The Evidence-Based Investor

Why fund houses couldn’t give a fig about poor performance

Posted by Robin Powell on October 14, 2015

There’s been so much scorn heaped on hedge funds for their dismal performance and exorbitant fees that you could be forgiven for wondering how much longer the industry can survive.

The fact that two of the most famous living investors, Warren Buffett and Bill Gross, have now joined the chorus of criticism, may even prompt a few nervous hedge fund executives to start to explore alternative employment.

Or will it? Granted, hedge fund performance has been consistently bad since the turn of the century, and this year’s figures are set to be its worst since the financial crisis of 2008. But those of us who would love to see the hedge fund sector implode before our eyes (believe me, no one would be happier than I) are set for disappointment.

In fact, far from undermining the hedge fund model, the latest interventions by Buffett and Gross help to explain why this formidable industry will endure, regardless of how shocking those performance tables look.

Let’s take Buffett’s comments first. Speaking at Fortune’s Most Powerful Women Summit, Buffett pointed out that as hedge fund assets grow in size, the managers don’t need to worry as much about performance. That’s because of the way that hedge fund managers are typically paid — a 2% management fee combined with a 20% performance fee. If a fund has £10 billion in assets, it receives £200 million from management fees alone; the 20% is no longer so important.

As personal wealth grows, so do assets under management. The US hedge fund industry in particular continues to increase its AuM, which currently stand at around $3 trillion. That’s one heck of a lot of management fees.

Another big reason why hedge fund executives won’t be losing too much sleep over the repeated failure to deliver anything like the returns to warrant those fees was highlighted by Bill Gross.

If a fund underperforms, Gross reminded us, there is a simple solution — shut it down — in what appears to be a thinly-disguised reference to Fortress Investment Group closing its macro hedge fund after a particularly testing couple of years. The fund’s chief investment officer, Mike Novogratz, will also retire with a $255 million payout based on his equity in the company. Very nice for him.

Hedge funds are closing at a record rate (about 80 a month in the US alone). So too are actively managed mutual funds and ETFs. Indeed, shutting down or merging funds to erase the data from performance tables is oldest trick in the book. According to Jack Bogle’s calculations, survivorship bias — focussing on funds that survive and ignoring those that don’t — inflates mutual fund returns by around 21%. Goodness knows, the figures look atrocious as they are.

So no, fund houses are much less worried about poor performance than you might imagine. As long as assets under management continue to grow, and as long as you can expunge a bad fund from the data simply by pulling the plug on it, there’s little cause for alarm. In fact it means there’s even more money to spend on PR and marketing — promoting all those exciting, new and shiny funds that journalists love to write about.

Most fund houses don’t see tighter regulation as a major threat either, such is the power and influence the industry wields. Like him or loathe him, Senator Bernie Sanders hit the nail on the head when he said: “Congress does not regulate Wall Street. Wall Street regulates Congress.”

So, what do the fund industry executives worry about? Investor education. Not the sort that simply encourages people to invest more — that just means more fees for them. What really keeps them awake at night is being found out. They dread the prospect of investors finally seeing through the spin and obfuscation — and refusing to be ripped off any longer.

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Robin Powell

A journalist and broadcaster, Robin Powell is a campaigner for positive change in the investing industry. He runs a communications company for the evidence-based investing sector called Regis Media.

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