Zuckerman’s Curse and the Economics of Fund Management
Plus: Deglobalisation, Fannie and Freddie, Banking Disruption
|Marc Rubinstein||Nov 20, 2020||18||7|
Welcome to another issue of Net Interest, my newsletter on financial sector themes. Every Friday I go deep on a topic of interest in the sector and highlight a few other trending themes underneath. If you enjoy Net Interest, please spread the word! It really makes a difference when you recommend this newsletter to others.
Zuckerman’s Curse and the Economics of Fund Management
A year ago, author Gregory Zuckerman published a book, The Man Who Solved the Market. It tells the story of Jim Simons and his quest to build one of the largest and most successful hedge fund firms in the world. It’s an industry Zuckerman knows something about. Ten years earlier he wrote his first book, The Greatest Trade Ever, about John Paulson and how he made a $20 billion return in his hedge fund during the financial crisis.
Zuckerman did very well out of these books. The one about Simons became a New York Times bestseller and was shortlisted for last year’s FT and McKinsey business book of the year. For his subjects, however, the books boded less well. Paulson went on to post very poor returns in his funds in subsequent years, eventually closing shop this summer. And although it’s still too early to draw definitive conclusions, Simons hasn’t had a very good year since the book about him was published. According to Bloomberg, some of his largest funds are down between 20% and 27% in the year to October.
There are a number of possible explanations for the misfortune. One explanation is that Zuckerman has a kiss of death and you should run a mile if he wants to write a book about you. (His other major book was 2013’s The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters, several of whom are no longer billionaires.) Another is that persistence of hedge fund performance is difficult to sustain and Zuckerman was unlucky in the timing of his profiles. But there’s a third, which touches on the economics of fund management.
There are two types of business: those that suffer from diminishing returns to scale, and those that benefit from increasing returns to scale. The first group comprises most companies—they reach certain limitations as they grow, and eventually reach a predictable equilibrium in market share. The second group uses technology to extract increasing returns to scale, often because of the network effects they possess. Investment managers may load up their portfolios with the companies in the second group, but they themselves sit in the first. Limited investment opportunities and potential negative price impacts from trading in large size erode fund performance when funds grow large. This is especially true in the hedge fund segment, where funds compete for market outperformance, an output that is in limited supply.
Warren Buffett puts it like this:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
Which brings us back to the protagonists in Zuckerman’s books. Nobody wants to read about a small-time investment manager; it’s the scale of these managers that make them worthy subjects of literature. But that scale undermines their performance.
According to Zuckerman, Simons’ firm, Renaissance Technologies, was running $65 billion of assets at the end of last year; at his peak, Paulson was running $38 billion. These funds may have simply got too big to manage. The academic research would certainly seem to think so.
So why do investment managers push beyond the upper bound of their capacity to create value for their customers? Ah, that’s easy: incentives.
The Agency Problem
Problems of agency crop up everywhere people delegate responsibility. They occur between politicians and the electorate, between employees and employers, between doctors and their patients. One party is expected to act in the other’s best interest, but how can we be sure they will?
Invariably, problems of agency occur between asset managers and asset owners, too. Like in all the other cases, asset managers and asset owners may have different perspectives on a whole range of issues. Aligning on these interests presents a challenge.
In asset management it can be especially difficult to untangle the problem. Most of what investment managers do is acquire information; it can be difficult for asset owners to judge the utility of that information if it does not bear directly on performance. Asset managers also control both the risk and the return in their portfolios, giving them two dimensions to flex, making the problem harder to solve.
The way agency problems are normally resolved is by setting up a contract between parties to lay down the rules of the game. In asset management, there are many types of fund but it is the structure of that contract that reflects their fundamental difference.
Mutual fund investors design their contract to go heavy on limitations. They impose risk limits, demand high levels of disclosure and restrict the range of investment decisions they allow their managers to make. In contrast, hedge fund investors allow a lot more latitude and even turn the restrictions on themselves by agreeing to lock up funds for longer periods. In place of restrictions, they use fees as the central pillar of their contract, together with some “skin-in-the game”.  Hedge fund investors pay fees linked to performance and often require co-investment by the manager; mutual fund investors pay a fixed fee and tend not to ask managers to invest in their funds.
Unfortunately neither approach is perfect. In particular there’s one common feature which flames conflict—charging fees as a proportion of assets under management. Using size as a determinant of fees is a surefire way to incentivise size, even if it is detrimental to performance.
