Fees and performance: Not always correlated
Let’s begin with the hedge funds. In 1949, a former Fortune journalist called Alfred Winslow Jones established what is generally accepted as being the world’s first hedge fund, and with it he invented the 2% management fee and 20% performance fee structure. Almost 70 years later, those fees stand at 1.6% and 19.5% despite nearly ten years of underperformance.
Obviously, any hedge fund which delivers the returns it promises does needs to be compensated for it but there are large pockets of underperformance. Industry initiatives to create more investor-friendly fee structures have been pushed heavily by the Teacher Retirement System of Texas and Albourne Partners, but its wider adoption is still a long way away.
Traditional asset managers are facing a different type of threat. As with hedge funds, performance has been slightly wobbly, but active managers’ fees – while considerably lower than alternatives – are in the Financial Conduct Authority’s (FCA) purview, following criticism that their charges are not competitive. It is hard for investors to ignore this.
The expansion of exchange traded funds (ETFs) and passive funds, which charge low basis points (bps) fees, but which have generated equity market returns that are far better than what active managers are producing is of course a very big threat. One presenter at Fund Forum in Berlin said he envisaged some passive products charging zero bps although quite how this would work was not explained.
ETFs and passives – put simply – are a product of a market bubble, and when it bursts investors will be hurt. This might give active managers – with their stock-picking value a competitive advantage, and remind investors why they pay a bit extra for their services. Conversely, if active managers fail to beat ETFs or passives in a downturn, then very serious questions will be asked.
Alternatives and traditional products are facing different challenges although performance is a shared issue. The brutal reality is that fund managers – who have traditionally taken home fairly generous pay packets – may have to posit their fees downwards if they are to confront regulators and passives head-on, according to delgates.
Disruption: You’ve been warned
In 1995, a now infamous Newsweek article prophesised the failure of the Internet, scoffing at the idea of “telecommuting workers”, “interactive libraries”, “virtual communities” and “multimedia classrooms”. As for commerce and business shifting from offices and malls to “networks and modems (the author did not believe in WiFi then either)”, this was to quote Newsweek “baloney”.
The same type of disdain levelled at the Internet more than 20 years ago was extensive among the asset management industry, who reacted with absolute blasé at the possibility of a Facebook or Google engineer running investor capital, or even creating new distribution platforms by which funds are sold to the mass market. Equal petulance was on display when robo-advisors became part of the fund management lexicon. So should fund managers be afraid?
Yes, and no depending on which organisations pile into robo-advisory or mass market online distribution. Most start-up robo-advisors with the possible exception of Nutmeg do not have scale, and will probably struggle to reach critical mass. Some fund managers are having internal strategy meetings trying to figure out if it makes sense to acquire or build a robo-advisory platform. One panel at Fund Forum seemingly acknowledged that unless the manager was BlackRock, launching a D2C robo-advisory was a tall order, as potential clients will not acquire funds through an unknown provider.
If a tech brand took a shine towards launching an asset management business, then the traditional providers could face an all different challenge, mainly because they will never be able to compete on brand or client reach.
The typical response of industry experts when asked about whether a Google, Facebook, Apple or Amazon will take on asset management will be one of the following ripostes. “Absolutely not, the capital costs of fund management are too great,” “categorically not, the regulatory oversight will be too destabilising” or “of course not, they do not possess the expertise.”
Now is the time for the fund management world to get some perspective on this. Apple’s market capitalisation is bigger than the GDP of most countries, so finding surplus cash is not a problem. While Basel III capital rules would probably discourage a technology giant from becoming a fully functioning bank, fund management capital obligations are relatively small fry, and perfectly untroublesome to these companies.
The regulatory argument does not convince either. Technology companies are subject to robust regulation already, as any data privacy lawyer will confirm, so becoming a regulated financial institution would simply require a few more legal and compliance hires.
On the point of expertise, fund managers should look to past precedent. Google, which began life as a search engine, is pioneering innovations in driverless cars. Elon Musk, the founder of PayPal is developing a space programme, which may even precipitate the colonisation of Mars. In light of such advancements and ambition, it would be foolish to assume that technology giants are incompatible with asset management or distribution.
Fund managers should at least contemplate engaging with these innovators to see where they can work together for mutual gain.
Are illiquid products the answer?
The beginning of the decline of hedge funds began ironically with its success. As investors withdrew from equity and bond markets, institutional flows found their way into this cottage industry, and it never quite recovered. Institutional investor risk tolerance is not high, while their tickets are big, thereby creating a poisonous mix of forcing once nimble hedge funds to adopt a more risk-constrained investment approach in a crowded trading environment.
The $3 trillion asset class has not quite managed how to wrestle this impasse. In response, investors are repositioning themselves into private equity, which to its credit has delivered good returns, so it is probable hedge funds will contract in the next two or three years. The problem now, however, is that private equity risks falling into the same trap as hedge funds by growing its AuM base too quickly.
Pressure was already being piled on private equity to execute deals. Those that did find deals were entering into transactions at irrational multiples over the valuation. This does not look good for institutions hoping to generate returns out of private equity versus hedge funds. Perhaps the biggest surprise for me at GAIM Ops came when an attendee mentioned the funds of private credit funds sector was growing.
This new asset class comes off the back of investor interest in alternative credit and private loans, but such products are already becoming victims of their own early success. As with hedge and private equity, unimpeded AuM growth in a niche industry will lead to a dry up of opportunities.
A delegate at Fund Forum in Berlin acknowledged that loan opportunities were already receding, suggesting a familiar pattern is about to emerge. It might not be long before we see money flowing back into hedge funds.
A macroeconomic face-palm in the UK
One of the most thought-provoking moments at GAIM Ops came when Alastair Campbell, former press secretary to Tony Blair, said the UK faced a stark choice on June 8 of either returning to the 1950s or the 1970s, before adding that any political partly whose guiding mantra was a hark back to the past would find success elusive.
At a time when artificial intelligence risks disrupting millions of jobs and climate change is recognised as a systemic risk issue to financial markets, the quality of political debate in the UK reached a nadir.
Industry opinions about the election results are mixed, although one Fund Forum attendee who hailed from Kensington (lost by the Conservatives to Labour by 20 votes) admitted he regretted not bothering to vote.
Fund Forum delegates broadly support a soft Brexit whereby the UK retains access to the Customs Union and Single Market, something which seems quite possible given the Conservative Party’s precarious majority.
Others, however, expressed dismay, stating it would prolong Brexit negotiations and could even precipitate the coming to power of a Labour party controlled by unapologetic Marxists. Needless to say, a loss of EU market access to the funds’ industry – irrespective of who is in government in the next 12 to 18 months – would be a terrible outcome.
Events in the US, meanwhile, continue to bemuse although the fall-out has not been as bad as expected. The election of President Trump coincided with NEMA Asia, and experts attending that conference in Hong Kong last November felt that China would likely bear the brunt of retributive trade tariffs. This has not happened. Nonetheless, anyone watching political developments in the US are naturally concerned that a period of uncertainty could be upon us soon.