Monday

2 and 20

2 and 20? A friend just ate at a top restaurant. Economists say she was ripped off. Nearby was a more famous eatery crowded with satisfied clients. Food there cost a few dollars compared to hundreds where she ate. I asked about her irrational decision avoiding "cheap" products but she said while aware of "lower" fees, differences in SKILL, EXPERIENCE and VALUE were obvious between 3 star Michelin chefs and McDonalds burger flippers.

McDonalds and index funds price "low" due to the ingredients, work and talent that goes into them. My clients can't stomach the contents of either. Their true cost is enormous. Top funds and restaurants are capacity constrained. If you don't like the fees DON'T INVEST and join the LOW FEE, HIGH RISK crowd. Investors are free to take their chances with zero skill. I'd certainly prefer if people invest elsewhere. AUM capacity is always a problem with access to talented managers. It serves me well if others avoid hedge funds. I can put more capital with the best.

Bogle is right. Go with cheap trash. DO NOT invest in hedge funds. I need EXCLUSIVE access to the best. STAY AWAY. Gamble your wealth on long only and enjoy vicious volatility and 50% drawdowns. Hard work, thorough analysis and risk management are for losers, right? My clients are risk averse and need AUM capacity before top managers close. Cost is determined by demand and supply. There's vast demand for a tiny number of great hedge funds. Fees are trivial compared to value. 2 and 20 for alpha is a bargain for its rarity.

Good hedge fund = three Michelin stars, passive index fund = cheap fast food. 2 and 20 has become the skill-based fee standard due to INVESTORS. Low fees are associated with low quality funds. Pay peanuts, get monkeys. The next bear market will show (again) how EXPENSIVE index funds really are. Unlike Fama, French and Malkiel, at least McDonalds workers earn their pay. Tenured fools do not survive long in the real world they claim to be able to model.

Incentives work. Economic incentives are the foundation of any functioning industry. Index funds have poor risk-adjusted returns and devastating drawdowns in bear markets because they are NOT incentivized or good enough to manage risk. Do you really want the B-team managing YOUR money? Be very wary of funds that don't charge performance fees. The manager is stating he is not good enough to charge them.

I once asked a group of large institutions 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. All, yes ALL, said they would choose A). They feared B and C might induce a manager to take too much risk. I've also seen two similar strategy hedge funds make it to a final selection "beauty parade" with the first charging 1 and 20 and the other 3 and 30. Guess who got the mandate? Quality rarely competes on price. Take a look at the "performance" of funds with no incentive fees! Hedge funds are an example of a Veblen good. The higher fees the more popular.

50% drawdowns and NEGATIVE real returns for over a decade are common with high risk index funds like the S&P 500. Get what you pay for. I've heard "fees are too high and will fall" for years but it never happens. Why should they drop? You can always find low cost INFERIOR products. In my experience hedge funds with low fees aren't top tier and just repackaging beta. Check out the abysmal risk-adjusted returns from "cheap" index and relative return funds.

Avoid funds that don't charge incentive fees. The manager isn't incentivized to manage risk or make money for YOU. John Bogle sits around destroying peoples' retirements with his absurd "advice". Investors need alpha because "cheap" beta is too risky. If you don't like "high" fees DON'T invest in hedge funds. It leaves more room for my clients that prefer absolute returns more than relative returns because they have trillions in ABSOLUTE liabilities to meet.

The capacity for a quality hedge fund is limited like getting a reservation at a good restaurant. MCD has lots of room and doesn't take reservations! The S&P500 risk-adjusted returns have been disastrous since 1957 but passive trackers charge outrageously high fees for the "work" involved. Why is such unsuitable, expensive, dangerous dreck still being sold to retail investors?

Price is what you pay, value is what you get. 2 and 20 fees for REAL absolute returns is a great deal. Demand outstrips supply but some investors still balk at paying for skill. It makes sense that those with the rare ability to generate alpha charge a fair rate for access to that technology. Alpha is like oil in requiring specialist expertise and equipment to locate and extract. Oil fuels airplanes and alpha fuels portfolios not beta if you are risk averse like me.

It would be great to have a stock market that went up 10% each and every year but we don't. It would be even better to buy a risk free bond yielding 5% above the inflation rate and be certain to receive back interest and principal but we don't have that either. It would be nice to live in a world where car and home insurance weren't necessary but they are. People pay insurance premiums to cover against bad events. Investors pay hedge fund fees to those FEW managers able to make money for them in tough economic conditions.

