A Random Walk Down Connaught Road?

“Do you sincerely want to be rich?” The once-notorious fund manager Bernie Cornfeld answered his own question by advising those who did: “Don’t fool around with light globes or steel, work directly with money.”

Malaysian journalist-turned-fund-manager Cheah Cheng Hye seems to have followed that advice, ending up as the most highly paid person at any listed company in Hong Kong. His salary and bonus as chairman and chief executive of fund management group Value Partners for 2007 totaled HK$253 million, almost double the previous record, set last year when by Hutchison Whampoa group chief executive Canning Fok Kin-ning.

Cheah was one of the two founders of 15-year-old Value Partners, which went public late last year; he owns 35 percent of a stock with a current market capitalization of around HK$11 billion. What is extraordinary is not his income, which is quite properly linked to the performance of a company highly dependent on a tiny number of individuals. It is that investors, institutional ones in particular, go along with “heads I win, tails you lose” remuneration arrangements with fund managers like Value Partners. It is all the more remarkable in that the medium-term performance of Value Partners’ public funds has been no more than mediocre when compared with most of the usual benchmarks.

For sure, its flagship fund, the Value Partners Classic Fund A units, have gained 1,685 percent since the fund’s 1993 launch compared with a gain of just 323 percent for Hong Kong’s Hang Seng index over the same period. But much of that performance of the Greater China focused fund was recorded in its earlier days when it was a small fund – no units were issued after 2002 – and today it comprises only 17 percent of the company’s public funds.

Of more relevance to most investors — and to the company’s remuneration — is short-to-medium-term performance. Thus the A fund over the year to February 2008 rose 23 percent compared with a Hang Seng index rise of 28 percent and an H shares index rise of 52 percent. Over three years with a gain of 103 percent it beat the Hang Seng index, up 93 percent, but was far behind the H share index, at 190 percent, let alone Shanghai’s 233 percent increase.

The US$278 million China Convergence fund shows similar characteristics. A 33 percent one-year gain and 152 percent three-year advance falls far behind all its own benchmarks, the H shares and the Shanghai and Shenzhen. Clearly the fund was playing safe and investing in more conservative Hong Kong stocks than higher-flying mainland issues. But judged by its own announced objectives it was abysmal.

The other China-specific fund, the China Mainland Focus Fund, with assets of US$152 million, likewise lagged its benchmarks by a long way, gaining only 29 percent over one year and 111 percent over three years – a period when H shares rose 52 percent and 190 percent, respectively and Shanghai rose by 50 percent and 233 percent.

The biggest of all the funds, at US$346 million, is the Value Partners High-Dividend Stocks Fund, which marginally outperformed its benchmark, the MSCI Asia-Pacific ex-Japan index, rising 81 percent in three years compared with 71 percent for its benchmark. But even that looks unimpressive given that over 67 percent of its investments were in Hong Kong/China/Taiwan, far higher weightings for those markets than is the case for the benchmark.

It could be argued that short-to-medium-term underperformance is not unreasonable for funds with long-term investment strategies. However, that does not explain why the management company should be so generously rewarded for short-term performance – and regardless of how they perform against their own benchmarks.

In the case of the Value Partners public funds – about two thirds of its assets under management – it gets a 15 percent performance fee on top of a 1.25 percent annual management fee and an initial charge of up to 5 percent. The performance fee is based on absolute not relative performance and accounts for the bulk of revenue. Gross performance fees totaled HK$2.075 billion last year compared with gross management fees of HK$436 million for total revenue of HK$2.5 billion. Even after paying huge bonuses to management, pre-tax profit was 65 percent of turnover.

The management fee alone is quite steep by US standards, though not by the inflated rates applied in Hong Kong’s cozy environment. As for the performance fee, it is extraordinary that investors should accept what amounts to a 15 percent tax on capital gains that have not been realized and regardless of how the managers have performed relative to market benchmarks.

Even more amazing in the Value Partners’ case is that almost all of their clients are other financial institutions, pension funds, funds of funds and foundations. According to its annual report, high-net-worth individuals account for 5.6 percent and retail investors for just 13 percent. It seems that most retail investors are too smart to be taken for a performance fee rise.

But other financial institutions, which themselves charge fees for managing money, do little but pass on the work to the likes of Value Partners ‑ as a result their clients’ investments are further pillaged by performance and management fees. For Value Partners in 2007 these amounted to roughly 4.4 percent of assets under management at year-end. It is a pyramid of which Cornfeld, father of the original Fund of Funds marketed by his Investors Overseas Services, would have been proud.