From: Mark Chapman
mchapman@aquamarinefund.com
Date: August 30, 2017
INTRODUCTION AND HEALTH WARNING.
My goal in researching and writing this note was to shed some more light on a relatively obscure and little studied corner of the world of alternative investments –whereby a professional money manager does not charge an asset management fee.
To get a better sense of this universe, I used two sources:
Firstly, and with the help of Aaron Westlund of Poor Creek Capital, I reviewed forms ADVart 1 which are filed by United States based investment advisors who are regulated by the SEC as well as by state-regulated investment advisors.
Because of the paucity of data from those forms I also canvassed hedge funds around the world through email, social media and personal contacts to find out more in an adhoc way. I did this work informally and alongside my work as a director of the Aquamarine Fund.
In reaching my conclusions I have taken at face value and on trust statements that have not necessarily been properly verified. Thus, none of the data and conclusions presented here should be considered conclusive or authoritative. Rather, they should be considered a jumping off point for further conversation and discussion.
In that spirit, please do provide me with feedback and updated, or more accurate information, so that I can incorporate it into this write-up and redistribute to you. The rest of this paper is divided into the following sections:
1. SHORT HISTORY OF HEDGE FUNDS AND FEE STRUCTURES
2. DATA & FINDINGS
3. CONCLUSIONS AND THOUGHTS
4. SURVEY RESPONSES
1. SHORT HISTORY OF HEDGE FUNDS AND FEE STRUCTURES
Hedge funds and their associated fee structures originated in the early fifties when an Australian-American, Alfred Winslow Homer, started what is considered to be the first hedge fund. There were two key innovative features to his fund: Zero Management Fees
Mark Chapman mchapman@aquamarinefund.com
• First, he combined two apparently risky strategies – shorting and leverage, with the goal of delivering better returns and lower volatility.
• Second, and unlike mutual funds, he did not charge a management fee. His fee structure was simply to take 20% of the profits each year.
Later that decade, Warren Buffett started his partnership, and he also did not charge a management fee. Moreover, instead of asking for 20% of the profits, he added a hurdle of 6% and a 25% performance fee. Subsequent to that, others also started funds, although few stuck to Buffett’s and Winslow’s zero management fee formula. Many funds standardized on a “One and Twenty” model.
But some went to “Two and Twenty”. And in his heyday, Steve Cohen’s SAC Capital is reputed to have gone as high as “Five and Fifty”. But the world seems to have shifted. Hedge fund returns have moderated and we have witnessed a boom in indexing, index funds and ETF’s. In this environment, while Two and Twenty still seems to be the most popular approach, there appears to be a trend to dial back down the fees that hedge fund managers charge their clients. This takes place through various mechanisms. In addition to simply reducing the percentage charged, the following are also used:
• Introduce a “high water mark” mechanism ensures that the manager has recouped all prior losses for an investor before the manager earns a performance fee with respect to that investor
• Introduce a “hurdle rate”, which requires the fund to achieve a stated return before the manager can earn a performance fee The benefits of lower fees are oftentimes offset by a “lock-up period” which specifies when an investor can or cannot make a withdrawal from the fund. So today, there exists at one end of the hedge fund fee spectrum a Two and Twenty like structure, where the manager’s approach is often: “If you don’t like it, go and invest somewhere else, as I need to be rewarded for my work even if I don’t make you any money”. But gaining popularity right at the other end of the spectrum is what we can call the zero management fee structure, where the manager only gets rewarded through a performance fee if he makes money, over a hurdle rate, for his investors.
2. DATA AND FINDINGS
In the universe of investment advisers registered with the SEC with Assets Under Management of over $100,000,000 there are just three advisers that manage private hedge funds and who only charge a performance fee (i.e. zero management fee) across all entities they advise. These are Quantitative Investment Management, Biglari Capital and Piper Jaffray Investment Management.
The underlying private hedge funds of these 3 advisers are Quantitative Tactical Aggressive Funds, The Lion Funds and Piper Jaffray Municipal Opportunities Fund. For state-registered investment advisers with Assets Under Management less than $100,000,000, there are only eleven advisers that manage active private hedge funds and who only charge a performance fee (i.e. zero management fee) across all entities they advise.
