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The fee hurdle for hedge funds is gigantic and the majority of managers simply can’t surmount it. (Marina Nezhinkay/Getty Images/iStockphoto)
The fee hurdle for hedge funds is gigantic and the majority of managers simply can’t surmount it. (Marina Nezhinkay/Getty Images/iStockphoto)

STRATEGY LAB

For hedge fund investors, the math is sobering Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

I applaud the protections given to freedom of speech in the United States. Sure, unrestrained gabbing might be unpleasant and less than edifying – like a few too many reality shows – but that is still far better than the alternative.

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However, even in the land of the free, some talk has been considered far too dangerous. While it might be perfectly legal for Honey Boo Boo to yammer on, hedge fund advertising has been banned for decades.

The imposed limitations effectively threw a veil of secrecy on the now sprawling industry. Paradoxically, it also conferred a measure of exclusivity that isn’t really warranted.

But the veil is about to be lifted because the U.S. Securities and Exchange Commission has decided to unmuzzle those downtrodden money managers and allow them to pitch their expensive wares to the masses.

The change will have a few beneficial effects. The funds will likely become more transparent and many will broadly circulate their letters to investors, which will be a treat for those of us who read them.

On the other hand, hedge funds will also start to look more like regular mutual funds, only run by greedier people. Which is fitting, because that’s what many of them are.

While some Canadian funds charge a fee of more than 2 per cent of assets annually, hedge funds often slather on a 20-per-cent performance fee on top. A few with very good records charge even more.

Problem is, as regular mutual fund investors know only too well, large annual fees can significantly reduce returns over the long term. Such high fees could make the difference between living the good life in retirement and just eking by.

To demonstrate the impact that different fees level can have, I’ll start with the returns of the S&P/TSX composite index over the last 30 calendar years, including reinvested dividends. Without fees, each dollar invested in the index would have grown to $13.94, which amounts to an average annual return of 9.2 per cent. That’s pretty good.

But, if you paid a fund 2 per cent annually to track the index, each dollar would have grown to only $7.94. Yes, even that seemingly small fee would have chopped the long-term returns almost in half.

Such is the tyranny of compounded fees. No wonder so many people are turning to low-cost exchange-traded funds these days.

But hedge funds dial things up by adding a performance fee. A fund that simply invested in the index and charged a 2-per-cent annual fee plus a 20-per-cent fee on gains would have turned each dollar into only $5.33 over the last three decades. That’s less than 40 per cent of the no-fee case.

Such high fee levels should be hard to stomach. But you might already be familiar with a similar levy because the 20-per-cent performance fee acts much like a capital-gains tax.

Although the numbers vary by individual and location, the Ernst & Young 2013 online tax calculator indicates that the top marginal tax rate for capital gains tax falls between a low of 19.5 per cent in Alberta and a high of 25.0 per cent in Nova Scotia.

That’s right around the 20-per-cent level of the performance fee. Do fund investors enjoy paying capital gains taxes so much, they effectively do so twice? Not only do such patriots do their civic duty, but they also hand their hedge fund manager a similar amount.

Add a 20-per-cent capital gains tax (realized annually) on top of hedge funds fees and each invested dollar would produce only $3.84 in returns. Real pessimists should also include the portfolio-crushing impact of inflation, which would further lower the results to only $1.80 in inflation-adjusted terms.

I fully acknowledge that some hedge fund managers are brilliant and a few are able to more than make up for the fees they charge. Problem is, the fee hurdle is gigantic and the majority simply can’t surmount it.

The lesson here is to try to minimize your costs and employ sensible tax planning methods. While a 2-per-cent annual fee might not seem like much, it can really add up over time. Throw in a performance fee on top, as most hedge funds do, and the costs skyrocket.

On the other hand, if you like paying taxes twice, you’ll soon be hearing more about some snazzy hedge funds.

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