The profitability (or quality) factor boasts a number of traits that makes it particularly interesting for passive investors:

• Profitability beat the market by 4% per year between 1963 and 2011.

• It’s strong in large cap equities – a rare treat for a return premium.

• It’s particularly powerful when partnered with investments in the value and small cap premiums because it’s negatively correlated with both.

• Profitable equities tend to suffer less in a downturn than the total market.

Profitability works by concentrating on the firms that exhibit traits which are suggestive of rude business health in the future. It’s a bit like looking a potential mate up and down and determining their fitness according to the size of particular dangly bits. On an individual basis, you’ll often be disappointed, but apply the profitability criteria to enough candidates and on aggregate it seems to work.

The real power of profitability though may come from combining it in a portfolio with other financial steroids like value funds.

US Professor Robert Novy-Marx revived interest in the profitability factor with his work showing that a dollar invested in the US market in July 1973 grew to over $80 by the end of 2011.

But if you’d invested it in value and profitable equities instead, then that dollar would have grown to $572 (before expenses)

That’s a 615% increase.

Tempting.

The Holy Grail of diversification

The combination works because profitable companies are generally larger and more highly valued by book-to-market ratio than traditional value equities.

The outcome of holding them both is the holy grail of diversification: negatively correlated assets.

When profitable companies are on a roll, value firms tend to flop, and vice versa.

Bring together those complementary behaviours, and you have a portfolio that’s better able to resist a severe dip – because one of the factors should buffer you against the misfortune of the other.

This means you’re taking less overall risk in your portfolio, even though both factors are risky in and of themselves.

Big profits are beautiful

The large cap tilt of profitability also means it’s likely to bear up when small caps are going through a rough patch.

This is important for practical reasons, too. It’s hard for UK passive investors to invest in truly small cap equities. Most so-called small cap funds tend to invest more in mid caps, in reality.

Yet premiums like value, momentum and size are usually more powerfully present among smaller equities.

This means that while a return premium may deliver eyebrow-raising returns on paper, the reality of real-life investing is that those theoretical numbers can be leeched away if you have to invest in funds that don’t capture the most potent sources of return, such as micro cap equities.

Funds are also undermined by their management and transaction costs and their inability to easily short poorly performing equities, in comparison to the theoretical returns offered by the premiums as touted by academics.

Happily though, the paper Global Return Premiums on Earnings Quality, Value, and Size shows that a long-only portfolio ¹ can deliver strong returns by combining value and profitability.

This twin tilt beat the market by 3.9% among large caps, and 5.8% among small caps.

In comparison to a pure value tilt, the addition of profitability added 1.2% to the large cap returns and an extra 1.8% to small caps.

The effect becomes more pronounced still when you throw momentum into the mix, as this factor is negatively correlated with value and has a low correlation with profitability and small cap.

To actually invest in profitability check out our review of UK quality ETFs.

Take it steady,

The Accumulator

1. That is, one that doesn’t short equities.[↩]

Good reads from around the Web.

This graph from J.P. Morgan via Business Insider tells an old story very well – that the huge volatility in the returns from shares tends towards a positive return, given sufficient time:

I know, I know – we’re all aware and cheerfully appreciative of this fact these days. We’re five years into a bull market, and everyone has forgotten what a bear market feels like, let alone the mood of despair at the bottom.

Maybe you could bookmark the graph, ahead for the next (inevitable) crash?

Please ‘like me’! Please!

Desperate pleading is seldom appealing to anyone – unless you’re a Dominatrix who has spent a fortune on a new home dungeon in your basement and you’re husband is finally playing along – but here’s another request for you to ‘Like’ Monevator on Facebook.

I don’t mean via the little ‘Like’ buttons at the top and bottom of this post.

Rather, can you please follow this link to officially ‘like’ the Monevator on Facebook using the Like button on the Facebook page that loads.

Several thousand people read Weekend Reading every Saturday and Sunday, so I know plenty of you do like Monevator.

Also, I’m often asked whether people can give donations or similar as a (very generous) thank you for our efforts here.

No, it’s fine, really. But please do Like us on Facebook!

I’m sick of it being under 1,000 Likes.

If we can get Likes into four figures then I can forget about it for a few years.

