Closing book on fees racket of hedge funds
At the risk of being called hypocritical after long advocating the use of hedge funds as a way of managing the downside risk of an investment strategy, I have swung 180 degrees in the other direction.
For 13 years I was a convert. I believed that the use of complex strategies, including concepts such as “shorting”, “leverage” and “downside risk management”, in the hands of very smart people had the potential to deliver on the loose promise of returning two-thirds of equity market upside and one-third of the downside.
When faced with the risk of emerging markets exposure, the capital protection proposition was just too appealing, despite the astronomical fees hedge funds have been charging. A typical fee structure used to be at least 1% basic management fee and 20% of all positive returns, with a high-water mark in place (the latter means that performance fees can only be levied on the positive returns once — if the performance dips, the loss first has to be recovered before new performance fees can be levied).
For 11 of the 13 years the hedge funds seemed to deliver exactly that. Given the delivery, no one looked at two key aspects: hedge funds delivered positive returns during a period of an almost continuous bull market that floated all boats, and they charged handsomely for that experience. A simple index fund tracking the FTSE/JSE shareholder weighted index charging a 0.20% annual management fee would have done better.
Other things have happened to hedge funds. Somehow the concept of high-water marks in performance fee calculations has been abandoned by many.
Other invisible fees were introduced, with or without the knowledge of investors, including termination fees and operational fees being levied within the funds in addition to management fees.
Most significantly, risk management frameworks that were strongly marketed to investors somehow dissipated into the ether. Survivorship bias, which meant that failing hedge funds disappeared, helped to perpetuate the myth that hedge funds overall did well — as did award ceremonies, magazines and surveys dedicated to hedge funds.
Unfortunately for hedge funds two major events came along that have forever changed their future. Regulatory change forced hedge funds to convert into unit trusts and become more transparent about the fees they really charge. Some have done so, others are still ducking and diving. But not for long.
The second change was the end of quantitative easing and free money hitting emerging markets. The tide turned when the US Federal Reserve started increasing interest rates. As inflows into emerging markets turned into outflows, negative, volatile market returns came back with a vengeance. This should be the ideal time for hedge funds to show they can finally deliver on the promise of preserving capital. The sad truth seems to be that they cannot.
In a world of macroeconomics and Donald Trump’s tweets driving returns, stock picking is largely irrelevant. What does it matter if Absa’s share price outperforms FNB’s if the rand volatility can take it all away? Hence, most hedge funds have lost more money than they have made.
Once you know that the emperor has no clothes you cannot in good conscience support what has become a management fee racket. Despite a 13-year performance track record, Sygnia has therefore closed all its hedge fund products, fired all hedge fund managers and hopefully closed a chapter on this form of investing. We are not alone. Internationally, similar trends have driven investors into passive or index-tracking investment propositions in droves. Long may the new rationality prevail.