Investors should try to minimize fees. This is as uncontroversial a statement as you can make in the investment world. And we fundamentally agree.
But it is also important not to dismiss fees for active management out-of-hand. “Minimizing” means reducing as much as you can. It does not mean avoiding fees to the detriment of achieving investor goals.
We have previously highlighted that with many active public fund managers, you are basically getting “hidden beta.” This is essentially just exposure to a mix of passive instruments that could be replicated much more cheaply. Below is a representative example of a manager that we believe fits this description. This is an actively managed public equity fund that aims to track the S&P 500 but with lower volatility.
The fund collects management fees at levels typical of actively managed funds, but - as the chart below illustrates - when you look at the fund’s historical returns, they are very similar to a hypothetical portfolio invested simply in a mix of cash instruments and the S&P 500.
We have also previously written about how information asymmetries and greater scope for active value-add contribute to private funds as a whole, and especially venture capital funds, having much greater potential for alpha generation. And because these factors derive from skill or knowledge, they are at least capable of being persistent over time.
All of which is to say that sometimes fees are worth paying. And we would argue that carefully selected private markets fund managers are very much worth their fees in terms of excess returns.
For many of you who have already invested in private markets, this may seem like a bit of a straw man argument that we are making. An increasing share of the wealth management community has invested in private markets, which suggests recognition that the extra fees in private markets are worth it.
But convincing people that it is worth paying another layer of fees is a different story, and fund-of-funds vehicles have been written off by a large section of the investment community as wasteful and unexciting.
But should they be? (Spoiler alert: the short answer is no, they should not. The longer answer is below…)
We analyzed historical performance data since June 2005 (data was too sparse before this date) to compare the performance of individual funds and fund of funds over an 18-year period in the three private asset classes most typically accessed via fund of funds: venture capital (VC), private equity, and real estate. The results (net of all fees) are presented as a range in the chart below, at the 25th, 50th, and 75th percentile levels:
Given the different underlying strategies and risk-return characteristics of each of these asset classes, the results were unsurprisingly different for each.
One commonality was a much tighter range of outcomes, as the inherent diversification served to reduce risk (and moderate some upside), but taking the asset classes in turn…
Private equity
The results showed a small decrease in overall performance at the median level (and our data shows the pooled mean was 0.6% lower)1, but with a notable lift in performance at the 25th percentile level (to a robust 12.1%).
Venture capital
The data appear to make a strong case for accessing venture via a multi-fund approach. The 25th percentile VC fund of funds has historically produced significantly higher returns (12.4% vs 3.9%) than the 25th percentile single VC fund. And the median VC fund of funds has returned 15.2% annually, versus 11.3% for single VC funds. Single funds have - unsurprisingly - greater upside (our data shows returns of 35.3% at the 95th percentile level, vs 23.3% for funds of funds)2. But the overall picture is that in an asset class with such a wide dispersion of returns, hedging your bets by investing across a number of funds appears to be an attractive option for mitigating downside risk, without sacrificing significant levels of upside.
Real estate
The results show a similar tightening of the range of outcomes as in VC, with stronger performance for funds of funds at the 25th (4.5% higher) and 50th (1% higher) percentile level, but reduced upside at the 75th percentile level (1.5% lower).
If nothing else, this simple analysis suggests that funds of funds have historically effectively reduced downside risk across private markets asset classes for their investors.
This is likely a function of the diversification they create in their portfolios, which helps mitigate risk. In addition, this may reflect the selection skill and access advantages they are able to bring to bear when choosing funds - which at the very least might help them avoid the worst-performing funds. We must, of course, point out that diversification may also reduce “home run” upside - it is difficult to invest in multiple outlying outperforming funds at the same time.
Our analysis suggests that funds of funds still have a role to play in individual investor portfolios, allowing them to participate in the upside of private markets, but with a more limited risk profile. The extra fees have historically not appeared to weigh on performance too heavily, but may be most worth paying for those who lack extensive internal resources to assess (and access) a broad funnel of fund opportunities. Many individual investors fall under this category - as many institutional investors did when they first started investing in private markets many years ago.
In short, you should ignore the rhetoric that demonizes funds of funds. The data shows that the extra layer of fees does not materially impact returns, and may provide value in producing more targeted outcomes.