Comment concerns

Finally, a few people have reported comments disappearing into the ether this week – and I have found a couple incorrectly chucked into the trash.

Generally they’re comments by people with financial websites that the spam filter is incorrectly labeling as junk.

No offense, I didn’t program it! 🙂

Monevator gets several thousand spam comments every single day, and at one point I was having to deal with them every few hours.

Now I have multiple layers of protection, and they work well. But the latest updates do seem a little trigger happy.

If you repeatedly post comments that never appear on the site – and you’re not a Ukrainian trying to sell dodgy wares over the Internet – then please do drop me a line and I’ll go looking in the garbage. (You’ll need to be quick, as the spam comments are ditched fairly regularly for sheer volume reasons).

On the same topic, I’m hoping to move to a more modern comment system soon that will enable you to hook up with Facebook or Twitter or else a Monevator user account.

It should also make it easier to have proper conversations with replies and so on.

[continue reading…]

This article on the high cost of fund of funds fees is from former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. His book, Investing Demystified, makes the strong case for index funds.

Back in early 2006, I was at the wedding of a good friend in the bride’s hometown near Chicago.

At the reception I sat next to her charming aunt, Mrs Straw.

Mrs Straw had lived in the same small town all her life and her husband was a couple of years from retirement at a local sub-supplier for one of the Detroit auto companies. She herself had not been working for 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?” Mrs Straw asked.

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

“I know what a hedge fund is,” she said, slightly offended that I had assumed she did not. “We’re invested in them through my husband’s pension plan at the plant. They’re great. He is 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 ventured. “Which funds are you invested with?”

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

“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.”

This conversation stuck with me.

Fund of fund fees add up fast

The following morning, as I was waiting for my wife to get ready for the post-wedding brunch, I jotted down some figures on the notepad by the bed.

These were numbers I had known about for a long time, but I’d never really focused on or added them 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 Mr and Mrs Straw see a penny,” I thought, increasingly mindful of the rapid aggregation of fees.

I even found myself crossing out some of my estimates and making them lower, so that the aggregate fees would look more reasonable.

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

Even after such tinkering, the conclusions were troubling, especially for investors in fund of funds.

I began to think the only way the numbers made sense for Mr and Mrs Straw would be if hedge funds all performed brilliantly every year – which clearly doesn’t happen in the real world.

Already underwater

Typically, Mr Straw’s pension fund would have its own set of expenses and fees. It would also usually hire an external advisor to assess what to do with its hedge fund allocation.

With the help of this advisor, Mr Straw’s pension fund might make an allocation to one or perhaps a couple of the larger fund of funds, depending on its risk appetite and its views on which fund of funds showed the greatest promise.

The fund of funds selected would then go about its work and decide which hedge funds to invest in – such as the hedge fund I ran back then, Holte Capital.

The end result is a lot of mouths to feed, particularly when you consider that in addition to their typical fees, hedge funds have trading and administration expenses to pay, too.

Here is an estimate of the annual fees and expenses Mr Straw might incur before seeing a return from his hedge fund investment:

		Fees	Notes
	Recurring	Performance
Pension fund (PF)
PF external advisor	0.15%
PF fees and expenses	0.75%
Fund of funds (FoF)
FoF expenses	0.15%		Admin, legal, audit
FoF management fee	1.00%
FoF performance fee		10.00%
Hedge funds (HF)
HF trading expenses	1.64%		See below
HF fund expenses	0.20%		Admin, legal, audit
HF management fees	1.50%
HF performance fees		20.00%
Total	5.39%	Variable

Source: Author’s research.

Notice that Mr Straw is already down more than 5% on his investment every year on fixed costs alone (that is, before performance fees ¹).

Mr Straw would do well to question if the hedge fund business can consistently provide the returns to make up for these huge costs.

How trading costs cut hedge fund returns

What about the trading expenses racked up by a hedge fund that I mentioned?

In the example above I have estimated these at 1.64%. The precise number will depend on the type of hedge fund that the fund of funds invests in.

For my back of a napkin estimates, I assume a typical long/short ² equity fund with 150% long and 75% short exposure. This was somewhat different to my own hedge fund at the time, which aimed to be more equally long and short, but the sums are fairly similar for most types of funds.