A listed hedge fund called Berkshire Hathaway recently issued a shareholder letter saying the 2 and 20 crowd is not worth it. That is obvious since talent is rare. The "crowd" cannot have skill, by definition. BRKA made "hundreds of millions" trading those apparent weapons of mass destruction called DERIVATIVES. Do as I do not as I say? The fee "debate" throws the baby out with the bathwater. As the hedge fund's manager Warren Buffett correctly wrote, "derivatives, just like stocks and bonds, are sometimes wildly mispriced". Surely those able to identify such anomalies can charge whatever fees clients are freely willing to pay. The crowd exists so that the best managers can arbitrage it.

If Warren Buffett can subsist on cherry coke and hamburgers that is his right and privilege but most people need more sophisticated fare in their diets AND their portfolios. No-one is forced to invest in hedge funds anymore than forced to eat at a good restaurant. People do because the after fee product is superior. It takes great skill to become a top chef and great skill to become a top money manager. Just like good food, alpha and outstanding risk-adjusted returns are worth paying for.

Hedge funds might appear to be portfolio deadweight during strong bull markets. It could even temporarily seem like an investor does not need them. The fees are "higher" and the performance will generally be "lower" comparatively when stocks are doing well. Hedging has a cost. Sophisticated strategies are also more expensive to implement. But such contentions fail to take account of the role of good hedge funds in achieving portfolio diversification, reducing volatility and monetizing true investment skill.

The fees for alpha stem from widespread investor demand but limited supply. Good hedge funds are rare but there are trillions of dollars of global money looking for a RELIABLE return higher than government bonds but with LESS risk than long only equity. Competent hedge funds more than justify their fees. Fund of hedge funds and other intermediary allocators charge a second layer of fees to those investors without the resources, time and expertise to do it themselves. Multistrategy is NOT multimanager.

There has been renewed attack on hedge fund fees recently. Some think they are too high so they avoid "expensive" hedge funds and take their chances with the enormous risk of long only equity. That is good for sophisticated investors since it leaves more room for those that understand the diversification value of SKILLED strategies. In a recent paper Mark Kritzman concludes that after fee performance of "all" hedge funds reduces their value to investors. So? We already knew the AVERAGE hedge fund isn't any good and does not merit its fees just like the AVERAGE restaurant.

Reliable alpha producers, after fees, CAN be identified ahead of time and that performance IS of great value to investors. However, it usually takes a bear market for investors to realise this. Mark Kritzman would have reached a very different conclusion had he used solely 2000-2002 or 1970s data. No-one disputes that if a fund makes 22% gross, the client would be better off if the fees were zero instead of 2 and 20. Next time you go shopping insist on paying only what it cost to manufacture what you bought. Good luck with that. And index funds don't seem so "cheap" when they squander 50% of YOUR money.

It surely does not take an empirical study to determine that 16% to the investor is not as good as 22%. What matters is that the 16% performance offers a new, diversifying 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 no doubt paying 2 and 20 for repackaged beta is unnecessary but 2 and 20 for alpha is a bargain.

The fee structure of hedge funds will not change because there is no incentive to change and professional investors, unlike the mainstream media, look at the after fee RISK ADJUSTED returns. Whatever the critics and hedge fund replicators think, 2 and 20 is here to stay. Warren Buffett was able to charge 0 and 25 in his hedge fund because he was the sole employee and markets were less complex and competitive in the 50s and 60s. The "2" nowadays goes towards the higher strategy development costs in today's markets and paying the deep benches of employees now required by investors. I'd be the first to concede that the "20" should only be charged on the alpha, not the beta.

The AVERAGE gold miner probably won't find gold and the AVERAGE fund manager won't find alpha. Those who figure out a way to generate alpha deserve the higher fees since it is worth more than gold. Alpha is theoretically in vast supply but the research costs are high. This is where these "limited supply of alpha" people get it so wrong. Gold is also considered "rare" because no-one, yet, has invented a way to economically isolate gold dissolved in sea water, but the world's oceans contain billions of tons. There is lots of alpha out there.

Alpha is rare and expensive because very few will ever reliably find a rich supply 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 premium for the highest quality money managers. Just because alpha, oil and gold are DIFFICULT to produce does not mean they are not abundant. It's the extraction costs that merit that 2 and 20. "Cheap" beta won't do it and is too risky anyway.

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