The following is an extract from chapter 19 of Lars Kroijer’s new book, Money Mavericks: Confessions of a Hedge Fund Manager.

An Expensive Acquaintance

In early 2006, I was at the wedding of a good friend in the hometown of his bride outside Chicago. At the reception I sat next to the bride’s charming aunt, Mrs Straw. Mrs Straw had lived in the small town all her life and her husband was a couple of years from retiring from work at the local sub-supplier for one of the Detroit auto companies. She had not been working for about a decade. Soon the conversation turned to what I did for a living.

“I work at an investment management company,” I said.

“Oh, interesting. Like a mutual fund?” she asked.

“Sort of. It’s called a hedge fund but it is quite similar in many ways.”

“I know what a hedge fund is,” she said, slightly offended that I had assumed she would not. “We’re invested in them through my husband’s pension plan at the plant. They’re great. He is so close to retiring and the pension manager told the folks that hedge funds were like a guarantee against markets going down.”

“Sort of like a sure thing,” I suggested. “Which funds are you invested with?”

“I think they invest in a couple of what are called funds of funds who are then able to pick the best hedge funds,” she said.

“That’s great,” I said, before moving the conversation on to other things.

The brother of the groom who had given up investment banking earlier that year had observed our conversation from across the table. “Dude,” he said later, “everyone’s in hedge funds these days. It’s the way of saying “I am a sophisticated investor” even if many people don’t have a clue what hedge funds actually do.”

The following morning, as I was waiting for Puk to get ready for the post-wedding brunch, I absentmindedly jotted down some figures on the notepad by the bed while watching basketball highlights. These were numbers I had known about for a long time, but never really focused on or added up from the perspective of the ultimate end investor. They went like this: pension-fund advisor 0.25%, pension-fund fees and expenses 0.75%, fund-of-funds management fee 1%, and so on.

“There are a lot of people who need to get paid here before my friends from last night see a penny,” I thought, increasingly aware of the staggering aggregation of fees. I would cross many of the fee numbers and make them lower so that the aggregate fees would be more reasonable.

“Surely external pension fund advisors only charge 0.15% per year,” I would mutter to myself.

Still, the conclusions were troubling, and I began to think the only way the numbers made sense for them would be if the hedge funds all performed brilliantly every year – which clearly wasn’t the case.

Typically, Mr Straw’s pension fund would have its own set of expenses and fees on top of the external advisor they would often hire to assess what to do with their hedge fund allocation. With the help of this advisor, Mr Straw’s pension fund would typically make an allocation to one or a couple of the larger funds of funds, depending on their risk appetite and their views on which fund of funds showed greatest promise. The fund of funds selected would then go about its work and decide which hedge fund to invest in, including funds like Holte Capital. That is a lot of mouths to feed, particularly when you consider that the hedge funds on top of their typical fees have expenses associated with trading and administration. Below is a summary list of all the annual fees and expenses Mr Straw could incur before seeing a return from his hedge fund investment:

Note that in this zero interest rate environment Mr. Smith is down more than 5% (before incentive fees) on his investment every year on fixed costs alone. He would be well advised to question if the hedge fund investment business can consistently provide opportunities to justify this?

The trading expenses clearly depend on the type of hedge fund. In this case I assumed a typical long/short equity fund with 150% long and 75% short exposure – somewhat different from Holte Capital which aimed to be more equally long and short, although the math is fairly similar for other types of funds. In order to generate its investment returns this fund will typically incur trading expenses as summarized below.

At Holte Capital our administrative expenses were less than 0.2% per year, but for smaller funds that could easily be several percent annually. Even adding the 0.2% to trading expenses listed above, the fund has spent nearly 2% (0.2% + 1.64%) of its assets yearly before the hedge-fund manager gets his management fee. And the list goes on. In some cases at least until a couple of years ago, hedge-fund managers also engaged in “softing”. This is when a broker charges you more than the going rate for at trade (say 0.2% instead of 0.1%) and gives part of this difference back to you in the form of things like a Bloomberg terminal, computers, etc. This effectively causes the hedge fund to charge its investors higher fees. In line with Holte Capital, this example assumes there is no “softing” going on (as if we did not charge people enough already!).

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