Dear hedge funds, it’s not you, it’s the fees

An open letter to active fund managers from the Canadian wealth manager PWL catches the eye.

Not for the newness of its truth, on which more below, but for the jaunty consolation to money managers everywhere after a year when the biggest US public pension fund, Calpers, and the world’s most famous investor, Warren Buffett, both advocated for passive index fund investing.

Right now it may feel impossible to pick the right stocks or guess the market direction, but do not let your confidence wane! You see, for everyone else to enjoy an efficient market, at least a handful of you need to continue your vigorous research and due diligence on securities. Each one of you may only get it right sometimes, but the aggregation of your predictions plays a role in getting accurate information into prices.

There will always be some investors eager to pay your high fees in hopes of beating the market, regardless of what the data says – you will never be obsolete. So please, ignore the media, the data, and the thought leaders, and keep up the great work!

Actually, Europe’s second largest public pension fund should be added to that list of detractors to ignore. PFZW announced on Friday that it has withdrawn all of its €4.2bn investment in hedge funds, issuing what the FT called:

a damning indictment of their performance, fees and “often limited concern for society and the environment”. The €156bn Dutch healthcare workers’ pension fund — known as Pensioenfonds Zorg en Welzijn (PFZW) — said that it had “all but eradicated” its hedge fund holdings because of its disappointment in their investment performance, cost and complexity…

PFZW said on Friday it had invested in hedge funds in order to add diversification to its investment portfolio, but had now decided its hedge fund holdings — which represented 2.7 per cent of its €156bn of assets in 2013 — no longer met its investment policy.

“For a long time, hedge funds were a useful tool in this regard, but lately they have not made a sufficient contribution to this objective,” the pension fund said.

It also cited what it termed “the sustainability factor” of the industry. “PFZW concluded that hedge funds are no longer a good fit for the portfolio, given the high remuneration in the hedge fund sector and the often limited concern for society and the environment.”

On the subject of adding value to portfolios, the average hedge fund post-fee investment gain for investors last year, as estimated by HFR, was 3.6 per cent . As it happens, 3.6 per cent is exactly the annual average investment return delivered by hedge funds 2008 to 2013, as estimated by HFR.

So 3.6 per cent is the new killing it!

Assuming typical fees — 1.6 per cent of assets each year as a management fee, and 18 per cent of gross investment gains on client capital — the average hedge fund has kept about two-fifths of the money it generates by playing with client capital. (i.e. It makes a 6 per cent gross return, then takes 1.6 points as management fee and 0.8 points for “performance”.)

The important aspect to note is the role of management fees, the cash for keeping the lights on, versus pay for investment skill. At an average 3.6 per cent net performance figure, management fees generate twice as much money for the hedge fund industry as performance fees.

More cash was actually paid out in performance fees, as losses in some funds offset gains elsewhere, but the effect for investors holding portfolios of hedge funds is clear: attaining even the average hedge fund result is a bad deal.

We’ll publish our own open letter:

Dear pension fund trustees of the world,

why, exactly, do you still invest in hedge funds?