It wasn’t always this way. The practice of charging fees as a proportion of assets became pervasive only after an East Coast/West Coast schism on the issue. Historically, fees were levied as a commission on transactions. The problem with this approach is that it incentivised churn. As an alternative, Arthur Clifford, an independent investment advisor based in Pasadena, California, began offering fixed fees for his services in 1915. On the other side of America, in Boston, Theodore Scudder of Scudder, Stevens and Clark (since subsumed into Deutsche Bank) chose instead to charge 1% of assets in 1919. The East Coast won out. In the late 1960s the Morgan Bank extended the practice to institutional money, charging 0.25% of assets. Under cover of asset appreciation, those fees edged up over the years to the rates they are today.
Given that the costs of acquiring information and making investment decisions don’t scale with asset size, the margins on incremental fees can be very high for asset managers. Large fund management firms typically have margins in excess of 40%.
Performance Fees: A Panacea?
An alternative model is of course the incentive fee that hedge funds charge. The first hedge fund is said to have been created by Alfred Winslow Jones in 1949. As well as being generally more secretive than a regular fund, it introduced the convention of a 20% performance fee.
It would be nice to say that Jones saw his fee structure as a solution to an agency problem, but the truth is that he saw it as a solution to a tax problem. At the time, marginal tax rates on personal income were 91%; capital gains rates were just 25%. Charging only incentive fees allowed him to keep more of his earnings. Of course, he didn’t tell clients this—he told them his profit share was modelled after Phoenician sea merchants who kept a fifth of the profits from successful voyages. Marketing investment management services has always been about telling a good story!
The difference with subsequent iterations of the hedge fund model is that while Jones charged performance fees as a substitute for asset-based management fees, later funds charged both, testing the water with a 1% management fee before nudging their fee structures up to “2 and 20”.
The introduction of performance fees creates a better alignment between asset owners and asset managers. But it still leaves gaps. These stem from the principle that performance fees are not entirely linear: you pay them in the event of gains, but the manager doesn't pay you in the event of losses. In the event of losses, you get “fee credits” which can be offset against future profits.
There are two ways this wrinkle can bite. First, performance fees are paid on individual funds; losses in one fund can’t be netted off against profits in another. Which makes some sense. Except that some firms exploit it by offering separate vehicles within fund families rather than consolidating into a single fund. The result is that investors can pay fees even if they suffer overall losses, as they did for example in 2008.
Second, hedge fund managers retain a “restart” option: they can close up shop if they’re underwater and re-establish themselves down the street with the performance clock reset to zero. This is something the market overall can’t do. You don’t know whether the market will be up or down tomorrow, but you do know that it will be open. So as long as you are not carried out by excess leverage, the opportunity to recoup losses is always there. Not so the hedge fund that shuts up shop, extinguishing the value of any “fee credits” that have built up while it was underwater.
Each of these features means that the cost of the performance fee can end up being higher than the 20% it says on the sticker. Academic research estimates that $314 billion of performance fees were paid on total hedge fund returns of $633 billion over a 22 year period, equivalent to an incentive fee rate closer to 50%. Indeed, after including management fees, investors collected about 36 cents for each dollar of gross excess return generated by funds on their invested capital. The other 64 cents were paid as management and incentive fees.
Bringing Shareholders into the Mix
If managing the relationship between asset owner and asset manager wasn’t complex enough, the picture becomes even more blurred once another stakeholder is brought into the frame: the outside shareholder.
While many hedge fund firms have stayed private, a number have sold minority or even majority stakes in their management companies. One of the first to go public was Och Ziff, now known as Sculptor Capital Management, which IPO’d in 2007. At the time it managed assets of $33 billion (they peaked at $48 billion and they are now $36 billion).
Bonding the relationship between asset owner and asset manager, there is another feature that we haven’t talked about yet: reputation. How impactful a feature it is depends on the manager’s personal make-up and where they are in their life cycle. However, reputation is not something that concerns shareholders.
One question to ask to ascertain how stakeholders rank in order of priority is which metric sits at the top of the manager’s dashboard. Is it the stock price (or some measure of the manager’s corporate value) or is it the funds’ net asset value? Barton Biggs, in his book Hedgehogging, alludes to a third: golf handicap; he questions how many points of performance a manager would be willing to give up to improve his golf game.
In the twelve years since Sculptor went public, it has returned $16 billion in performance to its investors, net of fees. Over that time, it has paid its staff $3 billion, absorbed $2 billion of other expenses, paid just under $1 billion in taxes and had $4 billion left over for shareholders. That illustrates just how attractive it can be to own an asset manager with economics that derive as a solution to the agency problem. Shareholders collect a quarter of the return that fund investors do, yet put up a fraction of the capital (in Sculptor’s case shareholder capital amounts to less than 1% of assets under management).
