Fees Are Out of Control, Returns Are Not

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 I’m not. 

As Institutional Investor pointed out in its story on AR’s 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 & Poor’s 500 lost nearly 5 percent.” And, “in three of the 11 years, the average hedge fund lost money.”

Forbes agrees, describing the 36 people who’ve become Billionaires from the hedge fund industry:

“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 didn’t stop the top three highest-earning hedge fund managers of 2011 from taking home billion-dollar paychecks.” Fees. Are. Out. Of. Control. You: ‘Nobody’s forcing pensions or sovereigns to buy these services. This is a free market.’ 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 they’re paying Wall Street, they could replicate upwards of 80 percent of what they’re paying Wall Street to do. 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, I’d wager they’d get the talent they require too.’ Me Again: ‘To the Masters of the Universe, Here’s the truth: You make seven, eight, and, yes, nine figure salaries not because you’re so much smarter than everybody else on the planet. You make that much because the people who sponsor your clients (the institutional investors) don’t realize that a lot of what you do isn’t that hard.’ You: ‘Lies!’ 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?  You: ‘Ummm.’ Me: ‘You know what’s 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 don’t 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, I’d say 90-95 percent of the budgets of these organizations don’t 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 don’t understand – literally – that sending $200 million off to Wall Street could be avoided by spending $20 million on local talent...oftentimes with the same result.’

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.