The Cost of Quality

By Cliff Stanton and Jeremy Frank

July 2016

As is likely the case with other liquid alts managers, we are sometimes asked the question about fee levels. Recently, we received such a question and went on to articulate what we thought was a well-reasoned position, only to receive feedback that our response was inadequate. Such feedback may be expected, so we thought we’d take another stab at addressing how to think about fees in the asset management world.

In business school many of us were taught that there are two generic strategies that a business can embrace, and if executed well, will increase the probability of success. Those generic strategies were high quality/high cost and low quality/low cost. To stake out territory somewhere in the middle is death, as the business has no identity in terms of either quality or price. While clearly an oversimplification, the basic concept rings true to us, and we think that this is playing out in real time between active and passive managers, and between financial advisors (the human kind) and robo-advisors.

Defining “quality” is always a bit difficult (and can drive you mad in the process if we correctly recall the plight of Phaedrus in Zen and the Art of Motorcycle Maintenance). But in the asset management business, we think most would agree that quality = alpha. Simple enough, except that alpha is itself a difficult concept. What we used to unquestionably consider to be alpha has increasingly been found to be systematic exposure to certain risk premia; a fancy way of saying “beta.” This epiphany came about as the data, tools and methodologies used in performance measurement all markedly improved over the last decade or so. Value, size, quality, etc. can all be harvested in fairly cheap ways, thus the rise of “Smart Beta.”

The result? Being an active manager has increasingly meant being under the gun; trying to convince investors of the existence of a discernable edge that can produce alpha with some consistency over time. And that is where the fee question becomes most relevant. No alpha? Better be cheap or you’ll disappear. Strong alpha after fees? Charge what you want (although don’t get too greedy; an alignment of interests with your clients is what builds a lasting business).

As is the case with any asset that an investor adds to a portfolio, it’s not the individual component that matters, it’s that asset’s contribution to the sum of the parts. And in the aggregate, the only question that matters is whether or not that collection of assets is able to generate the results required by the client. This sum of the parts analysis is inclusive of alpha (quality) and fees (cost). Many investors have come to the conclusion that either because alpha is elusive or ephemeral, or because the due diligence required to identify true alpha is too difficult, that they are better off with low cost investments. They’ve voted with their dollars, shifting hundreds of billions into passive vehicles. This is what an economist would call a “rational actor” looking out for his/her self-interest. We’d agree that the best course of action for most non-professional investors who aren’t using a financial advisor is to go passive, but some passive exposure makes sense as a part of any investor’s portfolio, sophisticated or not.

But we can’t lose sight of the fact that as is the case with risk exposures, the expenses of any one asset in the portfolio aren’t particularly meaningful. Further, cheap or expensive is always relative. Running a search in Morningstar for all index funds with a primary prospectus benchmark equal to the S&P 500 yields 169 funds (inclusive of all share classes), and the annual report net expense ratios on those funds range from two, yes two basis points (congrats Vanguard and Fidelity) to 231 basis points (name withheld to protect the guilty). In fact, there are 118 S&P 500 index funds with expense ratios exceeding 25 basis points. Point being 50 bps sounds cheap until you realize you can get the same thing for 10.

Further, if an investor believes, as we do, that active/passive is not a mutually exclusive decision, that embracing both can lead to the best outcome, consider the following. A simple portfolio of 60% S&P 500 (via SPY at 11 bps), 20% Barclays Aggregate (via AGG at 7 bps) and 20% in a managed futures fund (using the category average of 1.96% inclusive of all share classes), results in a total portfolio expense ratio of 47 basis points. I think most would agree that is quite a reasonable cost for a portfolio (and cheaper than many of the S&P 500 index funds that exist).

But again, the only reason you’d add that managed futures fund (or any active fund for that matter) is if it is truly additive to your portfolio. To justify a higher expense, an active strategy must either enhance return or reduce risk in a meaningful way, and the specific manager selected better be earning that fee by delivering true alpha.

