The Swedish Doctor

From World Alpha

Last night a colleague told me of a good analogy a portfolio manager passed along. He described your typical wealthy client, the Swedish doctor, who was presented with the option of investing in hedge fund of funds (FOFs). The Dr. liked the idea of investing in hedge funds, the cachet surrounding the space, and all the arguments place before him. What he didn’t understand was the amount of fees he would also have to overcome to achieve a respectable return.

The standard hedge fund receives a management fee of 2% and 20% of the performance (known as 2 & 20). There are funds, however, whose fees are much higher – SAC with a 0% management fee and 50% performance fee is one example. A FOF then layers on another 1% management fee and 10% performance fee for the value-added benefit of aggregating a number of funds into a portfolio.

A simple buy and hold portfolio since 1972 has returned about 11.5% with volatility of 10%. What sort of gross returns must the standard FOF return to beat this simple index bogey?

Simple buy-and-hold portfolio = 11.5%
Gross returns of FOF = (11.5% + 1%) / (100% – 10%) = 13.88%
Gross returns of hedge fund = (13.88% + 2%) / (100% – 20%) = 19.85%

The Swedish doctor, who has invested in this FOF as marketed by X-bank, must see the underlying hedge funds return almost 20% to beat a simple buy and hold return. The funds must either be extraordinarily talented to return 20% a year, or leverage more meager returns to get to 20%. Almost half of the hedge fund returns vanish as fees, which has prompted one portfolio manager to describe FOFs as "a compensation scheme masquerading as an asset class".

If the investor is looking for risk reduction and diversification, then FOFs may be an appropriate bond substitute. As an absolute return vehicle, they have a high return hurdle just to beat a buy and hold portfolio.

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