This has not been lost on fund investors themselves. In 2007, Goldman Sachs raised a $1 billion fund called Petershill explicitly to invest in hedge fund companies. Now, through a fund vehicle, asset owners have the opportunity to invest directly in the earnings streams they helped to create. Neuberger Berman followed suit in 2011, with Dyal Capital Partners, and Blackstone has done the same. The advantage of these structures over a single firm like Sculptor is that they provide diversification over multiple funds, benefitting from the wrinkle in the symmetry of performance fees. Since their first fund launches, these three firms have raised over $26 billion in the strategy.
The agency problem is a tricky one to solve. The success of these funds suggests one response is a in addition to requiring asset managers to put skin in the game, asset owners to put skin in the game of asset management.
 One study of “skin in the game” shows that while it aligns incentives, it has the effect of crowding out third-party investors from the best strategies. Greater inside investment incentivises managers to better manage the size-performance tradeoff discussed above. But it does so by restricting the entry of new outsider capital to the funds in which managers are invested. Insiders own $400 billion of the $3 trillion invested in hedge funds globally.
More Net Interest
The history of international banking is intertwined with the history of globalisation. While some countries have historically been very protective of their banking systems, others have been more open and have allowed foreign banks into their markets. There are many reasons banks pursue a strategy of international expansion: to diversify from their domestic market, to lock-in higher returns, to follow their customers. Or simply because they can.
Some of this is now being unwound. This week BBVA of Spain announced that it’s selling its US operations to PNC for $11.6 billion. That capital looks likely to be reinvested back in Spain via the acquisition of Banco Sabadell. If that goes through, it is possible that Sabadell will sell its UK operation, TSB. Sabadell bought TSB in a pre-Brexit era and after an IT disaster worthy of its own Net Interest, has been tidying the bank up ahead of a likely sale anyway.
This whole chain of events was sparked by PNC selling its long-held stake in Blackrock earlier this year. That capital looks like it's finding its way around the globe, even as the assets it unlocks consolidate at home.
Fannie and Freddie
Our piece from two weeks ago on the US mortgage market is our most viewed ever (thanks, Morning Brew). We expressed the view that resolving the ownership structure of Fannie Mae and Freddie Mac remains one of the last pieces of the financial crisis to fix. With two Presidents already having kicked the can down the road on the issue, it would likely fall to a third to sort out.
The WSJ reports that a fix may come sooner. Mark Calabria, who runs the Federal Housing Finance Agency and oversees Fannie Mae and Freddie Mac, is pushing to speed up their exit from government control, possibly before President Trump leaves office. A new capital rule has already been authorised, requiring the companies to hold over $200 billion of capital. But a lot of work still needs to be done: a decision needs to be made on how to treat the Treasury’s senior preferred stock; litigation brought by frustrated investors needs to be settled; and a fee for the government guarantee needs to be agreed. The next date for the diary is 8 December, when the Supreme Court will address part of the litigation issue.
One benefit of going now is that the IPO market is hot. Fannie and Freddie may not be as exciting as AirBnB but they do underpin what AirBnB does. Plus, it’s not often a duopoly comes to market.
Andy Haldane, Chief Economist of the Bank of England, delivered a speech this week about digital finance. He touched on the prospect for digital currencies, the subject of a Net Interest piece a few weeks ago.
One of the risks presented by digital currencies is that they challenge the very essence of banking. By drawing money from deposits they restrict banks’ access to cheap, stable funding and therefore their capacity to lend.
Haldane doesn’t necessarily see this as a negative.
...A widely-used digital currency would change the topology of banking in a potentially profound way. It could result in the emergence of something closer to narrow banking, with safe payments-based activities to some extent segregated from banks’ riskier credit-provision activities. In other words, the traditional model of banking would be disrupted.
While the focus so far has been on the costs of this disruption – for funding and credit provision – weight needs also to be given to the potential longer-term benefits of such a structural shift. Banking instabilities arise from the risk and duration mismatch which arise between the asset and liability sides of a bank’s balance sheet. Leverage and illiquidity are the common denominator of all banking crises.
In principle, separating safe payments and risky lending activities could lead to a closer alignment of risk and duration on the balance sheets of those institutions offering these services. We would move closer to a bifurcated intermediation model of narrow banking for payments (money backed by safe assets) and limited purpose banking for lending (risky assets backed by capital-uncertain liabilities). In principle, this would reduce, at source, the intrinsic instabilities of the traditional banking model.
So far, the biggest obstacle to banking disruption has been the regulator. If he’s on side, it changes everything.