Thursday, November 1, 2012

Who Makes Money in Alternative Investments?

Fellow portfolio manager and occasional Random Glenings reader Rich Sipley passed along an article to me that appeared in Tuesday's New York Times.

As I have written several times on RG, returns on hedge funds have generally not met expectations.  The "silver bullet" of alternative investments as a panacea to under performing expectations has not materialized, and investors are getting restless.

The article that Rich sent me discussed the move by a prominent hedge fund named the Endowment Fund to limit shareholder redemptions.

The Fund - started in 2003 by Mark Yusko, former chief of the endowment for the University of North Carolina at Chapel Hill - has delivered disappointing returns, which has lead to a investor clamor for their capital.

How have the numbers been?

Here's what the article says (I have added the emphasis):

For the 12 months ending late August, the fund was down 2.5 percent, compared with an 18 percent gain in the Standard & Poor’s 500-stock index and a 0.9 percent decline in the average hedge fund. Over the last five years, the Endowment Fund returned 5.7 percent annually, lagging the 7.7 percent gain by the S.&. P. 500 and the 7.3 percent annual gain by the average hedge fund.

Redemption's move to reducing the ability to redeem assets - called "gating" in industry speak - is one of the first in the industry, but may not be the last. Investors were promised better investment returns in return for less liquidity, but as the returns have lagged the move to head to the exits has grown.

If gating becomes more common, this could create a major public relations industry for the industry, if not reduce the attractiveness of alternatives.

Rich has noted that I have written several pieces in the past questioning the investment merits of alternative investments.

For example, in a note I wrote on July 12, 2012 (  I highlighted a news report published on the CNBC website on the poor recent returns of the hedge fund community:

They are supposed to be the smart money—the best of the best—yet they can’t even beat a basic Treasury bond fund. 
Hedge funds as a group are badly underperforming this year, which could lead to a series of redemptions, closings and rethinking of the lofty fee structures the managers of these alternative vehicles enjoy.

The Bank of America Merrill Lynch global diversified hedge fund composite index returned just 1.3 percent in the first half of 2012, well below the S&P 500’s 8.3 percent gain.

Funds that focus on betting against stocks performed the worst, falling 7.1 percent as a group, according to the report.

So who makes money in alternative investments?

Returning to the Times article:

But the fees investors have paid the Endowment Fund for its lukewarm performance have been considerable, up to about 3.5 percent a year. Additionally, the underlying funds can receive as much as 25 percent of any profits they make. 

On top of that, some of the fund’s investors who came in through Merrill Lynch financial advisers may have paid as much as a 2.5 percent upfront fee, similar to what is charged for other funds, according to internal Merrill Lynch documents.

To be sure, it is easy to criticize any manager for underperformance.  However, when you are taking a 3.5% annual fee, and 35% of any profits, and still not delivering on performance, it seems clear who the real winners are in the alternative investment universe.