Hedge Funds & Charitable Foundations
David R Kotok
Cumberland, July 12, 2016
Our first missive about the perils of hedge funds (http://www.cumber.com/hedge-funds/) evoked a number of client and reader responses. We thank all who sent a note.
Cumberland does not use hedge funds and is not a hedge fund. In fact, we have several asset management styles that compete directly against hedge funds. Instead of 2% and 20% fee structures, we use a straight 1% fee with an ETF strategy that permits no lockout period, futures, or options; needs no margin account; and involves no opacity. Our approach offers full transparency. The investor can know what is owned every day and what the market price is. The investor may cancel and liquidate at any time.
So let’s get to the hedge fund issues. First, there is the cost.
Here is an example. We thank Eric Balchunas and Bloomberg Intelligence data for the following information. Vanguard has about $3 trillion in total assets. At Cumberland, we use some Vanguard funds in our 401(k) management system for our clients, and we also use some Vanguard ETFs in our actively managed separate accounts. All are very low-cost and efficient. Vanguard’s revenue from that $3 trillion in assets is about $4 billion a year. Let’s compare. The hedge fund industry as an asset class has about $3 trillion in assets, roughly the same as Vanguard. Hedge funds as a group, however, derive about $48 billion in fees, a number 12x higher than Vanguard accrues. Eric Balchunas notes that this estimate is based on the average hedge fund fee of 1.8%, versus Vanguard’s average of 0.13%. Eric also cautions that this estimate does NOT include the extra performance fees derived by hedge funds, which he estimates are an added 14%. Source: Bloomberg Brief – ETFs, May 31, 2016.
Let’s talk about hedge fund performance.
Here is a column by Barry Ritholtz entitled, “If You’re Such a Great Investor, Where’s Your Alpha?” (http://www.bloomberg.com/view/articles/2016-05-26/if-you-re-such-a-great-investor-where-s-your-alpha). We advise reading Barry’s post in full but will excerpt two items. Barry notes that in 2005, The Economistdescribed hedge funds as “a compensation scheme masquerading as an asset class.” Read Barry’s note about Jim Chanos and how there were only about 100 hedge funds many years ago, and they were generating “alpha.” Today, Barry notes, there are 10,000 hedge funds, and, still, only about 100 of those are generating alpha. Is it any wonder the hedge fund industry is bleeding assets and performance is lagging?
How about hedge fund industry shrinkage?
Sources in the hedge fund industry estimate that it will shrink by about 25% this year. Performance has been lousy and costs high. So the investor class is leaving. We see that in decisions of major pension systems like CALPERS. Industry estimates are not just assertions. A hedge fund knows it is losing assets because its investors are giving notices of withdrawal as they wait out lockout periods. So remaining investors have to ask themselves if they really want to remain in an asset class that is shrinking.
The new Department of Labor fiduciary standard will alter hedge fund usage in certain portfolios. We avidly support the fiduciary standard and would like to see it extended to the entire financial services industry and not just retirement plans. It will create a standard for any DOL-listed portfolio type (IRA, pension, etc.) that may use a hedge fund. Under the Best Interest of the Client Exemption (BICE), a hedge fund or hedge fund advisor or consultant will be required to explain to the client why the investment in that hedge fund is in the client’s best interest. Some interesting reading may soon be forthcoming.
What about charities and foundations and hedge funds?
The charity and foundation sector has been overlooked. The DOL rule doesn’t address it. Furthermore, the regulation of charities seems “light” and is often covered by state law (as is the case in Florida). Our research is showing some interesting and surprising data.
We are currently researching the investment holdings of the community foundations in Florida. We will be preparing a report for our clients and plan to release it to the public when it is completed and after our clients have been advised. Our Florida clients are users of many foundations, and charities in Florida and have been asking us for this analysis. We are finding that community foundations and charities are vastly under-performing their benchmarks. Essentially they are using high-cost structures and delivering less than optimal benefits for the charitable purposes that constitute their missions.
We also are finding a prevalent use of hedge funds. In one case we found an $18 million investment in a fund-of-funds hedge fund system with a lockout period and with the stated custody in the hands of the fund-of-funds’ manager. The public reports of this foundation show only the investment. The philanthropic donors have no way to know what is in the hedge fund, what it is worth, and how it got there. Furthermore, the fund-of-funds documentation says the foundation faces a two year lockout period if it wants its money. The decisions were made under the advice of an investment committee. We can only wonder how many board members and how many donors actually know that the money they gave to charity was used in this way.
Eight foundations are currently under review by us. There are 29 in Florida, and we will eventually set up a system to track every one of them.
Hedge funds have their supporters. One of them, a referring consultant with a major firm, disagrees with our stance on hedge funds. He asked to remain anonymous but graciously gave us permission to quote his response to me. It is reproduced, without editing, below.
“Hedge funds are not a product; they are a structure an investment manager chooses, just as Cumberland has chosen the separately managed account (SMA) structure to invest client assets. Investors have a number of structures to choose from, such as private equity, open-end mutual funds, closed-end funds, UITs and ETFs. All of these structures have their own fee structure. More importantly, every structure has a multitude of options with different time horizons and diverse investment philosophies, strategies and tactics. Some hedge funds specialize in illiquid investments for investors with a long time horizon who could care less what the market does on a daily, weekly, monthly or yearly basis. Most hedge funds use leverage, many do not. How is it possible to put any active manager, not just hedge funds, in one generic box as a ‘triumph of hope’ strategy?”
“As a financial advisor, who is a value investor, when I identify a sector or region or financial instrument that is undervalued, I then search for the best active value manager with a proven track record net of fees to execute that strategy. I am agnostic as to their fee structure. If the best manager only offers a hedge fund, that’s what I recommend to my clients. Or, the manager could be an open-end mutual fund, an SMA like Cumberland, or a closed-end fund, or a hedge fund, or a private equity fund. I prefer active management, and if I cannot find an active manager, I will use ETFs as a placeholder till I do.”
“As you know, the overwhelming majority of active managers, whether mutual funds, SMAs, or hedge funds, underperform ‘the market.’ So what? To paraphrase Will Rogers, invest with managers that go up; if they don’t go up, don’t hire them. There are a lot of lousy rotating ETF SMA options available to investors. Does that mean we should tar brush that entire ‘investment industry sector’ in general and Cumberland in particular?”
“Blanket statements and generalizations and insinuations of moral superiority because of different fee structures just feed the beast that hates ‘Wall St.’ As a proud member of the wealth management industry who respects all managers with integrity regardless of the fee structure they choose, I think your blog post belittles us all. As a value investor, [I encourage you to] keep up the misinformation. It’s what creates opportunities.”
We thank all the readers and writers who answered our first hedge fund piece with their observations.
As for Cumberland and hedge funds, we remain out of this asset class. We have other less costly and more transparent choices to recommend to our clients.
David R Kotok, Chairman and Chief Investment Officer