In recent years there has been a significant increase in the number of retail investment funds using hedge fund management strategies and, even more worryingly, hedge fund style fee structures. This is something that really concerns me so I though I should explain why in a blog article.

Traditional investment funds buy assets such as shares, property or bonds and aim to make a profit from income payments (shares pay dividends, property earns rent and bonds pay interest). They may also benefit from a price increase when they come to sell the asset. There are strict rules governing the type of investment techniques/strategies each fund may use. These funds are known as “long only” investments and are relatively simple and easy for investors to understand. They typically charge a simple management fee based on the value of assets. For share funds this fee is often around 1.5% pa but can be substantially higher.

Hedge funds on the other hand are able to use a mind-boggling array of techniques including short selling (betting against shares, bonds, currencies or anything else they choose and profiting from any fall in value). When I was researching a presentation for the Institute of Financial Planning (IFP) Scottish Conference a few years back I found 154 different hedge fund indexes covering different markets, styles and strategies listed on FE alone.

The American hedge fund manager John Paulson famously made billions betting against sub-prime mortgage securities which ultimately caused the “credit crunch” and the stock market collapse of 2008. Another well known hedge fund guru, Gorge Soros earned the name “the man who broke the bank of England” when he made vast profits betting against the Pound during the ERM crisis of September 1992.

Hedge funds claim to be able to earn money in all market conditions. In fact market crisis such as the Credit Crunch and the current Euro Zone debt crisis should be exactly the type of environment in which hedge funds thrive and provide investors with valuable protection against market falls.

A recent article in The Economist starts with the words “With bold promises of strong returns in good times and bad, hedge funds have seduced many an investor.” But how have they actually performed? Well, 2008 was the worst year on record for Hedge Funds and 2011 was pretty much the same – according to Reuters they performed worse than traditional funds at exactly the time when they were supposed to protect investors.

Fortunately, hedge funds can’t be marketed directly to retail investors in the UK, although they can be held within some other funds that are.

A few years back a form of hedge-fund-lite known as Absolute Return funds started to be marketed aggressively by fund managers and Independent Financial Advisers (IFA). In 2011 alone the top two funds in the sector Standard Life Global Absolute Return Strategies and Newton Real Return each attracted around £2.5 Billion of new investment. These funds are available to retail investors and are able to employ limited hedge fund style management techniques. The marketing story states that Absolute Returns funds seek to provide investors with a steady positive return in all market conditions – They haven’t succeeded!

However, that isn’t the biggest issue with Hedge funds and Absolute Return funds. The biggest issue is manager remuneration (or fees to you and I). While traditional funds typically charge investors around 1.5%pa to try and beat their benchmark (and very few actually succeed consistently), hedge funds claim that, in order to attract the best talent and ensure their interests are aligned with investors, they need to charge higher basic fees AND charge a performance fee. Another Economist article starts “Hedge-fund managers are the smartest investors around. With keen eyes and sharp brains, they spot and exploit inefficiencies in the markets. Or at least that is what the industry tells its clients.”

A typical hedge fund fee structure is “2 + 20″  which means the manager earns 2% of the value of the fund every year no matter what.  However in years where the fund makes a profit, the manager also earns 20% of the profit. I have seen funds with fees of 3 + 30!!!

In reality most funds do have a”hurdle” where the performance fee is only paid on profits above an agreed benchmark such as Bank of England Base rate. Many funds also include a “high water mark” which is designed to protect investors by ensuring that managers don’t earn performance fees until they have at least clawed back their previous losses. i.e. they are only paid for real gains.

The marketing would have you believe that performance fees are used for the benefit of investors, “if we don’t beat our benchmark we don’t get paid”. However, nothing could be further from the truth as the following example will clearly show:

Let’s assume an investor placed £1 million in a hedge fund two years ago and the fund achieved a return of 10% pa before fees. You would expect the fund to have grown by £200,000 less fees of 4%pa (2% of the fund value plus 20% of the 10% return = 4% in total) giving a net return of 6%pa. In this case our investor would have earned £119,365 over the two year period and the fund manager would have earned £86,435. The fund manager would have earned almost three quarters of what the investor earned. This sounds bad but wait until you see what would really have happened!

As with other investments, hedge fund returns don’t usually deliver a nice even return of 10% every year. Some years they make large profits, others they lose substantial amounts. In 2007 John Paulson’s Advantage Plus fund returned over 160% but last year it lost 52%. In order to make my simple example work let’s assume our fictitious hedge fund earned 150% in year 1 and lost 52% in year 2. This would imply a return of £200,000 before fees over two years giving us a simple average return of 10%pa as before.

But what happened to the fees?

In the first year the fund made a profit of £1.5million making the annual fee £350,000 (of which £300,000 is a performance fee). At the end of the first year our happy investor has a fund of £2,150,000 and is probably feeling quite smug about his choice of fund manager. However, in year two the fund fell by 52% which slashed the value of his portfolio by £1,118,000 before fees. Obviously, the fund manager would receive no performance fee this year but would still receive the basic annual fee of £20,640 (2%). Our unhappy investor would finish the second year with a fund of £1,011,360 giving a total return on investment of £11,360 over the two year period (an annual return of a little over 0.5%). However, the fund manager pocketed a total of £370,640 (33 TIMES the return to the investor!!!). Incidentally, hedge fund manager John Paulson earned over $5 billion in 2010 alone.

The manager now has to grow the fund by over 110% before he has clawed back the losses and starts to earn performance fees again. This requires two things to happen; a massively risky investment  bet (speculation) and a huge amount of good luck for the bet two pay off! According to The Economist last year nearly 90% of hedge funds were still below their 2007 high water mark. In reality, our intrepid fund manager may simply close the fund and start a new one with no high water mark to beat.

We have already started to see an increase in the number of hedge funds closing but expect to see many more in the coming months.

While the above example is massively simplified and refers to extreme returns for hedge funds, the same principles hold true for retail investment funds such as Absolute Return funds which often now include performance fees. Look at the example above again and decide whether this move is to help investors or benefit fund managers.

Most investors have no idea what they are paying in investment fees and transaction costs each year. At Forty Two Wealth Management we are acutely aware of the impact of costs on investment returns and work very hard to keep these as low as possible. Often when we show new clients the level of fees they are suffering they are horrified. Understanding your existing investment portfolio, including the level of fees deducted, is the first step towards a successful investment experience.