5.12.2011 Ernst Grönblom

FAQ: HCP Asset Management

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Question: Compared to several competitors your way of operating seems to be a lot simpler. For example, your fund HCP Focus is relatively focused (in other words, the fund holds very few companies). Why?

This is a correct observation. Like you can see, the solutions we recommend seem to be very simple and understandable. When most of our competitors, most likely, will build a complex portfolio, comprising of tens or even hundreds of different components, our portfolio stands out with its simple structure. This is not a coincidence: we believe that complexity is a risk factor in a world that is becoming more complex itself. Therefore we strive to keep things as simple as possible without sacrificing performance. Albert Einstein said once: “Everything should be made as simple as possible, but not simpler.” It can be added that in the financial industry, as in every other industry, a classic trick is to hide poor quality under complexity. To quote Einstein again: “Any intelligent fool can make things bigger and more complex. It takes a touch of genius – and a lot of courage – to move in the opposite direction.”

HCP’s fee structure is extraordinarily simple and easy to understand. As we indicated before, complexity should be avoided: things should be kept as simple as possible without sacrificing optimal performance. Asset management fees are not an exception to this rule.

Question: Your Company is relatively small. Doesn’t this affect negatively the quality of asset management services provided?

It is true that HCP is young (founded in 2007) and currently a relatively small company. Some potential customers have indicated their concerns about this fact. The correlation between the quality of asset management services (measured by alpha) and the service provider’s size (assets under management) has been researched, but no clear correlation has been found (for example, Chen et al. “Does Fund Size Erode Mutual Fund Performance?”). Instead, according to several more limited researches (for example, Freund, “Do Boutique Funds Have an Edge?”) and sources based on anecdotal information, claim that the size of the asset management company and the quality of the investments are negatively correlated. In other words, smaller asset management companies perform generally better than bigger ones. Some suggested reasons to this are the lack of bureaucracy in the decision making process, greater entrepreneurshipand the lack of consensus –thinking (common in larger companies), which prevents new innovative ideas from seeing daylight. (for example, BusinessWeek, 20.06.2005, Lewis Braham, “Why Boutiques Have An Edge”)

Question: Your company is small. Isn’t this a risk factor? What will happen to my money if your company goes bankrupt?

One factor influencing the customer’s decision making when choosing an asset management service provider is counterparty risk. In other words, risk that the service provider cannot satisfy the payment or other requirement stated in the customer contract. A good example of counterparty risk is when a customer, who has deposits in a bank, loses all of his money due to the bank’s bankruptcy. HCP is currently a relatively small company and small companies are often viewed riskier than bigger ones. Two things should be kept in mind:

a) The asset management industry is a supervised industry and licenses are required in order to operate. Licenses are granted only to companies that are financially sound and have adequate risk management procedures and operations. All these components need to fulfill the requirements stated by the law. HCP has a license granted by the Financial Supervisory Authority (FSA). The size of the company is not a criterion in the process of applying for a license. This means that quality and safety requirements are the same for HCP as they are for companies who have billions of euros under management.

b) Some might fear that the small size of our company increases bankruptcy risk and therefore the risk that they will lose their money in a possible bankruptcy. This fear is based on a misconception of the judicial structure of asset management companies: customers’ assets are not part of the company’s balance sheet, but instead are kept separate and therefore they cannot be used in a bankruptcy to, for example, pay back company’s outstanding debt (Bank deposits on the other hand are on the banks’ balance sheets and therefore the customer can lose all or part of his/her assets in a case of a bankruptcy).

Question: Your fee structure seems to differ quite significantly from traditional. For example, you don’t follow the so-called “high water mark” principle that is generally viewed just. Why?

HCP uses the same fee structure (management fee 1.0% p.a. and performance fee, 10% of quarterly profits.) in both wealth management services and funds. The fee structure has at least two features that differ from the mainstream.

a) The so-called “high water mark” principle is not used

b) Performance fee is calculated based on absolute return (not for example based the excess return against a benchmark index or interest rates)

At HCP, we are aware of the fact that our fee structure is different from the prevailing mainstream fee policies and that it might initially raise some questions mainly concerning its: a) level and b) fairness.  High water mark – principle is traditionally used when a manager charges a performance fee. The performance fee is linked to the portfolio’s return. Most of us find it intuitively unjust, if the fund manager charges a performance fee from a period of time when the portfolio didn’t make a profit. This is why the so-called high water mark – principle is applied to several fund managers and funds. The high water mark – principle prevents the charging of performance fees after a negative period until the fund has reached new all time highs.

This might sound rational, but unfortunately the high water mark – principle brings some problems with it. The most serious problem is the so-called “agent-principal” – problem. This problem refers to the contradiction of interest between the agent (manager) and the principal (customer), caused by distorted incentives. In practice this means that if the portfolio is far off its highs, the fund manager has an incentive to take on more risk in the hope of making up for the occurred losses as fast as possible, in order to charge performance fees again, even though this might not be in the customer’s best interest.

