Review & Outlook

Our take on the investing, financial, & economic themes of the day

Creeping ‘Hedgefundification’

22 April, 2014 by Matthew O'Brien, Ph.D. in Commentary

“Hedgefundification” is what Stephen Foley in the Financial Times calls the trend;  Ben commented on it here in an earlier post entitled “Madoff’s Revenge: the Rise of Liquid Alternatives”.  It’s the mainstreaming of hedge fund investing, and it’s happening in a number of different ways.  Overall, I don’t think that the trend will benefit ordinary investors.  Ben discussed the growing popularity of “liquid alternative” mutual funds, which in effect are hedge funds sold to retail investors through mutual fund wrappers.  A cynic might say that these “liquid alt” funds allow the ordinary retail investor to share in the excessive fees, illiquidity, and opacity that heretofore have been the exclusive privilege of institutional investors and ultra-high-net-worth individuals.  The Wall Street Journal recently noted the rapid growth of liquid alt funds:

BF-AH054_22hedg_G_20140321173903

Foley’s article in the FT discusses the rise of liquid alts as well as “unconstrained” bond funds, which are bond mutual funds that mimic “go anywhere” approach of hedge fund strategies by investing in all manner of fixed-income, from investment-grade corporate debt to junk bonds, U.S. to emerging market debt, and credit derivatives.

Another facet of hedgefundification was reported on the other day by the WSJ.  An increasing number of mutual funds are involved in private placements with start-up companies.  There’s a ceiling on how much any given mutual fund may invest privately, since by law mutual funds may not invest more than 15% of their assets in private securities, but more and more big funds are getting into the practice.

mutual fund vc

There’s nothing wrong with hedge funds or private placements in general.  Indeed, we at O’Brien Greene manage a limited partnership that is technically a hedge fund: we invest the fund on behalf of some of our clients in small-capitalization public equities.  (Our fund has rarely hedged, however, and at present has long-only positions.)  But there seems to be a basic contradiction in the “hedgefundification” of mutual funds, which is like mixing oil and water.  Mutual funds are meant to be liquid public investments with relative transparency of assets.  Mutual fund managers have to be able to meet their shareholder redemption requests daily, even if it means selling their underlying assets at a loss.  Hedge funds are typically meant to provide returns that are uncorrelated with public stock markets and they do this by investing in alternatives to ordinary stocks and bonds that can be difficult to value and hard to buy and sell.  It’s these difficulties that provide the opportunity for skilled investors to provide uncorrelated return.

By mixing illiquid and hard-to-value assets with an investment vehicle that is  traded and valued daily on public markets, liquid alt mutual funds are primed for mishap.  (It’s another reason for investors to avoid mutual funds altogether, as we do here at O’Brien Greene, if you have sufficient assets to invest directly in individual securities.)  Study after study has shown that ordinary mutual fund investors tend to be terrible market-timers, regularly selling at the bottom and buying at the top.  This is the main reason why the individual returns for mutual fund investors are much lower than the stated returns for the funds in which they invest.  (Morningstar recently tabulated that for the ten year period ending in December 2013, the average mutual fund investor gained an annualized return of of 4.8%, while the average mutual fund had an annualized return of 7.3%.  See Russell Kinnell, Mind the Gap 2014.)

mutual fund flows

The effect of bad mutual fund investor timing on liquid alts could be much worse than the effect on conventional funds that invest in public stocks and bonds.  Indeed, the WSJ quotes one hedge fund manager salivating at the prospect of taking the other side of the trade when liquid alt mutual funds are forced to sell their alternative assets in order to meet ill-timed redemptions:

“Who are they going to sell to? I hope it’s us,” Paul Westhead, chief executive of Irvine, Calif.-based Rimrock Capital Management, a credit-focused hedge-fund firm, wrote last month in a letter to investors. “We may be the ones to provide the liquidity, but they are not going to like the price.”

Apart from the possible costs of ill-timed asset sales, there is also the guaranteed cost of high fees, which Ben discussed in his previous post.  Consider one liquid alt mentioned by the WSJ, which is the Goldman Sachs Multi-Manager Alt fund (ticker: GMAMX).  Class A shares in this fund charge an up front sales commission of 5.5% of assets, a 2.55% annual expense ratio (which includes the annual 0.25% 12-b1 marketing fees), and the fund has an average annual turnover of its underlying investments of 102%.  The big sales commission larded into funds like this one surely explain much of the asset growth in liquid alt funds, since brokers have such an incentive to sell them to their clients.

Let’s say that you invest $10,000 in A shares of the Goldman Sachs Multi-Manager Fund with an assumed average annualized return of 5% for 20 years.  Compare this to making a similar investment in the SPDR S&P 500 ETF (SPY) for the same time period.

  • The total fees and expenses from 20 years of owning the SPDR S&P 500 ETF ($301.81) would amount to less than half the fees and expenses from owning the Goldman Sachs Multi-Manager Alt fund for one year ($793.81).
  • After 20 years, you would have made $5,056.87 in profit from the liquid alt and you would have paid Goldman Sachs $6,688.86 in fees and expenses.
  • By comparison, your investment in SPY would have returned $16,059.69.

 

gs liquid alt

The point of this comparison isn’t to say that an S&P 500 index fund is a better investment than a liquid alt.  After all, liquid alts are supposed to be uncorrelated to the S&P.  Rather, the point is to show just how high the self-imposed hurdle is on liquid alts like the Goldman fund due to big fees.  Combine the cost of the big fees with the additional risk of investing in illiquid assets through a liquid investment vehicle, and there is a powerful case against ever buying a liquid alt fund.  After all, plain old cash provides a relatively uncorrelated return compared to the S&P 500, so keeping a small percentage of assets in a money market fund makes much more sense.