Hedge fund fees?

Which incentive fee is lower for investors? Three years at 20% each year or 40% after three years? 3 x 20 is 60 so "only" 40% after 3 years must be better, right? WRONG. As with most performance measurement, conventional "wisdom" and first impressions can be misleading. Here's a look at the "lower" fee structure proposed by Lisa Rapuano for her so-called "hedge fund", Lane Five. Lots of positive commentary on this fee structure "innovation" which is odd considering how BAD a deal it is for clients. Every investor should know simple arithmetic. Running "value" strategies requires numerical skills.

Instead of assuming it's better let's compare the NET return of 40% triennial versus 20% annual incentive fees. Some quick algebra PROVES that her "cheaper" fee structure must have a negative year to have any chance of offering a better deal than annual performance fees! But minus years are unacceptable to hedge fund investors like me. I require absolute returns in all conditions. Clients would redeem well before the promised land of the 40% incentive fee kicks in.

Suppose Lane Five and a rival fund generate gross, before fee, performance of 10% above the S&P 1500 over the next three years. Assume the index itself stays flat to isolate the "pure" alpha fees. Both funds charge a 1.5% management fee but Lane Five's returns compound for 3 years and then levies the 40% cut of profits at the end of the 36 months. The other fund charges the standard 20% each year on NEW profits above the high water mark. Using these assumptions:

Lane Five (1.5%, triennial 40%) 3 year net compounded return +16.64%
Other fund (1.5%, annual 20%) 3 year net compounded return +21.82%

A 40% triennial performance fee costs investors MORE than the usual 20% annual and rather than achieving symmetry actually has higher payoff asymmetry. Under the assumed return scenario, triennial is ONLY better if the incentive fee is LESS than 21.30%. In fact the 40% fee structure is only better if one or more of the three years is negative and even then not always...

If gross +10%, +10%, -10% Lane Five 3y CAGR = +2.51% Other fund = +0.95% cheaper
If gross +20%, +20%, -10% Lane Five 3y CAGR = +14.56% Other fund = +16.63% NOT cheaper

Of course she is charging on index outperformance rather than the usual hurdle of zero. So "hedge fund" is a misnomer; Lane Five is just a relative return product and consequently of ABSOLUTELY no interest to absolute return seekers like me. A 40% triennial performance fee solves no existing compensation issues and potentially creates new ones. If things have been rocky after 3 years and Lane Five is flat to negative the temptation to "go for it" will surely be far greater than in a single losing year. And how is she going to compensate employees while rival funds will have bonus paying ability every year? Maybe she is so good she doesn't need help but investors are into teams, deep benches and REDUCING key-person risk these days.

Then there is this traditional index benchmark of the S&P 1500. What if, or more likely, WHEN the index itself drops 50% in the next 3 years? Isn't the point of a proper hedge fund to make absolute returns no matter what? Is Lane Five an expensive hedge fund or an incredibly expensive mutual fund? She will have to be very good to generate absolute alpha NOT relative alpha in a bear market for her benchmark. Seems to be a lot of chatter about her value stock picking abilities but not much mention of her short selling, hedging and risk management knowledge. Hopefully she knows about these as well because they are as important skills as buying the right stocks in the hedge fund world. Her FIRST trade should be to short the S&P 1500 index so she can isolate her alpha and reduce business risk.

There is an inescapable fact of life in the hedge fund industry: investor impatience. People pay the modal 2 and 20 for consistent positive monthly returns. One negative month is not taken well, a negative quarter very badly, a negative year, sayonara. The standards of performance expected of hedge fund managers is brutal and rightly so, and I am not sure there are that many investors out there with the patience to stick around for years. It is possible a strategy like hers is incompatible with hedge fund investor requirements. There are also added complications of equalization as clients join and redeem during a three year period. What happens to an initial investor who bails after 35 months? Or joins 1 month before the claim on 40% on all that massive expected alpha looms. And what interim numbers do you report for the first 35 months, gross or net?

You can't eat relative returns. You also can't eat arithmetical returns. There is yet another lesson here of the importance of path dependence in compounded performance. A big final year fee or drawdown can severely impair or even eliminate several previous years of good performance. A good chunk of the rip-roaring 1990s got taken out by 2000-2002. All that Japanese growth in the 1980s basically got taken out in a single year, 1990. The curse of the back-end clawback, be it from a performance drawdown, fees or taxes, is not to be ignored by any investor.

Maybe Lisa Rapuano is good at what she does and Lane Five turns out to be a successful relative return fund but there is nothing threatening to real hedge funds about this innovation. A revolution in hedge fund pay structures? No. Other hedge fund managers in a panic? Hardly. Might become the norm? Definitely not.