Why it can make sense to pay exorbitant asset-management fees
There is a case for paying more if it truly diversifies your portfolio
Asure way to irritate a private-equity manager is to say the “t” words: two-and-twenty. Their eyes roll: this again. Two-and-twenty (or 2-and-20) is, or used to be, a common fee arrangement for a certain class of asset managers. It comprises a 2% annual fee and 20% of the profits.
With a sigh, the manager tells you how it really is. He gets paid a 20% performance fee only if the returns clear a hurdle rate. The typical management fee is in the low to mid ones. And big investors get fee-free stakes in a fund’s portfolio companies (“co-investments”).
High management fees are avoidable. You can build a diversified portfolio that includes developed- and emerging-market stocks and bonds, plus commodities, using low-cost index or exchange-traded funds. True, it is a bit harder to get cheap access to assets that truly diversify your equity risk or are reliable hedges against inflation. But you could always simply hold more cash.
Yet it is quite wrong to insist, as many do, that the only good fee is a low fee. There is a case for paying more for access to a stream of cash flows that is genuinely different from those you already have. The asset manager may not deserve the fee for his efforts. It may just be a pure rent. But sometimes it is best to suck it up. After all, it is returns net of fees that you should care about.
There has been a long-running shift in assets under management from high-fee, actively managed portfolios into low-fee, “passive” index funds. It is almost quaint these days to pay a hefty fee for stock-picking or for a bespoke bond portfolio. But push down fees in one place and they tend to pop up somewhere else. Capital has also poured into “alternative” assets, including private-equity, venture-capital and hedge funds, which levy the sort of fees that incite a taste for yacht-racing and caviar.
The appeal for investors is in large part raw returns. The best private-equity or venture-capital funds have paid out jackpots. It is also diversification. For many people’s tastes, private equity is repackaged stockmarket risk, with added leverage. But some alternatives are truly different.
If you are up to your teeth in the mature, ripe-for-disruption firms that make up much of leading share indices, it might be a sensible hedge to also get exposure to the would-be disrupters the venture-capitalists are busy grooming.
A common view is that the performance-fee part of charges is fine, but the management-fee part is indefensible. Say you invest $100m in an alternative fund. And, for simplicity’s sake, say “success” means after ten years you double your money and “failure” means you get it back. At 1.5-and-20, you pay $35m in fees if the fund is a success and $15m if it fails.
If the structure was, say, 0.5-and-30 it would better align the incentives of the manager with yours. The charge for success would also be $35m; but for failure it would be just $5m. Why don’t funds offer this kind of a fee structure?
Actually, some do. But there’s a twist: pension-fund managers are not always keen. Should the fund prove wildly successful, they would have to explain to their trustees why they gave away such a big slice of the upside.
What really matters, says Dylan Grice of Calderwood Capital Research, is whether you are getting value for the fees. The flagship fund of Renaissance Technologies, a wildly profitable hedge fund, charged 5-and-44, before it was closed to outside investors. The net-of-fee returns were amazing; why complain?
This attitude might be applied to other niches: funds that invest in esoteric corners of the credit market, say; or funds that lend to biotech or oil-exploration companies in return for a stream of royalty payments, which they package and sell to investors. These might earn, say, a steady 15% gross and pay investors 10% net.
This is attractive, especially if it adds true diversity to your existing portfolio. The fee is the price of entry to a market that is hard for most investors to navigate. Or as Mr Grice puts it: “They know how to do it and you don’t.”
Fees are a drag. The more they take, the less you keep. And it can be galling to stump up for access. Few asset managers will admit that this is what you are paying for. The best venture-capital funds, for instance, claim they are world-class developers of the startups in their care.
But in many ways they resemble elite universities.
Because the best students turn up at their door, they are able to charge high fees—not so much for the stewardship of these precious assets, but for the accreditation and the social networks they provide. So be it. Some irritations are best ignored.
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