Hurrah! Hedge fund fees are falling!

The Motley Fool
FTSE 100 falling prices
FTSE 100 falling prices

I've got some good news for you - but perhaps not for the reason you'd first think...


Here it is: hedge funds across the world are cutting their fees.

Perhaps you're thinking: "Great - maybe I can put some of my pension into one of these high-flying funds and get rich with the big boys!"

Or maybe: "Who cares - I am not an oligarch with a few million pounds to invest. This news is irrelevant to me!"

Well, sorry to be a know-it-all, but I think both responses are wrong in their different ways.

Firstly, if you want to put money into hedge funds, you probably shouldn't.

And if you don't care at all about hedge funds, you probably should - if only for a slightly philosophical reason.

Allow me to explain.

Hedge fund haircuts

Firstly: those shrinking fees.

According to industry monitor Eurekahedge, the average annual management fee charged by the 2,600-odd hedge funds it tracks across the globe is now 1.39% of the value of client assets.

That's down from 1.44% in 2015, and about 1.68% a decade ago.

According to Reuters, Eurekahedge has found performance fees are falling, too.

The standard hedge fund fee model has always been known as "2 and 20", reflecting a fund's 2% annual charge and 20% take of the profits.

However, in reality the performance fee has been cut from an average of 18.77% in 2007 to 16.69% today.

Strangely, the language of hedge funds hasn't yet caught up.

I guess that "1.39 and 16.69" doesn't sound as slick as "2 and 20" in the wine bars of Mayfair.

Performance fees eat your wealth

In any event, today's lowered fees are still enormous. You can try running a few examples with a compound interest calculator to see the massive impact of losing 3-4% a year on your returns over a few decades.

Now, you might argue that if hedge funds deliver superb returns then the fees are worth it.

But even if your fund achieves returns similar to the legendary stock picker Warren Buffett, paying "2 and 20" - or anything like it - will leave you with a fraction of your potential returns.

The outspoken fund manager Terry Smith once worked out that an investor who put $1,000 into Buffett's Berkshire Hathaway back in 1965 would have seen it grow to $4.3m by 2010.

By contrast, he calculated that if Buffett had been charging "2 and 20" on Berkshire's returns, the investor would have a mere $300,000.

Think on that: $4.3m versus $300,000.

That's the impact of high fees, on the returns of one of the very best investors of all time, who enjoyed a better-than-20% a year record.

Rotten returns

While we can't be reminded too often about the impact of high fees, it's actually pretty moot these days with hedge funds.

You see, they are not delivering returns anything like Warren Buffett.

In fact, hedge funds are not delivering returns anything like a simple - and cheap - index tracker fund.

The hedge fund industry's average return on investment in 2016 after fees is just 3.4%, according to the Barclays Hedge Fund Index.

In 2015 it was 0.04%.

In 2014 it was 2.9%.

True, the average was 11.1% back in 2013 - but that was the year the key S&P 500 benchmark rose 32.4%!

These figures are frankly woeful.

Now, hedge fund defenders always moan that you shouldn't compare a hedge fund to an index fund, because supposedly sophisticated hedge fund techniques make them less volatile and lower risk.

On current evidence, this looks like nonsense, too.

With hedge fund returns so miniscule, there are other ways to match or beat their returns with lower risk and volatility.

You could, for instance, invest just half your potential money in a global tracker fund, and keep the rest in cash.

But don't take my word for it.

Investment manager SCM Direct calculates that over the past five years, a simple 60/40 strategy (60% in equities and 40% in bonds) would have delivered 3-4 times the return of the average hedge fund.

This 60/40 approach requires you to buy just two cheap index tracker funds. That's it.

Of course, it doesn't buy hedge fund managers many sports cars.

But that's their problem, not yours.

Too big to prevail

Why have hedge funds got to this laughable position where they're posting rubbish returns, cutting fees, and being roundly trounced by the cheapest funds money can buy?

Many reasons have been put forward, from the increasing efficiency of the stock market to the dampening of volatility caused by years of low rates to the impact of insider-trading convictions a few years ago.

But a key reason is surely that the hedge fund sector is just too vast.

You see, despite the dire returns, people with literally more money than sense continue to pour money into hedge funds.

As of the second quarter of 2016, there was around $3.4 trillion invested in hedge funds - close to the all-time high.

Sure, these funds follow a variety of different strategies.

But $3.4 trillion is $3.4 trillion, however you slice and dice it.

I believe there's just too much supposedly smart money chasing the same opportunities. As a result, the high returns of yesteryear have been arbitraged away.

A win for mass affluence

I hope you can now see why I don't think you should want to put money into hedge funds, even if fees are falling.

They're still far, far too high. And the returns aren't worth it anyway.

If you want to reduce the risk in your portfolio, just sell some of your shares and buy bonds or hold cash instead.

Wait! Didn't I say it was good news that hedge fund fees are down?

Well, yes. But that's almost from a political angle as much as investment one.

I find it pleasing there's no evidence that, in general, the very rich can access far more lucrative investments than you and me.

These falling fees reflect that reality. Even hedge funds can't hide behind their mystique forever.

Of course, there will always be some hedge funds that beat the market - just like some vanilla fund managers might, and just like you or I might try to do with our own stock picking.

But the statistics don't lie. Most funds fail to deliver decent returns after fees and they charge through the roof to do it.

Investing is truly democratic, it seems.

Buy-And-Hold Investing

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