New Hedge Fund Fee Structures Reveal Traditional Model On Verge Of Collapse

Nearly a decade ago, Warren Buffett bet Protege Partners, a fund of hedge funds, that over the course of 10 years the S&P would outperform Protege's returns net of all fees, costs and expenses.  To make it real, the loser agreed to pay $1 million to the charity of the winner's choice.

 

At this past year's annual meeting, Warren Buffett provided an update on the now 8-year-old bet and, sure enough, the S&P has obliterated Protege's net returns by over 40%, on a cumulative basis. 

 

Buffett referred to the bet as the "most important investment lesson in the world." 

“I believe this is the most important investment lesson in the world.”

 

“[Losing by 40 points] may sound like a terrible result for the hedge funds, but it’s not a terrible result for the hedge fund managers.  If you have a couple percentage points sliced off every year, that is a lot of money ... It’s a compensation scheme that is unbelievable to me and that’s one reason I made this bet.”

 

“It’s so obvious and yet all the commercial push is telling you you ought to do something different today than you did yesterday.  You don’t have to do that. You just have to sit back and let American industry go to shop for you.”

 

“No consultant in the world is going to tell you just buy an S&P index fund and sit for the next 50 years.  You don't get to be a consultant that way and you certainly don’t get an annual fee that way.”

Perhaps this simple example helps explain why many of the largest pension funds and endowments are pulling back on investments in hedge funds and seeking fees cuts from managers that they choose to keep in their portfolio.

And as Bloomberg points out, at least some of the world's hedge fund managers are starting to take notice of the fact that their scam of charging billions of dollars in fees to generate results their investors could have easily obtained, or beat, by simply buying 'SPY' and/or

maybe a couple of industry ETFs, and are changing up their fee structures to attract capital.

Take Noviscient, founded by Scott Treloar, for example, not only are they proposing a fee structure with no management fee but they're also willing to cover the first 5% of annual losses for limited partners.  Granted, Treloar would like to keep 50% of everything he makes above 10%...

Asian manager Noviscient, founded by Scott Treloar, plans to start a fund that will charge investors no management fee and will absorb the first 5 percent of annual investment losses, Bloomberg News's Klaus Wille and Bei Hu reported Friday.

 

You read that right. Granted, the fund, which uses computer models to trade stocks, futures and currencies, will charge 20 percent of gains on the first 10 percent of profits, and half of whatever it makes above that.

 

That's the catch. A 50-50 share on profits above 10 percent is a lot. Here's the problem, though: Hedge funds seldom make returns exceeding that level. I'm not suggesting Treloar can't. It's just that hedge funds make far less than that on average. In the past decade, they've often lost money.

...but, given that most hedge funds rarely exceed that 10% threshold it may not be such an awful deal for LPs.

 

Of course, the real issue is whether large pension funds would be willing to take the counter-party risk of such a fee structure. 

Under Noviscient's proposed system, an investor with $100 million in an average fund in 2007 would have paid roughly $2.6 million in fees. That's not much different from what would have been paid under a traditional charging structure. When the going's good, there's not much to be gained from betting on Noviscient versus any other manager.

 

Macro funds have had negative returns in four of the past 10 years, though. The worst was 2011, when they were down 4.2 percent. If Noviscient had been operating a macro fund under its new fee structure, it would have forked out $4.2 million to make up the losses on a $100 million investment. Awesome for the investor, not so good for Noviscient.

 

While it's inevitably a slow process, over the long term, business models that no longer make sense, like paying billions in fees for returns that could be accomplished for almost nothing, eventually die off...it looks like hedge funds just entered Phase 3 (a.k.a. "Bargaining") of a 7-step process.