Finance Fridays With Mary, Volume 5: Why Fees Matter : Planet Money : The Indicator from Planet Money Do hedge funds and private equity firms charge too much money to their investors — including, potentially, your pension fund?

Finance Fridays With Mary, Volume 5: Why Fees Matter

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CARDIFF GARCIA, HOST:

Hi, everyone. Welcome to THE INDICATOR FROM PLANET MONEY. I'm Cardiff Garcia, and I'm joined today by my friend Mary Childs, a finance reporter over at Barron's, for the next installment of Finance Fridays with Mary. Mary, how are you?

MARY CHILDS: I'm great. How are you?

GARCIA: Good. I hope you enjoyed your brief hiatus from Finance Fridays with Mary because you have come back with some pretty big news, actually, for our listeners.

CHILDS: That's right.

GARCIA: You want to tell them?

CHILDS: I do. Everybody, I'm joining Planet Money.

GARCIA: Yes. You're now going to be my colleague.

CHILDS: I can't even believe it.

GARCIA: Yeah, you're joining our sibling podcast, which has those beautiful longer-form narrative podcasts about business and economics. It's going to be awesome. And today we are gonna be fielding a listener question about the fees that are charged by hedge funds and private equity firms, OK? And I think a lot of people are going to hear this and be like, why would I care about that? That sounds like a thing for rich people to worry about. Tell them why that's not the case.

CHILDS: So actually, you should care. It turns out that of the $4.2 trillion invested in private equity, some 44% of that is actually from pension funds.

GARCIA: Pension funds.

CHILDS: That's right. Those are the funds that are supposed to help people in retirement - actually, for their retirement. So you put in a dollar today, and in 25, 35, whatever years, it comes back to you in a nice fixed-income stream, and you get to live happily ever after. And in hedge funds, which is like $3.6 trillion, that's 42% of that comes from pension funds. So it's substantial. These are real normal people that are trying to live out their lives. They just want to relax in retirement. They earned it. And we're depending on hedge funds and private equity for them to do that.

GARCIA: So it matters that hedge funds and private equity firms do well. And also, by the way, it means that it matters if the fees that they charge those pension funds and other types of institutional investors, like philanthropies, like endowments and universities, it's a big deal if they're overcharging them. But is that the case? That is the question we are going to be exploring right after the break.

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GARCIA: OK. Mary, today's listener question is about the fees that are charged by hedge funds and private equity firms. Real quick explainer, first, about what hedge funds and private equity firms actually are - a hedge fund takes money from pension funds and universities and other big investors and then invests that money using all kinds of sophisticated strategies, including a lot that I don't really understand. Private equity firms do something a little different. They take that money and they invest it by buying out whole companies and then running those companies for a period of time, like seven to 10 years, and then hopefully selling that company again for a profit.

So with that out of the way, here is the question from listener Stephen Murdoch (ph).

STEPHEN MURDOCH: Hello, this is Stephen Murdoch calling from Kent in the United Kingdom. My question is, why do people tolerate the exorbitant fees that hedge funds and private equity firms charge? For a long time, these groups have charged a 2% management fee every year and a 20% performance fee if they're successful. After the 2008 crash, many people said that the 2% and 20% fee structure would change, but I'm not sure it has. Has it changed?

GARCIA: OK, first off, Mary, though, I need to explain to our listeners what that 2% and 20% structure actually represents. So if I'm a pension fund and I give my money to a hedge fund, then right off the bat, the hedge fund will keep 2% of all that money as a fee. That's the management fee. But then once the hedge fund starts investing the money, it will also take 20% of the profits that it earns through the investment. That also is a fee. That's the performance fee - so 2% and 20%. And Stephen is wondering why it is that hedge funds and private equity firms are still charging 2% and 20% fees. So the question is, are they?

CHILDS: Stephen's instincts are actually sort of correct here; they are not really charging 2% and 20% anymore. Private equity is charging, on average, 1.8% in management fee and 17-ish% for performance, and hedge funds 1.5% and 19% for performance. That's according to Preqin.

GARCIA: OK. So in other words, they're charging less. But is that a lot less? Like, how should we think about that?

CHILDS: For sure, emotionally, it's a lot less.

GARCIA: (Laughter) Emotionally? All right.

CHILDS: They're having a hard time with it. They hate it. The 1.5%, they say, is actually particularly painful, especially for a startup hedge fund, a new hedge fund. It's harder and harder to actually be able to function as a business with lower management fees because you may go through, you know, a dry spell where you're making no profits and you don't get that 19%, and that's where the real money is. But you really believe in your investments, and you may not make it to that day if your management fees are too low to survive.

GARCIA: OK. So obviously, they're not going to like it - the fact that they are having to charge less, right?

