Hedge funds – the failing sector just doesn’t get it on fees

There's an article on finding good hedge funds in the FT today. It lists five that the paper thinks are exceptional (Bloom Tree Partners, Chenavari Capital, Jabcap Emea, Latigo Ultra and Mid Ocean Credit Opportunity) and talks to a few other managers about the industry as a whole.

The five listed are all interesting, and have all shown very good returns since their inceptions (the worst has an annualised return of 10.38%, and the best 53.76%). However, the fact that they have done well doesn't go very far towards making the case for the sector.

Why? Because none of them have been around for more than seven years. Their managers could be super skilled, or they could be just lucky. We don't know, and we won't know for another three years (a ten-year record of excellence surely suggests some admin skill at least).

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At the same time, a few good performers can't rehabilitate the reputation of what is beginning to look like a failing sector. Hedge funds as a whole have now been underperforming the S&P 500 for six years in a row. As the FT points out, in the year to November 2014, the average hedge fund had made just over 3%, while the average investor in a cheap US index fund would have pocketed not far off 14%.

Then there is the question of hedge fund fees. Most funds are still trying to charge management fees of 2% and performance fees of around 20%. We'd say the management fees are double what they should be, and the performance fees just shouldn't be there at all (success brings rising assets under management and should therefore be seen as its own reward). I suspect that any hedge fund investors planning to stick with the asset class (many big institutions are dumping them) would agree with us.

The business doesn't seem to get it. Jon Hansen of C/A Capital Management ($10bn under management) suggests to the FT that "management fees should be progressively reduced to 1.5%" as funds get larger.

Regular readers will know that I do believe in the possibility that active fund managers can consistently outperform over the long term and that I do understand, as a good letter to the FT pointed out over the holidays, that "to do well in the long term you sometimes have to do poorly in the long term*."

But for an industry that has underperformed quite as badly as this one for the last few years, the suggestion that cutting fees to double what most of us think is acceptable on mainstream investment funds will do the trick shows remarkably little humility.

*The letter (Why do we have to beat the market every time?) was from Dennis Butler of Centre Street Cambridge Corp in the US, and made the excellent point that if everyone stopped focusing on outperforming some index or the other over the short term, they would have a much better chance of doing so over the long term.