These funds are: Lockbox I, Steele Partners, Klute Capital Fund, Prelude Opportunity Fund, Lucky Man Partners, Weidmann Capital Partners, Asset Appreciation Fund of America, Wellford Partners, Bridge Reid Fund, Krohne Fund, Borman Creek Capital and SG3 Capital. This is a miniscule fraction - considering the tens of thousands of Registered Investment Advisers in the US. But there is one wrinkle that suggests that the number might be higher:
While many advisors do charge a performance-only fee to some of their funds, clients or classes they also manage other funds, clients or classes where a performance and management fee is charged and it’s just not possible, with the available data, to isolate and separate out data which will show advisors who charge a blend – performance-only to some funds/clients/classes versus performance and management fee for others. Take the Pabrai Funds for example.
It is well documented that Mohnish Pabrai has not charged his Pabrai Investment Funds investors a management fee for very many years. However, on his Form ADV, the box “compensated by a percentage of assets” is ticked. This is surely the case for many other advisors, who in reality only charge performance fees.
Aaron Westlund adds colour to this: “Some of our initial non-accredited investors didn’t qualify to be charged an actual performance fee. So, for those initial nonaccredited investors (we no longer have any non-accredited investors), we put in a management fee but committed that we would waive that fee down to what would have been charged as a performance fee instead”.
Notwithstanding what appears to be a small number of advisers that charge only a performance fee across all their funds, I was inundated with commentary from advisors and their friends across the globe about individual funds charging performance fees only (i.e. zero management fee funds or classes within a fund). The chart below shows where our responses came from and not surprisingly the USA was top of the list with 41%.
Some features from the commentary that was received from zero management fee
managers follow:
The lock-up period for investors was generally one year but in some cases, there was
no lock up and in one case a three year lock up. In general, I found that for funds offering
zero management fees, the percentage of the fund beneficially owned by the manager
and related persons was higher than I would normally expect to see in a private fund. I
thank Rhys Summerton, from Milkwood Capital Limited who flagged this up for me
when he wrote “I suspect what you will find is that the higher percentage of own capital
of a fund, the more the fund manager will accept zero management fees and focus on
performance fees”. Almost 100% of the respondents issued their NAV’s monthly and
the predominant fund strategy was long only in a global geography. The most telling
feature however was the significant number of managers who claimed to be value
investors.
Whilst acknowledging that our sample size was small and there could be an element of
bias on account of the fact that I am the director of a value fund, it is an interesting
question whether managers who focus on value investing also believe they should only
be rewarded if they perform significantly better that the market. The most popular
performance fee structure in the zero management fee environment was a twenty-five
percent (25%) annual incentive allocation in excess of a six percent (6%) non-cumulative
hurdle return calculated annually, compared to the typical a twenty percent (20%) annual
incentive allocation in the Two and Twenty scenario. However, this did vary up to thirty
percent (30%) annual incentive allocation in excess of an eight percent (8%) hurdle.
I also found that new investors, when given the choice, were more likely to pick a zero
management fee class rather than a Two and Twenty class, signifying a general investor
recognition than managers should be compensated for performance. However, for tax
reasons I found that existing investors in a fund offering both options in different
classes, were often loathe to shift to the zero management fee class as they would likely
crystallize a taxable gain on the change in class.
In addition, I found several innovative fee structures, for example one run by Orbis
Investments, called the Refundable Reserve Fee share class, where the high-water mark
concept is scrapped. The performance fee is based on the relative performance
experienced by each client and such performance fees are refunded in the event of
subsequent under performance. I thank Dan Brocklebank of Orbis Investments for
sharing their complex but very fair fee arrangements with me.
3. CONCLUSIONS AND THOUGHTS
Upon further thought, the apparent rise in managers’ willingness to reduce their fees is rather remarkable – given the hurdles – or barriers standing in the way of a manager who does not want to charge his clients an asset management fee. The first is that unless the manager has some other source of income, or is independently wealthy, implementing a zero management fee structure is a real stretch for most managers. Many of them desperately want to do it but the reality is that covering start-up expenses and the risk of a general market downturn in the first years of operation make in likely that few will venture this path. For while every manager will do their level best to outperform from year one, periods of underperformance are a fact of life and in a zero management fee environment, the manager may have to sustain years of operating losses before breaking even on the enterprise. Thus, only the very luckiest or very best managers will be able to finance their first period of operations with no management fee unless they have the private, personal or family financial wherewithal to survive the start-up period.
