam of it, or develop a sustainable way to mine that seam. But plenty of alpha is out there and investors will ALWAYS be prepared to pay a rich premium for the highest quality alpha product.