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When Peter Kraus founded Aperture Investors, he departed from the traditional active management model. Rather than reap fixed fees, Kraus’ $3.8 billion business operates on a performance-related fee structure, charging 30% of alpha. That’s more than the industry norm, but since inception about half of Aperture’s funds have generated alpha above their benchmarks. Kraus sat down with CNBC’s Delivering Alpha newsletter to explain why he’s focusing on a pay-for-performance setup and how he’s putting capital to work in today’s environment.
(The following has been edited for length and clarity. See above for the full video.)
Leslie Picker: What do you think is the main problem with the traditional model? And what do you think is the best way to fix it?
Peter Kraus: The key problem is very simple. The existing model, in almost all cases, rewards people whether they perform well or not. So these are fixed fees and as the assets increase, you earn more money. Well, clients don’t hire us to grow our assets, they hire us to perform. So you would think that the performance fee or actual fee would be tied to performance as opposed to asset growth. We also know that asset growth is the enemy of performance. This is increasingly difficult to achieve, the more assets you manage. So fees don’t help you – those traditional fees don’t help you in that regard, because the manager has an incentive to keep growing the assets, which makes performance harder and harder.
Of course, there are performance fees in the market and hedge funds and private equity, but they also have quite significant management fees. Thus, they too have incentives to grow their assets. Basically, Aperture is anathema to that – it’s the opposite. We charge a very low base fee which is equal to that of the ETF, then we only charge if we beat the index. So you pay for performance. If we have no performance, you pay what you pay to buy the ETF.
Picker: So how do you choose which index is relevant for specific strategies?. I mean, do you invest in certain ways that would reflect or be comparable to certain indices that you are then able to outperform?
Kraus: Exactly. So we’re very, very careful about the index because we’re actually charging people to beat the index. So, for example, in global equities, we would use the MSCI Global Equity Index. For US small caps we will use the Russell 2000. For European stocks we will use the Euro Stoxx index. Very simple indices, not complex, no real question as to whether the manager actually creates a portfolio that tracks this index. In fact, we test the correlation of the portfolio to the index to ensure that the index continues to be relevant.
Picker: People who advocate their management fees will say that it is essentially necessary to keep the lights on – that this essentially ensures that the operations of the fund can cover all of their fixed costs and cover their expenses. How can you do it with lower management fees?
Kraus: People say, well, I have to keep the lights on. Well, okay, how many assets do you need to keep the lights on? And once the lights are on, do you still have to charge the fixed fee? Because your incentive is simply to keep gathering assets. So it’s really a function of how many assets we have and we’ve built a business where we think the scale of assets pretty much talks about revenue to cover fixed expenses. And then the rest can only be won if we perform. One of the things I love about Aperture is that I’m driven, as the business owner, the same way the customer is. I don’t make a lot of money, if any money, unless we actually perform.
Picker: What about your ability to recruit and pay employees? Does this affect compensation?
Kraus: Sure. The portfolio managers receive a strict percentage of the performance fee. So portfolio managers are typically paid 35% of the 30% we charge. We charge a performance fee of 30% and we pay management, portfolio managers and their team 35% of this sum. And we picked that percentage because we think it’s very competitive with both the hedge fund industry and the long-only industry. And if managers perform on the amount of capital they have, their compensation can be quite attractive. And that is, indeed, how we believe we can attract some of the best talent in the market.
Picker: It doesn’t seem, however, at least in the current context, that LPs are too deterred by the traditional model. I mean, there were almost 200 hedge fund launches in the first quarter, exceeding the number of liquidations. AUM represents approximately $4 trillion for the entire hedge fund industry. So, it doesn’t look like LPS has really pushed back, at least in terms of new launches and overall AUM size. So I’m just curious what your conversations have been like on that front?
Kraus: Well, there’s $4 trillion in the hedge fund community, but there’s $32 trillion in the long-only community. And I don’t think that’s a hard question to answer. If you look at the trend between the active management industry and the passive industry, money is moving into the passive industry at a rapid rate – unchanged for 10 years. And the hedge fund space, the $4 trillion – we’re talking about all sorts of different types of hedge funds, of course, it’s not a monolithic industry. But essentially, most of the managers or most of the dispatchers that I talk to would prefer not to pay a performance fee multiplied by the beta that their money is exposed to. They would like to pay a performance fee for actual performance. And so, we provide that clarity that many hedge funds don’t. And in the long-only space, there’s virtually no pay-for-performance. It’s almost all settled.
Picker: Since there is so much at stake when it comes to performance, I have to ask you what is your strategy? What are you thinking right now? How do you put capital to work in the current environment in a way that you believe will outperform benchmarks?
Kraus: It depends on the strategy, whether it’s an equity strategy or a fixed income strategy. But in equity strategies, we’re what you’d expect – heavily research-dependent, looking for specific opportunities with companies that we believe have long-term growth, or are undervalued and will accelerate in value over time. And this period is generally from 18 months to three years. In the area of credit, again, it’s about fundamental research to find credits and, of course, being market conscious, because credit markets tend to be more macro-oriented. But it’s all of the above and it’s what we spend our time doing. We believe that if we do this consistently over time, we can perform well.
Picker: Are you net long or net short in the current environment?
Kraus: Interestingly enough, in the only hedge fund we manage, we’re pretty close to stagnation. So I would say a very low net position. In the other funds we manage, we manage 100% long position. So, in other words, we are what I call a beta one, 100% exposed to the index. But we have shorts, so we’re over 100% raw in those funds. But I would say that in general right now our risk positions are low.
Picker: So, not much leverage?
Kraus: Not a lot of leverage, but more importantly, the actual stocks and bonds we choose and the positions we take, we are, I would say, at the bottom of our risk scale.
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