Why you can't trust the fund fat cats

An old client from my stockbroking days has just sent me a chart of the performance of a hedge fund run by some people he doesn't seem to like much.

The chart shows the fund doing fantastically well until the middle of 2005. Then it shows things falling off nastily throughout 2006. Anyone who invested in 2003 and 2004 is more or less even. Anyone who invested after that has lost a lot of money if you gave the fund your cash at the peak you'd be down about 30%.

Now this isn't unusual, and it isn't even anything to get upset about a lot of modern hedge funds are risky investments and when you put your money in them you do so knowing this. But here is the thing my ex-client is stewing about: the risk is all on one side that of the investors. The two founders of the fund paid themselves $50m (£24.7m) in performance fees in 2005 (you didn't read that wrong). But when all that performance subsequently disappeared they didn't have to return any of it: they make hugely disproportionate amounts of money when their fund does well but are in no way penalised when their fund does badly. Irritating isn't it?

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It also provides managers with all the wrong incentives. Last year, before the sub-prime crisis in the US really blew up, I had a conversation with another young hedge-fund manager.

We agreed you'd be completely nuts to buy any of the various "investments" related to US mortgages. Or I thought we'd agreed you'd be nuts. He, after a few seconds' thought, announced that there was an exception: if you're running a newish hedge fund and want a chance to get rich quick, he said, buying this stuff makes sense.

Sure, everyone knows the sector is going to blow up, but nobody knows when. In the meantime you can make excellent returns from fiddling about with mortgage-backed securities and their many derivative products. So why not do it? You can charge whopping performance fees until the crash comes, then when it arrives you can just shut up shop and go home. Your clients will have lost money, but as long as you get a couple of years at the trough you'll be set for life.

This is a very cynical industry, and the worse things get in hedge-fund land the clearer that is likely to become.

I'm not suggesting that the entire industry works like this I dare say there are managers out there working to create long-term value for both their businesses and their clients. But it is more and more important for us as investors to be aware of how skewed much of the financial-services industry is, and not in our favour.

You see, this kind of thing isn't just prevalent in the hedge-fund sector. Many ordinary funds, both investment trusts and unit trusts, now charge some kind of performance fee and none of them ever has to give it back when they underperform.

A personal favourite of mine in terms of absurdity rather than investability is the 3i Quoted Private Equity Fund (QPE).

You might think, given that 3i is a private-equity firm and that the fund has private equity in its name, that QPE is a private-equity fund. You'd be wrong.

Instead, the idea is that the managers use their private-equity skills to identify a limited number of quoted companies that might have been "over-looked" or "under researched" by the rest of the market. They then influence the management of that company to change its behaviour to create "private-equity-style returns."

Sounds good. But boil it down to its essence and you see that, clever marketing concept aside, the company's aim is much the same as that of all other ordinary investment funds to make money out of buying shares in quoted companies. I mean, who isn't looking to invest in "overlooked" companies? I have never once read a fund prospectus that informed me the managers would spend their time looking to invest in exactly the same companies as everyone else.

No, the real difference between this fund and its thousands of competitors is in the fees. There's an annual fee of 2% and then a fee of 20% of the increase in net-asset value, if that increase is more than 8%.

What this means is that if they manage to increase the value of the fund by 8% in any six-month period, they get to charge you 20% on not just the returns above 8% but on all the returns the fund has made. They may think this is somehow justifiable. It isn't. It's an outrage. How do these people sleep at night knowing they charge so much for so little, I asked a colleague this week. "On very expensive beds," he said.

I've written here before about how charges can eat into your returns, but it is worth remembering that overcharging is endemic in the financial-services industry. The average unit trust ends up having about 2.5% taken off it each year 1.5% or so in management fees and the rest in general costs (dealing commissions and so on).

This makes a huge difference. Invest £10,000 in a fund that grows at 7% a year and costs you 1% a year and you'll have £13,338 in five years. Invest it in one that costs you 2% and you'll have only £12,667. That's a difference of more than 5%.

Trusting the financial-services industry to make you rich is a dangerous thing to do.

First published in The Sunday Times 9/9/07