The Democratization of Alternatives: Unpacking the Impact of FEES!
By Paul White CAIA, Ph.D.
“Democratization of Alternatives Is Coming, but It’s Not Exactly a Field of Dreams”, ISS Intelligence, 5 January 2023
“The Democratization of Alternatives” has been accompanied by “The Democratization of Alternatives Fees”. “The Democratization of Alternatives” is a phrase popularized by proponents of the use of alternative investments1 inside portfolios. Alternative investments are gaining in popularity due to lackluster expectations of the returns of both stocks and bonds but also as the diversifying effect of bonds on stocks continues to be questioned2. The question being raised more and more is, “why don’t you have alternatives in your portfolios?”. Advisors themselves are being steered toward the zoo that is the zoo of alternative investments. The zoo may include following categories: hedge funds; real return/commodities; private real estate; private equity; and others Similar categorizations are found in syllabi from the CFA studies, CAIA studies, MBA coursework, and other places. None is wholly right, and none is wholly wrong.
A more sanguine approach to classification is driven purely by the economics of the matter; the following is only to illustrate the evolution of fees via democratization. For example, take hedge funds. Hedge funds may come in Limited Partnership (LP) format. Liquid hedge funds (or “liquid alternatives”) may come either in Mutual Fund (MF) format or Exchange Traded Fund (ETF) format. Hedge funds are like any industry and have a sales lifecycle (Figure 1). A manager starts with a hedge fund idea and begins selling. The Introduction/Growth phase are probably the most profitable, i.e., the hedge fund manager can charge the most for the hedge fund idea. In the Maturity phase, the hedge fund idea still makes some profit, but product innovation continues to decline and process innovation has already peaked. In the Decline phase, the hedge fund idea is still available and fees are compressed.
“Wall Street is great at repackaging the same idea and re-selling it” is a quote from an unknown trader. Imagine that a hedge fund manager has an idea that is in the sales lifecycle. He/she starts by selling that idea for 2/20, a typical hedge fund fee arrangement. As the idea becomes more widespread and rival products that do similar things arise, the hedge fund manager has to adjust pricing. In order to keep the overall firm profit the same, he/she has to sell to more people, i.e., “democratize the alternative”. If it is in the form of Mutual Funds or Exchange Traded Funds, then it is deemed a liquid alternative that is available to everyone, not just qualified investors. Everyone can pay the fee. It is the same idea, but it costs less and is marketed to a much larger audience. The is illustrated in the table below (Figure 2).
This is a hypothetical framework with a hypothetical hedge fund manager, but it should give an investor pause about how ideas flow from a more exclusive audience to a much wider clientele. This is not to say that the hedge fund idea is worthless, but even more care must be taken about why it is in the portfolio and what it is expected to do.