In order to generate its returns, the typical hedge fund will incur trading expenses as follows:

Market exposure
Long market value	150.00%	Long £150 per £100 in assets
Short market value	75.00%	Short £75 per £100 in assets
Gross market value		£225 per £100 in assets
Costs incurred
Borrow fee (to short)	0.5%	Can be higher with some names
Annual churn	2.5x	Number times portfolio traded yearly
Bid/offer spread	0.25%	Bigger for smaller companies
Commissions	.10%	In US done in cents per share
Softing	0.00%	Assume none (see below)
Margin costs	0.00%	Assume zero as below 100% net long

Source: Author’s research.

Using these assumptions, we can calculate a typical hedge fund’s annual trading expenses as something like the following:

Borrow fee	0.38%
Commissions	0.56%	Gross market value x churn x commissions
Bid/offer spread	0.70%	Gross market value x churn x bid/offer x 0.5
Total	1.64%

Source: Author’s estimates and calculations.

In the first table I also included an estimate of administrative expenses close to those incurred at my hedge fund at the time – which were less than 0.2% per year. For smaller funds these could easily be several percent annually.

Even adding the lowball 0.2% estimate to the trading expenses we just calculated, we see the typical hedge fund will spend nearly 2% (0.2% + 1.64%) of its assets every year. And that’s before the hedge-fund manager gets his or her explicit management fee.

The list can go on. Until a few years ago, for example, hedge fund managers typically engaged in ‘softing’. This sees a broker charge the manager more than the going rate for a trade (say 0.2% instead of 0.1%) and in exchange gives part of this difference back to the manager in the form of products and services, such as a Bloomberg terminal, computers, research and so on.

Softing effectively causes the hedge fund to charge its investors higher fees.

In line with my own fund at the time, I’ve assumed there is no ‘softing’ going on with our example. We don’t exactly need it to make the numbers look bad!

What about the end investor?

Let’s get back to Mr Straw’s pension.

We’ll assume for simplicity’s sake that all the hedge fund managers that his fund of fund manager invests in achieve a return of 10% a year.

This 10% is before any fees and trading and other expenses.

So how much does Mr Straw get to bring home to Mrs Straw, to help the couple enjoy their golden years?

Not a lot, it turns out.

As shown in the table below, in this simple example Mr Straw will see around 3% return per year, even when the hedge fund managers achieve a quite respectable 10% gross return.

Let me repeat that: Mr Straw’s money generated a return of $10. Mr Straw gets to keep less than $3.

Here’s the maths:

Gross ‘gross’ performance*		10.00%
		—
Hedge fund (HF)	Fee	Net of 3
Trading expenses	1.64%	8.36%
		—
Standard ‘gross’ performance		8.36%
		—
HF fund expenses	0.20%	8.16%
HF management fee	1.50%	6.66%
HF incentive fee 4	20.00%	5.33%
		—
Fund of funds (FoF)
FoF expenses	0.15%	5.18%
FoF management fee	1.00%	4.18%
FoF incentive fee 5	10.00%	3.76%
		—
Pension fund (PF)		—
PF external advisor	0.15%	3.61%
PF fees and expenses	0.75%	2.86%
		—
Net return		2.86%

Source: Author’s research. *Normally gross performance is quoted after trading expenses.

Heaven forbid that Mr Straw should have to pay tax on his gains!

Instead of enriching these many layers of financial advisors and principals – and taking risks with his money to earn 10%, only to see it dwindle to a 2.86% return to him – Mr Straw could have just put his money in government bonds for a smaller but far less risky return, and slept more easily at night (particularly as his retirement date was fast approaching).

Luxury pricing for everyday performance

There is one more piece of the puzzle that’s worth thinking about.

Namely, how did the example hedge fund generate its 10% return?

If the fund was just long the S&P500 index and the index was up 10% for the year, Mr Straw paid his large fees for very little additional value. He could have bought a cheap index fund and paid say 0.2% in total fees, not 7% (though he might not have been able to avoid some pension fund costs in order to gain tax advantages).

Long-only funds charge high hedge fund fees, but they do not add as much value (because they just own something that goes up) compared to those who generate 10% pure alpha (i.e. non market-related gains), perhaps by being market neutral in their mix of long and short exposure.

