A key contributor to these poor returns has been the high level of fees charged by alternative fund managers. On average, the primary share class of alternative funds charge 1.9 per cent. In a zero (or negative) interest rate environment, this creates a significant drag on returns and therefore a challenging hurdle to meeting the investment objectives. This, in turn, reduces the probability that these funds will meet their objectives in the future.
Despite the performance drag created by high fees, it appears that as a whole, investors are insensitive to fees in this market. This is demonstrated by the fact that the distribution of assets across different fee levels is similar to the number of funds at each level. If investors were more fee conscious, one would expect the former to exhibit negative skewness versus the latter.
While it is not possible to identify the source of this fee insensitivity with complete confidence, it seems likely that two factors are especially important. The first is that alternative funds currently face little competition from passive options. The presence of a passive alternative to an active fund is becoming a key source of fee pressure in the active management arena.
In contrast to this, we estimate that there are currently only four passive, alternative funds (excluding ETFs) widely available to UK-based investors. The competition posed by passives is therefore tiny compared to the pressure exerted on fees by passive funds investing in traditional assets. Without this competitive pressure, it seems unlikely that fees will decline quickly.
The second likely source of continuing high fees is an enduring belief in the ability of alternative funds to generate the forecasted return stream. This desire has become increasingly strong (despite poor results) due to the lack of ‘low risk’ returns available from traditional asset classes such as cash and bonds. While it appears reasonable to pay for scarce investment skill, it is ultimately self-defeating to pay so much that the fee consumes the benefits of that skill. This is an especially important consideration in a Ucits environment where managers are less able to capture an illiquidity premium or use high levels of leverage to boost returns.
It is also worth noting that the returns received by the average investor tend to be below that delivered by the fund as investors typically buy and sell funds at the wrong times in an attempt to chase past-performance. Data from Morningstar Direct shows that over the decade to the end of 2015, the average investor return from alternative funds lagged the fund return by 0.64 per cent a year.
