Research by behavioural financial specialists, Inalytics, has found that the average fund manager loses more than 60 basis points of precious performance, or £60m for every £10bn (€15bn) under management, each year through inefficient portfolio allocation. Why? Because being human like the rest of us, fund managers tend to pay more attention to the things they hold dear at the expense of the things they don’t. Some 72 per cent of the 70 equity portfolios analysed by Inalytics were losing performance through their heavily underweight positions as fund managers struggled to identify stocks that were likely to underperform.
By contrast, only 5 per cent of portfolios were losing performance through their heavily overweight positions. Rick Di Mascio, chief executive of Analytics, says the findings contradict claims by fund managers to have a process that prevents their portfolios from losing performance from inefficient portfolio allocation.
He explains that fund managers carefully scrutinise every price move, meeting and set of results relating to their overweight positions, while failing to apply this process as rigorously to their underweight positions.
However, as if to prevent poor pension fund trustees from crying out in despair, the research points out that most fund managers demonstrate both the ability to pick stocks that outperform and to allocate them efficiently across their portfolios.
“We have identified for the first time that the industry does have the skill. Even underperforming managers are very good at selecting winners,” says Mr Di Mascio.
If that statement fails to reassure trustees, shouldn’t they sidestep active managers and opt for the “black box” of quantitative investment process? Mr Di Mascio claims that quant funds suffer the same performance problems.
He says Inalytics has analysed numerous quant funds and come up with the “radical conclusion” that they behave exactly like traditional active funds.
Why would that be? Mr Di Mascio suggests the reason is that in the final analysis the computer models which quant funds rely on to process data are designed by humans. And the flaws of human behaviour are somehow fed along with the statistics and the mathematical algorithms into the quant process. Well, if this really is the case, the investor might be best advised to subscribe to a wider range of specialist strategies in an effort to minimise performance leakage.
A benevolent hedge fund?
As hedge fund performance has dipped of late, disappointed investors who bought into the asset class, particularly through the funds of funds route, are scrutinising the fees more closely.
Typically, funds of hedge funds levy an annual management charge of 1-1.75 per cent on top of an incentive fee of 15 per cent above a hurdle return of 3-5 per cent. Hardly small change when returns are languishing in low single digit territory.
So, cost-conscious investors might be pleased to learn that Absolute Fund Management has just launched what its chief executive, Christopher Aldous, believes is the first performance fee-only fund of hedge funds. His new Absolute Focus Fund imposes no annual management charge, while investors only pay a fee if performance is positive. What’s more, he adds that if the fund produces a negative return in one year, not only will no investment management fee be charged, but the fund will have to recover those losses for the investor before any further fees can be levied.
By comparison, Mr Aldous says in a conventional fund of hedge funds fee structure, investors have to cough up regardless of whether returns are positive. The product is aimed at portfolio managers who are already charging their clients a portfolio management fee and wish to boost portfolio returns by keeping any additional fees as low as possible.
Given the high-cost history of the alternative investment industry, investors would do well to ask why a hedge fund manager would willingly forego an established revenue stream – or am I being unduly cynical?
Meanwhile, Peter Baxter, chief executive of Old Mutual Asset Managers UK, hails his multi-strategy fund (50 basis point annual management charge and a 10 per cent performance fee above the hurdle rate of cash) as a cheaper alternative to a fund of hedge funds.
By contrast, Peter Toogood, chief investment officer of Forsyth Partners seems unconcerned about the extra layer of fees charged by funds of hedge funds. While acknowledging that high charges are a problem, he claims that funds of funds represent the only option for investors wishing to access hedge funds while avoiding operational risk.
But the good news is that a combination of high charges and low returns is exerting downward pressure on the fees levied by fund of hedge fund managers who have benefited from substantial inflows from first-time investors. That can only be a positive development for everyone concerned.
Henry Smith, editor,
Henry.Smith@FT.com