The events of the fall of 2008 proved a large number of hedge funds were indeed simply long the markets – and the value they generated was thus lower.

Investors in such hedge funds were paying for beta. They paid a high cost for simply being long the market.

It is no coincidence that the surge in hedge fund assets under management occurred at the same time as a 30-year bull market in equities and other asset classes.

In this environment, a lot of beta was sold as alpha, yet just how much is perhaps not readily apparent to the end investor until the market starts going down. Even then there are ways to disguise it.

Speaking from personal experience, I can tell you it is incredibly hard to generate 10% gross ‘alpha’ every year.

If you do, funds of funds will love you, invest lots of money with you, and simply leverage up their investment in your fund to fit their risk profile.

The holy grail of funds of funds is to create a portfolio of hedge funds with no correlation to markets or to each other. This would almost guarantee continued positive performance.

Unfortunately there is very little doubt that in sum the hedge fund industry does not create an average of 10% alpha per year. We create far less and hedge funds correlate quite highly with each other, particularly in bad markets.

In the good years, rising markets disguise the fact that it is not 10% alpha, but rather 3% alpha and 7% being long the market, that generated the returns. Mr Straw may not know the difference and happily pays his fees.

That said, while the likes of Mr Straw may not be much wiser today than they were a few years ago, I do think institutional investors are a bit savvier about what they’re getting when they put money into a hedge fund these days.

While the total assets management by the hedge fund industry has climbed to a new all-time high, I believe average fees are far lower than before the financial crisis, so it seems some of these lessons have been learned.

I also think that today’s investors are wiser about what they’re paying for than they were before the 2008 crash revealed how many hedge funds were essentially leveraged long-only bets on the market. More people now understand they need to look for true alpha to justify paying high fees – although whether they find it would be the subject for another article.

Let’s try this in real life

At the end of the day, just how big a difference does all this siphoning off via fees have on Mr Straw’s money?

Let’s imagine Mr Straw invested $100 in the type of fund of funds we’ve walked through above, while Mrs Straw takes $100 from her savings and puts them in an averagely cheap index fund.

Suppose that both Mr and Mrs Straw’s investments return 10% per year before any fees over ten years. After that Mr and Mrs Straw are ready for retirement.

How much have they got?

The result may not surprise you by this point, but it’s still staggering:

	Year 0	Year 10
Mr Straw in ‘Hot Hedge’	$100.00	$132.57
Mrs Straw in index fund	$100.00	$254.70
		—
Cumulative fees to ‘Hot Hedge’		$35.48
Cumulative fees to Fund of Funds		$17.76
Cumulative fees to index fund company*		$4.68

Source: Author’s research. * I’ve assumed the index fund costs 0.2% a year.

Mrs Straw simple investing strategy leaves her with a pension fund that dwarfs her husband’s.

The table makes it easy to see where the difference went. The fees paid to the hedge fund and fund of funds are ten times larger than to the index fund company – and this is before the pension fund’s charges and expenses.

Wake up to the huge cost of high fees

None of this is to say that investing in a hedge fund never makes sense for anyone.

I’ve assumed in the example above that both the index fund and the hedge fund returns 10% a year. Some people may be optimistic that their chosen hedge fund will do far better than the market.

Maybe so, but clearly the bar that Mr Straw’s fund has to clear for it to make sense for him to stick with hedge funds compared to switching to using index funds is very high indeed.

Back in Chicago, I was still working through this maths when my wife was finally ready to head out for the wedding brunch.

As we took the short walk there, I tried to explain my re-discovered revelation about the multiple fee structure and how it did not make sense for Mr and Mrs Straw – or even pension funds generally – to be invested in hedge funds.

My wife was oddly casual about it.

“Don’t you think the rest of the world knows that finance guys are not worth what they are getting paid?” she said with a smile.

I gave her the usual song and dance about uncorrelated risk-adjusted returns at my own hedge fund, but her mind was already elsewhere.

As was mine.

Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.

1. Also known as incentive fees.[↩]
2. Long means you own the assets and look for them to go up. Short means you have sold the assets, betting they will get cheaper in the future.[↩]
3. i.e. ‘Minus’ the fee in left column.[↩]
4. aka performance fee[↩]
5. aka performance fee[↩]