Julie Creswell of the New York
Times sums up pretty succinctly why so many
institutional investors are rethinking the way they do
business: ...while their fees have soared, their returns
have not. She points to the case of the Pennsylvania
State Employees Retirement System, which has paid
...$1.35 billion in management fees in the last five
years and reported a five-year annualized return of 3.6
percent. Value for money? No. It seems to me,
fees are out of control. This is a world where a man can lose
ten billion dollars over the past decade, net, and still get to
be a billionaire himself. I wish I were joking. But Im not.
As Institutional Investor pointed out in its story on ARs
Rich List, published last week, hedge fund managers became,
and remained, billionaires during the hardest period to
make money on Wall Street in several generations from
2001 through 2011 when the Dow Industrials rose a total
of just 13 percent, the Nasdaq Composite climbed a mere 7
percent and the Standard & Poors 500 lost nearly 5
percent. And, in three of the 11 years, the average
hedge fund lost money.
Forbes agrees, describing the 36 people
whove become Billionaires from the hedge fund
The past year was an
interesting one for this elite group. For starters, 2011 was
officially the second worst year in the history of the
industry, thanks to largely unforeseen levels of volatility in
the commodity, equity and European debt markets that
interrupted the international economic recovery. As a result,
the average hedge fund was down approximately 5% last year.
However, challenging markets didnt stop the top three
highest-earning hedge fund managers of 2011 from taking home
Fees. Are. Out. Of. Control.
You: Nobodys forcing
pensions or sovereigns to buy these services. This is a free
Me: Bullocks. The
politicians tell pensions to earn unrealistic returns and then
give them no choice, due to insufficient resourcing, but to
look to Wall Street for help. In other words, the only reason
finance professionals get to charge the fees they charge is
because the people that preside over institutional investors
generally have no clue that if they paid their staff one tenth
of what theyre paying Wall Street, they could replicate
upwards of 80 percent of what theyre paying Wall Street
You: Stop being so
naïve. Public pension funds could never hire the
sort of talent that resides on Wall Street.
Me: Bullocks. Many funds
already do; Ontario Teachers has been doing it for three
decades with an IRR of 10 percent! And if public pensions
started paying anywhere near market wages, Id wager
theyd get the talent they require too.
Me Again: To the Masters
of the Universe, Heres the truth: You make seven, eight,
and, yes, nine figure salaries not because youre
so much smarter than everybody else on the planet. You make
that much because the people who sponsor your clients (the
institutional investors) dont realize that a lot of what
you do isnt that hard.
Me: Do you like apples?
You do? Well, a friend of mine who runs a large public pension
fund is saving, right now, over 100 million dollars per year by
in-sourcing all fixed income strategies (while still meeting
benchmarks). How? The in-house portfolios are managed at ~2
bps, while the external portfolio was being farmed out at
40bps. Boom. $100 million. How do ya like them apples?
Me: You know whats
actually funny about all of this? Well, not ha ha!
funny...more like say what funny. The reason most
politicians fall into this trap stems from the fact that most
dont connect the fees paid to external service providers
with the costs paid to internal teams. Most funds have their
budgets for external fees and internal salary
and headcount separated. In fact, Id say 90-95
percent of the budgets of these organizations dont go
through formal appropriation simply because they are in the
form of external fees. As a consequence, the holders of
the purse strings focus all their attention on 5% of the costs
(salaries). They dont understand literally
that sending $200 million off to Wall Street could be avoided
by spending $20 million on local talent...oftentimes with the
This is the dirty secret of
funds management: The finance professionals get paid more than
any other profession on the planet because the politicians and
Boards refuse to properly resource their own funds (all the
while asking them to make unrealistic returns). And this lack
of resourcing (and overly aggressive return targets) gives the
finance professionals asymmetric bargaining powers. And, as you
might expect, they use it.
And this is why more funds will look to move assets in house.
Not because they think they can do things better than Wall
Street. But because they think they can do the same thing...at
a tenth the price. And with the right commitment by
policymakers, I think they might be right.