No management fee sounds cheaper. But the platform and the winning managers are paid before the investor, whatever the fund returns.
In a pass-through fund the investor pays the platform's costs and the portfolio managers' pay before the performance fee, so total fees depend on how the pods did, not just on the fund's return. In an illustrative year in which the pods make 16.00 per cent gross, a 3.00 per cent fixed pass-through, 15 per cent payouts to winning managers and a 20 per cent performance fee take 8.24 points, 51.5 per cent of the gross return, and leave the investor 7.76 per cent. The same gross under 2 and 20 would net 10.96 per cent, with fees taking 31.5 per cent.
Worked in full in Alternative Investments by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Multi-manager (or multi-strategy, "pod") hedge funds replaced the management fee with a pass-through of expenses: the cost of the platform, data and technology, and above all the compensation of the portfolio managers who run each book. The investor then pays a performance fee on what is left. The headline sounds cheaper, no 2 per cent, and in a good year it can be fair value for access to the platform. The arithmetic is still worth doing, because two features make the cost behave differently from a classic fee: the pass-through is paid whatever the fund returns, and the managers are paid on their own books with no netting against the losers.
| Input | Pass-through fund | Classic 2 and 20 |
|---|---|---|
| Gross trading profit of the winning pods, % of NAV | 22.00% | n/a |
| Gross trading loss of the losing pods, % of NAV | 6.00% | n/a |
| Fund gross return | 16.00% | 16.00% |
| Fixed pass-through: platform, data, staff | 3.00% of NAV | |
| Portfolio manager payouts | 15% of each winning book's profit | |
| Management fee and fund expenses | None | 2.00% + 0.30% |
| Performance fee on the net gain | 20% | 20% |
Gross return = 22.00% − 6.00% = 16.00%
Manager payouts = 15% × 22.00% = 3.30%, paid on the winning books only
Pass-through = 3.00% + 3.30% = 6.30%
Gain before performance fee = 16.00% − 6.30% = 9.70%
Performance fee = 20% × 9.70% = 1.94%
Net to investor = 9.70% − 1.94% = 7.76%; total cost 8.24 points, 51.5% of gross
In Excel: =(B1-B2-B3-B4*B1)*(1-B5) with the winners' profit in B1, the losers' loss in B2, the fixed pass-through in B3, the payout rate in B4 and the performance fee rate in B5.
On the 1,000,000,000 fund that is 160,000,000 of gross profit, of which 63,000,000 goes through to the platform and the managers (30,000,000 fixed and 33,000,000 of payouts), 19,400,000 to the firm as performance fee and 77,600,000 to the investors. The classic structure on the same gross charges 2.30 points of fee and expense, 2.74 of performance fee and nets 10.96 per cent: the pass-through costs 3.20 points more, 1.63 times the fees.
| Winners | Losers | Gross | Pass-through | Net, pass-through | Fee share | Net, 2 and 20 | Fee share |
|---|---|---|---|---|---|---|---|
| 10.00% | 10.00% | 0.00% | 4.50% | −4.50% | n/a | −2.30% | n/a |
| 16.00% | 8.00% | 8.00% | 5.40% | 2.08% | 74% | 4.56% | 43% |
| 22.00% | 6.00% | 16.00% | 6.30% | 7.76% | 52% | 10.96% | 32% |
| 30.00% | 5.00% | 25.00% | 7.50% | 14.00% | 44% | 18.16% | 27% |
The fee share is regressive: highest in poor years, when investors can least afford it. In a flat gross year the fixed costs and the winners' payouts still go out, so the investor loses 4.50 per cent against 2.30 under a classic fee.
| Winners | Losers | Manager payouts | Pass-through | Net to investor | Fee share |
|---|---|---|---|---|---|
| 18.00% | 2.00% | 2.70% | 5.70% | 8.24% | 48.5% |
| 22.00% | 6.00% | 3.30% | 6.30% | 7.76% | 51.5% |
| 30.00% | 14.00% | 4.50% | 7.50% | 6.80% | 57.5% |
| 40.00% | 24.00% | 6.00% | 9.00% | 5.60% | 65.0% |
This is the netting risk. The investor's gross is the same 16.00 per cent in every row, but the more the books disagree, the more is paid to the winners while the losers' losses fall on the investor. If payouts were charged on the fund's net gross instead, they would be 2.40 per cent in the base case; paying them book by book adds 0.90 points.
Comparing the pass-through with "2 and 20" by looking only at the absence of a management fee, or by quoting the pass-through as a single average figure. It is not a fixed rate. It moves with how the pods performed and with how far they diverged, and it is paid ahead of the performance fee, so the investor bears all of it even in a year when no performance fee is due. The right comparison is the investor's net return across a range of gross outcomes and dispersions, as in the two tables above. The same discipline applies to classic terms; see the gross return a hedge fund needs to net 8 per cent after 2 and 20.
A pass-through fund can justify its cost only by producing a higher gross return, and the question to ask is how much higher. In this illustration, at 16.00 per cent gross the investor keeps 7.76 per cent against 10.96 under a classic fee, and in a flat year loses 4.50. Ask the manager for the pass-through history by year alongside the gross and net returns, and for the payout dispersion, not just the average. The wider question of how much of a reported return actually reaches the investor runs through the free workbooks for this book.
They are costs the fund charges directly to investors instead of a management fee: platform, data and technology costs and, above all, the compensation of portfolio managers. In the illustrative case they come to 6.30 per cent of NAV, a 3.00 per cent fixed layer and 3.30 per cent of payouts to winning managers, before a 20 per cent performance fee on what is left.
Only if the pass-through fund does not earn a correspondingly higher gross return. On the same 16.00 per cent gross, the illustrative pass-through fund nets 7.76 per cent and a classic 2 and 20 fund 10.96 per cent. The gap widens in poor years: at zero gross the pass-through investor loses 4.50 per cent, the classic investor 2.30.
Portfolio managers are paid on their own books, so winners are paid even when losers offset their gains at fund level. With gross held at 16.00 per cent, widening the spread from 22.00 per cent winners and 6.00 per cent losers to 40.00 and 24.00 raises payouts from 3.30 to 6.00 per cent of NAV and cuts the investor's net from 7.76 to 5.60 per cent.
This article is one calculation from Alternative Investments. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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