This $3.8 billion hedge fund is shaking up the industry with its pay-for-performance model

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When Peter Kraus founded Aperture Investors, he deviated from the traditional active management model. Rather than raking in fixed fees, Kraus’ $3.8 billion firm operates on a fee structure linked to performance, charging 30 percent of alpha. That’s higher than the industry standard but since inception, about half of Aperture’s funds have delivered alpha above their benchmarks. Kraus sat down with CNBC’s Delivering Alpha newsletter to explain why he’s focused on a pay-for-performance set-up and how he’s putting capital to work in the current environment. 

(The below has been edited for length and clarity. See above for full video.)

Leslie Picker: What do you see as the key 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 or not they perform. So, it’s a fixed fee and as assets grow, you earn more money. Well, clients don’t actually hire us to grow our assets, they hire us to perform. So, you would think the performance fee or the actual fee would be connected to the performance as opposed to the asset growth. We also know that asset growth is the enemy of performance. It’s harder and harder to perform, the more assets that you manage. So, the fee doesn’t help you – that traditional fee doesn’t help in that regard, because the manager is incentivized to continue to grow assets, and that makes it harder and harder to perform. 

Of course, there are performance fees in the marketplace and hedge funds and private equity, but they also have rather large management fees. So, they too have some incentive to grow their assets. Basically Aperture is the anathema to that – it’s the opposite. We charge a very low base fee that’s equal to the ETF and then we only charge if we beat the index. So, you pay for performance. If we don’t have any performance, you pay what you pay to buy the ETF. 

Picker: So, then how do you choose which index is relevant for the specific strategies?. I mean, do you invest in certain ways that would mirror or would be comparable to certain indexes that you’re able to then outperform?

Kraus: Exactly. So, we’re very, very thoughtful 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 U.S. small cap, we would use the Russell 2000. For European equities, we would use the Euro Stoxx Index. Very simple indices, not complex, no real question about whether the manager is actually creating a portfolio that is following that index. In fact, we actually test the correlation of the portfolio to the index to make sure the index continues to be relevant.

Picker: People who advocate for their management fee will say that it’s necessary, essentially, to keep the lights on – that it basically ensures that the operations of the fund can meet all of their fixed costs and cover their expenses. How are you able to do so with a lower management fee? 

Kraus: People say, well, I need to keep the lights on. Well, okay, how many assets do you need to keep the lights on? And once you have the lights on, then do you need to keep charging the fixed fee? Because your incentive is just to continue to gather assets. So, it’s really a function of how many assets we have and we’ve created a company where we think that assets scale pretty much speaks for revenues to cover the fixed expenses. And then the rest is only earned if we perform. One of the things that I like about Aperture is that I’m incentivized, as the owner of the business identically with the client. I don’t make much money, if any money, unless we actually perform.

Picker: What about your ability to recruit and pay employees? Does it have any bearing on compensation?

Kraus: Sure does. The portfolio managers are paid a strict percentage of the performance fee. So, portfolio managers are usually paid 35% of the 30% that we charge. We charge a 30% performance fee and we pay the management, to the portfolio managers and their team, 35% of that. And we’ve selected that percentage because we think that that is highly competitive with both the hedge fund industry as well as the long-only industry. And if managers perform on the amount of capital that they have, their compensation can be quite attractive. And that’s, in effect, how we believe we can attract some of the best talent in the marketplace.

Picker: It doesn’t appear though, at least in the current environment, that LPs are too dissuaded by the traditional model. I mean, there were nearly 200 hedge fund launches in Q1 outpacing the number of liquidations. AUM stands around $4 trillion for the hedge fund industry overall. So, it doesn’t appear that LPS have really been pushing back, at least in terms of new launches and total AUM size. So, I’m just curious kind of 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 it’s a question that is hard to answer. If you look at the trend between the active management industry and the passive industry, money’s been moving to the passive industry at a rapid pace – unchanged for 10 years. And the hedge fund space, the $4 trillion – we’re talking about all sorts of different types of hedge funds, for sure, it’s not a monolithic industry. But essentially, most managers or most allocators that I speak to would rather not pay a performance fee times the beta that their money is exposed to. They would like to pay a performance fee for actually the performance. And so, we offer that clarity, which many hedge funds do not. And in the long-only space, there’s virtually no payment for performance. It’s almost all fixed.

Picker: Since there’s so much on the line with regard to performance, I have to ask you, what’s your strategy? What’s your what’s your thinking right now? How are you putting capital to work in the current environment in a way that you believe will outperform the benchmarks?

Kraus: It depends upon the strategy, whether it’s an equity strategy or fixed income strategy. But in the equity strategies, we are what you would expect – highly research dependent, looking for specific opportunities with companies that we think have long term growth, or undervalue and will accelerate their value over time. And that timeframe is usually 18 months to three years. In the credit space, again, it’s fundamental research to find credits and obviously being careful about the market because credit markets tend to be more macro driven. But it’s all of the above and that’s what we spend our time doing. We think that if we do that consistently over time, we can perform.

Picker: Are you net long or net short in the current environment?

Kraus: Interestingly enough, in the one hedge fund that we do run, we’re pretty close to flat. So, I would say a very low net position. In the other funds that we run, we run 100% long. So, in other words, we are what I call beta one, exposed to the index by 100%. But we do have shorts, so we’re gross more than 100% in those funds. But I would say in general, right now, our risk positions are low. 

Picker: So, not much leverage then? 

Kraus: Not much leverage, but more importantly, the actual stocks and bonds that we are choosing and the positions we’re taking, we’re on, I would say, the low end of our risk scale.