Hedge Funds Can’t Save Themselves With Lower Fees: Matthew Lynn

Date: Wednesday, March 18, 2009
Author: Matthew Lynn, Bloomberg

It works for street traders. It can work for airlines, retailers and carmakers. But hedge funds?

As the financial community staggers from disaster to disaster, some alternative-investment managers have decided that slashing their fees is the only way to salvage their business.

Firms such as Centaurus Capital Ltd. and Harbinger Capital Partners are cutting the charges they levy on investors. As sales fall and redemptions increase, don’t be surprised if many others do the same thing.

It won’t work. The hedge-fund industry was never about price and never will be. These money managers are now showing that their ability to manipulate figures on a screen doesn’t necessarily translate into knowledge about how business works.

Throughout its explosive growth, the hedge-fund industry has been dominated by two simple numbers: 2 and 20. Typically, the funds charged 2 percent of assets under management and collected 20 percent of any gain made. Some of the biggest fortunes of recent times have been built on those two figures.

Now, with returns plummeting and investors heading for the exit, hedge funds are searching for a new strategy.

This week, London-based Centaurus Capital said it was starting a new fund that would charge a more modest 1.5 percent plus 15 percent of profits. Earlier this month, Harbinger Capital Partners, run by Philip Falcone, proposed lower management and incentive fees if investors agreed to have their money tied up for two years rather than one. New York-based Prentice Capital Management LP is offering similar incentives for tie-up periods.

‘Cost-Conscious Clients’

Expect to see more price-cutting by hedge funds in the months to come. The consulting firm Mercer released a survey in February that indicated a greater willingness to cut fees among 3,400 alternative-investment managers.

“Anecdotal evidence suggests that increasingly asset managers will have to negotiate their fee structures with ever more cost-conscious clients,” Divyesh Hindocha, worldwide partner in Mercer’s investment consulting business said.

It isn’t hard to understand why. Hedge funds are expensive products. In a world where investment returns are looking miserable, costs will be scrutinized more than ever before. A lot of people have been paying top-of-the-range prices for bottom-of- the-range performance. Not surprisingly, they aren’t happy about it. If customers are saying they want lower charges, it is difficult for the managers to say no.

Wrong Responses

The first response of many hedge funds to the crisis has been to bring down the gates to stop their investors from leaving. When they realized that imprisoning the customer wasn’t much of a long-term strategy, they decided to opt for price- cutting instead. Both responses were wrong.

Any manufacturer setting out to make and sell a product has to make a simple choice before starting: Be a low-cost, high- volume producer to sell “value” to the consumer, or be a high- cost niche producer to sell “brilliance” and “exclusivity.”

Both can be good choices. In fashion, you can be Giorgio Armani SpA or you can be Hennes & Mauritz AB. In airlines, you can be British Airways Plc, pushing its business-class seats, or Ryanair Holdings Plc, promising dirt-cheap, minimal-service flights. There is money to be made with either strategy.

Sometimes you can even straddle both within the same parent company. Volkswagen AG, for example, owns the Skoda and the Audi brands. Both of them do pretty well.

But you have to make a decision about what strategy you are pushing. And the one thing you can’t do is switch from one to the other -- at least not overnight, and not without some planning.

Choice of Strategy

There is no point in Armani suddenly flooding the market with jeans selling at 10 euros ($13) a pair, just as there isn’t much point in Hennes offering a shirt for 500 euros. Audi can’t suddenly introduce a cheap-and-cheerful city car, nor Skoda a luxury sports car. Consumers would stagger away in confusion.

Likewise, there isn’t much point in discount hedge funds.

In fund management, investors have a clear choice: They can place their money with one of the low-cost index-tracking funds, which can be run by just about anyone with a medium-powered personal computer. Or else they can put it with a hedge-fund manager who promises to consistently beat the market.

In making that decision, price isn’t really relevant.

If the asset manager can come up with a technique to outperform the market, then paying 20 percent of the profits isn’t a problem for most investors. They don’t care what the manager makes as long as they deliver an extraordinary profit.

Yet, if they can’t beat the market, a 10 percent performance fee won’t make that more palatable. You might as well put your money into an index fund charging half a percent and not pay any other fees.

One point has become clear in the past year. Many people in the hedge-fund industry didn’t know as much about investment as they thought they did. And now it turns out, they don’t know much about business either.

(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net.