The Data

The S&P 500 Index was essentially flat for the month, while the MSCI EAFE was down more than 3%. The month ended with rather extreme volatility, especially in Europe, as Great Britain voted to leave the European Union. This created a sharp selloff globally, though most markets rebounded nicely heading into month end. This volatility also created an interesting environment for many alternative funds. Long/short equity was the laggard for the month, losing 0.89%, though there was rather high manager dispersion depending on funds geographic exposure. Managed futures was able to take advantage of the volatility, posting a very strong 3.74% return and bring both year-to-date and trailing twelve month returns into positive territory. Looking longer-term, managed futures continues to have had the strongest three-year performance, earning 3.72% annually while equity market neutral posted the weakest annualized return at 0.38%.

Flows continued to be negative across almost all categories, with only managed futures seeing positive inflows during June. As we mentioned last month, even within managed futures the vast majority of flows continue to go to the largest manager in the category. Multialternative funds continued their reversal, losing more than $1.2 billion in assets during the month and bringing year to date outflows to nearly $1 billion. Overall, asset raising in the alternative mutual fund space has continued to be rather difficult, but that is true for active management more generally, and has been the case for an extended period—something not likely to reverse anytime soon.

Alternatives in the News


Who’s winning?

Carl Icahn is claiming victory in the Icahn vs. Ackman battle over Herbalife. Ackman has accused the company of being a pyramid scheme and has been short the stock for several years. If the move in Herbalife’s stock post settlement with the Federal Trade Commission is the arbiter in this case, than we suppose Icahn is winning, as Herbalife gained nearly 10%. But the statement from FTC Chairwoman Edith Ramirez suggests otherwise. Ms. Ramirez said, “Herbalife is going to have to start operating legitimately, making only truthful claims about how much money its members are likely to make, and it will have to compensate consumers for the losses they have suffered as a result of what we charge are unfair and deceptive practices.” In response to this glowing review from the FTC, Herbalife’s CEO, Michael Johnson said “The settlements are an acknowledgment that our business model is sound and underscore our confidence in our ability to move forward successfully, otherwise we would not have agreed to the terms.” We must admit that Mr. Johnson would make a great politician. The ability to completely ignore reality to further one’s own cause is a rarefied skillset. Evidently not operating legitimately and lying to members (not our words, just the natural corollary of Ms. Ramirez’s) is the basis for a sound business model. We have great respect for the principles of capitalism, but gosh, some of these guys do make it tough to extinguish the residual Bern.

Janus Team to Head Windham Liquid Alternatives Group

From FinAlternatives:

Investment management firm Windham Capital Management announced the addition of a liquid alternatives team with the hiring of Richard Lindsey, Ph.D. and Andrew Weisman. In their roles at Windham, Lindsey and Weisman will serve as co-heads of the Windham Liquid Alternatives group, according to the company.

Lindsey and Weisman co-managed Risk Premia strategies at Janus Capital before coming to Windham. Prior to that, Lindsey was President of Bear, Stearns Securities Corp. and a member of the Management Committee of The Bear, Stearns Co., Inc. Weisman was the CEO of WR Managed Accounts from 2008 to 2012, and managing director and chief portfolio manager for the Merrill Lynch Hedge Fund Development and Management Group from 2005 to 2008.


Tough Times at Bridgewater

The world’s largest hedge fund has hit rough times recently, with its flagship fund, the $68 billion Bridgewater Pure Alpha Fund, down 12% for the year. However, it’s not all bad news at Bridgewater, as the firm’s slightly smaller ($60 billion) McNugget inspired All Weather fund earned more than 10% in the first half of 2016. Bridgewater appears to be responding to its recent difficulties by slowing or suspending hiring. The firm, which currently employs about 1,500 people, has been hiring (and losing) 100’s of employees a year.

“Headline Risk” – They Called It

An April 13, 2016 article from Reuter’s discussed the reasons that the hedge fund Platinum Partners had struggled to raise assets despite a strong 13-year track record. The explanation – headline risk. As the article put it, “An important reason is what industry insiders call “headline risk.” Nordlicht’s investments and his approach to them, these hedge fund investors say, come with too many potential public-relations challenges.” They nailed that one. Two and half months later Reuter’s ran this headline; “Platinum Partners raided by federal agents amid dual investigations.” Not the headline an investor in a fund wants to see…


As Alice Cooper would say, school’s out for summer…(also, we have nothing particularly interesting to say at present, and as a wise soul once said, “Don’t speak unless you can improve the silence.” So we won’t.)

And Lastly

What to do when your entire yield curve is negative? Build a vault and have some fun!



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