The Cost of Alpha Generation

Multi-PM platforms have experienced a surge in popularity driven by strong risk-adjusted performance and alpha generation capabilities. However, with higher fees and expense pass-throughs, investors are left wondering: is it worth the cost?

To better understand the expense pass-through, we conducted a thorough analysis of audited financial statements from thirteen leading multi-PM platforms, boasting a combined AuM of over $200 billion. Our comprehensive analysis scrutinized the fees charged by these platforms, with the aim of determining whether their higher costs can be justified when compared to their “cheaper” 2% & 20% counterparts.

The chart below provides an overview of the fees charged by these platforms:

Our analysis shows that besides performance fees, three managers do not have an expense pass-through, six managers have a management fee and an expense pass-through, and four managers only have an expense pass-through.

Expenses

Total Expense Ratio

We found that the average total expense ratio (TER) is 9.1% including performance fees. This figure is undoubtedly high in absolute terms. Excluding performance fees, the TER falls to 6.6%, which is still significantly more expensive than the traditional 2% management fees. Though platforms are clearly more expensive on the surface, it is crucial to understand what investors are paying for.

Our findings reveal that the most expensive funds have produced the best performance. However, there are also similarly strong performing funds that charge much less. This suggests that diligent investors can identify good value and managers that strike an optimal balance between cost and performance.

As seen in the chart above, the average TER has increased by 1-2% over the past five years. This upward trend is partly due to the strong performance and significant inflows into this investment strategy group. Other factors such as higher infrastructure and compensation expenses, to remain competitive, have also contributed to this increase.

However, the primary driver behind the rise in TER is the increase in competition for talent, which has driven up PM payout ratios from 15-18% five years ago to 18-22% currently. This shift is a reflection of the exceptional value that PMs bring to these platforms, as they are responsible for generating alpha focused returns, and the competition to attract and retain good PMs.

Fixed Expense And Compensation

In the world of multi-PM platforms, talent is unequivocally the largest expense for firms. Excluding performance fees, approximately 75% of a firm’s total expenses can be attributed to compensation, with the remaining 25% consisting of fixed costs.

The graph above indicates that average fixed expense ratio has remained relatively stable, with a slight downward trend. However, in absolute terms, we have observed an increase in fixed costs. This suggests that firms are benefiting from economies of scale, but it may also indicate a lack of investment in infrastructure and technology, as firms are not increasing their fixed costs proportionally with the growth in AuM. It is important for investors to carefully discern between these two possibilities.

In contrast, the compensation expense ratio has on average increased. This is not surprising given the formulaic payout of PMs and the strong performance backdrop of the platforms, especially in 2020 when compensation sharply increased as highlighted above. Currently, the PM payout ratio is between 18% and 22.5%. We believe that this could increase even higher, up to 25%, as firms continue to compete for top talent.

Return Retention Ratio

We believe that the return retention ratio provides a good indication of how expensive a fund and provides a metric for comparison. It is defined as follows:

The return retention ratio is a critical metric that measures the proportion of gross returns that investors retain after accounting for all fees and expenses. Excluding years with negative performance, the average return retention ratio is 55%. However, this figure can vary significantly across managers, ranging from a high of 74% to a low of 24%.

As expected, funds without an expense pass-through tend to have a higher return retention ratio as seen in the chart above. If these funds were removed from the analysis, the average return retention ratio would decrease from 55% to 50%.

The average return retention ratio of 50%-55% is reasonable for funds whose performance is driven almost solely by alpha and investors should target platforms that provide at least this level of return retention ratio.

The average return retention ratio increased since 2018, and peaked in 2020 before declining slightly in 2021 as shown in the chart above.

Plotting the average gross returns reveals that lower gross returns tend to result in a lower return retention ratio. This is a result of the minimum level of fixed expenses and base compensation that firms must incur to run the fund. Additionally, investors assume the PM netting risk, which means that even if the fund produces a low return overall, the small proportion of PMs who generate positive returns will need to be compensated, increasing overall expenses and reducing the net return. However, as gross returns increase, fixed expenses and base compensation represent a smaller proportion of the overall return, and the PM netting risk decreases as more PMs generate positive returns, leading to higher net return and hence an increase in the return retention ratio.

An intriguing observation is that in 2021, average gross return was higher but the average return retention ratio was lower that in 2019, when one would intuitively expect that the return retention ratio would at least remain similar to that of 2019 given the higher gross return. Two possible explanations come to mind: firstly, the average PM payout ratio among these platforms increased between 2019 and 2021, as highlighted in the previous section. Secondly, the dispersion of PM performance in 2021 could have been wider than in 2019, which negatively impacted the PM netting risk.

The chart above plots the return retention ratio alongside the gross return of the respective funds by year, which brings to light two key observations. Firstly, we observed that there is minimal dispersion in investor return retention ratio (50-55%) for funds that generate a gross return above 35%. Of the seven instances (last two columns on the right in the chart) where the return retention ratio falls between 50%-55%, they all took place in 2020 with the exception of one fund (2019-2021). Secondly, there is a very wide dispersion in how much investors retain for a certain level of gross return between 10-20%.

The Cost of Alpha

At first glance, the average return retention ratio of 50-55% and the average TER of 9.1% including performance fees seem high. Especially when one compares the average TER excluding performance fees of 6.6% charged by the platforms against the average fund that charges a 2% management fee resulting in a 3% TER overall. The 3.6% difference can be explained by the expense pass-through. However, it is important to consider the quality of the returns and the amount being paid for the alpha generated.

Multi-PM platforms are specifically designed to have a low correlation to traditional markets, resulting in a low equity beta and low factor exposure. This strategy leads to a higher proportion of alpha generation, which typically accounts for more than 90% of the total returns for these platforms.

Therefore, when evaluating the TER of platforms, it is essential to put it into the context of the proportion of alpha generated. This is where the value proposition of these investments lies. In contrast, traditional hedge funds charging 2% & 20% typically generate returns with a lower proportion of alpha than multi-PM platforms. This means that even a simple 20% performance fee, with no management fee, could result in a high cost of alpha if a significant proportion of the return is attributed to beta.

For example, if a fund generates 10% gross return and 8% net return after 20% performance fees, and 40% of the return is attributed purely to alpha, investors would be paying 2% to generate only 3.2% of alpha. This translates to a return retention ratio of 62%, as investors should not be paying active fees for beta. If a 2% management fee were added, the return retention ratio would fall from 62% to 42%, indicating an even more expensive cost of alpha than that of the platforms.

Key Takeaways

Analysis of thirteen leading multi-PM platforms, representing over $200 billion in AuM, finds despite the higher expense ratios, investors benefit from the higher level of alpha generation, which justifies the higher fees charged by these platforms. In addition investors should also note:

• Multi-PM pass-through costs are high in absolute terms and have trended upwards over the past five years.
• Talent is by far a platform’s largest expense and competition for it could drive this expense up.
• Investors should target platforms that provide the highest return retention ratio (at least 50%-55%).
• The cost of alpha generation is the most crucial factor to consider when assessing the level of pass-through costs, and certain multi-PM platforms are delivering exceptional value to investors.