We think that the previously mentioned conflict of interest represents a greater risk for the customer in the long run than the manager charging performance fees after a period of negative returns, without the portfolio reaching new highs.  The fact that in our HCP Black portfolio performance fees are charged from the absolute return, instead of excess return over a benchmark index, enables us to manage the portfolio without any incentive to take on more risk than necessary for the best performance of the portfolio and the best interest of the customer.

Our fee structure is a conscious choice. There is no such a thing as a perfect fee structure and every structure has different problems. In other words, we are aware that our fee structure is not perfect, but we find it to be the least unperfect option, out of only unperfect options.

On average, the value of our HCP Focus portfolio fluctuates a lot more than the HCP Black portfolio or our other wealth management solution. (the volatility of HCP Focus is 17.4% when the volatility of HCP Black is only 3.7%). This is why we don’t charge a performance fee based on absolute return in HCP Focus, but instead a performance fee is calculated on the excess return over a benchmark index MSCI ACWI IMI (one of the most comprehensive global equity indexes gross of tax, including dividends). This way the customer doesn’t have to pay for the volatility of the portfolio, but instead, only for the excess returns. Our effort is to keep the HCP Focus fully invested in stocks.

Question: How much do your services cost? Are you cheaper or more expensive than average asset managers?

Almost every trade has a common denominator regardless of the place, time or the object of the transaction. The buyer always thinks that the price is too high and the seller thinks the price is too low. Asset management services are not an exception. It is difficult to come up with a “right” price for asset management services. The service is abstract, the results are highly influenced by – not only the skills and diligence of the manager – but also luck. For example when compared to barber services, asset management services are complex and very difficult to evaluate by an outsider. Because of several different reasons, it is difficult to form a precise understanding of how much the asset manager actually charges from the services (see the next question about kickbacks). A good example is structured products such as index notes.

Along with the fees charged by asset managers, it is difficult to comprehend full content and services received by asset managers. For example the market is full of “closet-index funds”, funds that are marketed as active, but due to their structure and strategy are de facto index funds. These funds combine the worst parts of active and passive portfolio management: the high fees of actively managed funds and the low returns of passively managed funds. Majority of the equity funds promoted by big banks can be viewed as closet-index funds. Another serious problem in the industry is hidden fees (for example the so called kickbacks).

We want to believe that rational investors are willing to pay for quality services. HCP emphasizes in its fee structure: a) reasonability and b) transparency. HCP uses the same fee structure in wealth management and portfolios (management fee 1.0% p.a. and performance fee, 10% of quarterly returns). Let’s assume our annual return is 7%, the customer will end up paying 1.65% of the invested capital as fees. This is quite accurately the average fee charged by Finnish equity funds. (Source: Arvopaperi 9/2008). We genuinely believe that if the hidden fees charged by most of our competitors would be taken into account, HCP would place in the lower quarter based on total fees.

Question: You emphasize that you return all commission fees received to your clients. What are “kickbacks” and why do you think they are so important?

According to the Finnish Securities Markets Act chapter 4 1 § 3, kickbacks, are fees or other benefits paid or given to a third party in related to an investing- or other subsidiary service.

A typical kickback is paid or received when an individual investor buys shares of a third party fund through an asset manager. In this process the asset manager works as a middleman. Usually funds charge a management fee and a transaction fee when buying shares of the fund. The transaction fee and the annual management fee can be several percentage points of the total transaction.

It is typical that the third party fund pays part of the transaction and management fees back to the asset manager. These fees returned by the third party fund to the middleman are called kickbacks.

Basically a kickback is a commission fee, which is used to reward the middleman for the performed sales job. Commission fees itself are not suspicious, (for example, retail industry lives through commission fees, in other words, retail margins) but if commissions are received and paid without the client knowing it, commission fees can have harmful side effects.

Kickbacks are very common in the financial industry and form a key component of the total income for several banks and asset management companies.

Kickbacks paid in the financial industry have at least three harmful side effects; a) they encourage the asset manager to maximize the received kickbacks(instead of looking after the clients best interest and maximizing the value of the portfolio) which can lead to distorted objectivity and independence; b) they lower the total return of the client’s portfolio; c) they create a hidden expense, which makes it difficult for the client to understand the total fees charged and to compare different funds.

Kickbacks and the problems related to them are not widely discussed. One reason to the silence around this issue might be that the subject is abstract and unknown to the majority of the clients. It can also be assumed that the people working in the investing industry prefer to keep the general public unaware of the issue, in order to benefit from it financially.

Helsinki Capital Partners thinks that the prevalent kickback policy in the industry is unethical. As far as we know, HCP is the only asset management company in Finland, which has agreed to return all kickbacks fees and similar benefits to its clients, in its customer contracts.

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