CHILDS: Yeah, they want more money.

GARCIA: So here's a question that I think a lot of people are going to have, Mary, which is 2% and 20%, or slightly less than 2% and 20% - it sounds like a lot of money that hedge funds and private equity firms are charging for their services - do they actually justify those high fees?

CHILDS: So for private equity, over a historic period, yes, they have outperformed public equities, according to Cambridge Associates.

GARCIA: They do better than the stock market.

CHILDS: That's right. There's sort of an asterisk to that, though...

GARCIA: Uh-oh.

CHILDS: ...Because the outlook for that is less sunny, right? So people are concerned that now, with the stock market so high, private equity companies are having to pay a ton of money when they want to buy a company and take it private, which means that it's even harder to make that company worth more money in the future.

GARCIA: Because it already is so expensive, right?

CHILDS: Exactly.

GARCIA: OK, so bottom line is, for private equity, they've done well in the past, but they might actually not do as well in the future. What about hedge funds?

CHILDS: So it's been a bit spotty. They've done really well some years, and other years not so well. In the years since the crisis, on aggregate, they've kind of not crushed it. It's been meh.

GARCIA: Here's my question - there are other things that people can put their money in, right? Like, there's mutual funds. There's exchange-traded funds - these are vehicles that just invest in the stock market basically, where the fees are a lot lower, right? How do private equity fees and hedge fund fees compare to the fees charged by, say, a mutual fund?

CHILDS: The average for mutual funds and exchange-traded funds is 0.48%.

GARCIA: That's a lot less than 2%.

CHILDS: So much less.

(LAUGHTER)

GARCIA: OK. So Mary, if these other vehicles charge so much less and it's not clear that hedge funds and private equity firms in the future are going to always be able to justify the higher fees that they charge, why would pension funds or anybody else put their money into hedge funds and private equity firms in the first place?

CHILDS: It's mostly for diversification. So if you think that the stock market is really expensive right now and the bond market is really expensive right now and you're kind of anxious and you think that maybe things are going to go down, it's really good to have something that's different from just a long mutual fund that just is betting on the stock market and betting on the bond market with both (ph) fancy tools.

GARCIA: Have something that might not go down, right?

CHILDS: Right. You want something that can bet using other things that aren't accessible to those regular vehicles. So for a hedge fund, that means they can short things; they can bet against things. For private equity, that means they buy a company and put it in a cabinet, tinker with it and make it better, and then in, like, seven years, they'll trot the company back out, and it's better and more expensive. But you're not going to experience the fluctuations of the market, which might just be, like, down 30% - ahh (ph). Like, you don't have to deal with that; you'll just bypass that entirely.

GARCIA: Yeah, I got to say, it's interesting to me that there was a standardized 2% and 20% fee structure in the first place because I would just assume that if a hedge fund has really talented managers and does a great job of investing money on behalf of its investors, that that hedge fund would be able to charge more than 2% and 20%, and hedge funds that aren't as good or less experienced would have to charge less. Why isn't there more variety in the fee structures?

CHILDS: There's actually - you hit on something interesting. The 2% and 20% legend kind of came to be in the dark ages of hedge funds, when what are now considered the kind of grandfathers of the industry were pioneering it and generating crazy returns, doing really, really well.

GARCIA: Not that long ago though, right? Like, the '70s, '80s - right around there?

CHILDS: Exactly. So since then - you know, with any market, when it becomes very popular, a lot of people enter it, maybe some of those people are less talented, the performance deteriorates. So as a result of these kind of other people joining that are less talented, they can't charge as much; they're not as good.

So today there is this great dispersion between fee structure. If your past performance is stellar, you can still charge 2% and 20%; in fact, you can charge a lot, lot more because investors are more than willing to pay it. They want that performance, and they want your specific talents to generate it. And then there are other hedge funds that just aren't the same amount of talented, and they just can't charge as much.

GARCIA: So that 2% and 20%, then, it's fair to think of it as more of an average - right?

CHILDS: Exactly.

GARCIA: ...Than it is representative of any hedge fund that you put your money into?

CHILDS: It's a colloquialism that, functionally, it represents the industry, but it's not actually true.

GARCIA: Mary Childs, thanks so much.

CHILDS: Thank you.

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GARCIA: This episode of THE INDICATOR was produced by Rachel Cohn. And special shoutout to Rachel, by the way. She's been with us for the last couple of months and will soon be starting a new role at "Reply All," this amazing podcast that we all love. She's been a total rock star for us. Thanks for everything, Rachel. This episode was also fact-checked by Nadia Lewis and edited by Paddy Hirsch. THE INDICATOR is a production of NPR.

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