For example, David Shapiro of Willis Towers Watson shared with me the story of Bedlam Asset Management, a UK based manager, launched in 2002 ridiculing 'grossly overpaid' fund managers and using the slogan: 'No gain, no fee'. Bedlam was never really able to achieve the gains needed to make enough money for its performance-fee model to thrive but they did run for ten years before closing quietly in 2013, having got their AUM to over $500 million.
So, while new managers are not necessarily opting for Two and Twenty, they usually charge some sort of management fee to get their operation started, even if it is expensebased rather that asset-based.
Thus, existing managers often offer a blend of management and performance fees to exiting investors and performance only fees to new investors. The Aquamarine Fund, where I am a director has such a structure. In our case, the manager can afford to not get paid any performance fee for a significant period, relying on the pre-existing management fee for his survival. For example, from 2014 to the start of 2017, performance fee only investors paid Guy Spier nothing for his expertise and his efforts. While those periods may not be comfortable, they are doable.
And if this does not present a fraught enough picture for the aspiring zero management fee manager, he can have no doubt that the fund’s attorneys and other advisors will strongly counsel him against this course of action – at least in part because they are mindful of the need to pay one’s bills – especially theirs.
But in spite of these significant hurdles, I have no doubt that a multitude of zero management fee structures are currently being established.
Why is that?
Part of the reason is the competition that comes from indexing. Even Warren Buffett – who used to run a zero management fee fund now advocates for low-cost index funds. With so much money flowing into that part of the market and with many traditional hedge funds underperforming, managers feel the pressure to be able to demonstrably deliver value and driving their fees down is a way to do that.
Also, part of the explanation is that investors are becoming increasingly sophisticated, and understand quite clearly that in the case of indexing, by being forced to buy into the most over-valued members of the index, they may actually be setting themselves up for inferior results.
But rather than opt for a flat-fee manager, sophisticated investors realize that the only managers who would be willing to go to all the trouble and expense of setting up a fund in which they only get paid if they outperform a hurdle are the ones who are capable of outperforming. If one believes that, then simply choosing to invest in funds with zero management fees may be the best way to identify and invest with the best managers.
Even if only some investors think this way, that may be enough reason to entice better managers (or at least those with a high opinion of themselves) to step up and go the extra mile with a frugal fee structure.
Thus, offering a zero management fee structure may serve as a kind of signal for prospective investors.
If this is indeed the case, there is a lot more for fund managers to do in order to signal that they can beat the market. In most cases the annual hurdle rate is 6%, which makes a lot of sense. Most investors should be contented with a 6% annual return. But in the case of most funds with a 6% hurdle, it also has the feature that it is non-cumulative. That means if you are down 6% one year, the next year your hurdle isn’t 18% but it reverts to 6%.
A manager that truly wanted to signal his confidence in delivering superior annualized returns would be able to demonstrate that - by making their hurdle a cumulative one. So far, very few have done that.
Tony Hansen added:
“Another factor you will find commonplace in zero fee managers is their willingness to restrict the size of their AUM, to ensure they can generate returns at a level that will be sufficient to generate performance fees. They are far less prone to becoming ‘asset gatherers’ as this could potentially reduce their capacity to earn fees. To this end, my own fund ‘soft-closed’ at $50m (i.e. only existing unitholders can contribute further) and will ‘hard-close’ at $100m (i.e. no further additions – save for a once annual offer to replace redeemed funds). This relatively modest AUM will allow me the long runway I seek (30- 40 years) with excess size not likely to become an impediment for many years.”
Other Sources
Alfred Winslow Jones https://en.wikipedia.org/wiki/Alfred_Winslow_Jones The Jones nobody keeps up with –
Carol Loomis in Fortune Magazine – 1966. http://fortune.com/2015/12/29/hedge-funds-fortune-1966/b
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