Thomas Wehlen is the co-founder of the San Francisco-based investment firm Coburn Barrett which manages about $70 million in private accounts and the Caymans-based Global Leveraged Indexing (GLI) Fund. Bloomberg ranks the fund, which has had an annualized return of 14.89% since inception in 1998, among the top 1% of all funds for total returns. Despite this strong performance, the GLI Fund—which has a $2 million minimum investment requirement and a 2% management fee—does not charge performance fees. To find out why, FINalternatives’ Mary Campbell recently spoke with Wehlen by phone.
First of all, can you tell me something about Coburn Barrett?
Basically, we run a bunch of private clients’ accounts and an offshore, non-U.S. investment fund which is a global macro strategy… We have only non-U.S. clients. We’re toying with the idea of opening U.S. funds, but [there’s a] lot of extra overhead required for U.S. investors and [in the U.S.] it’s a multi-institutional game and we’re not really well connected in the institutional world.
How would you describe your investment process?
Well, it’s a global macro fund, mostly long-only. We don’t invest in individual stocks, so we invest in stock indices, in government bonds, in commodities, currencies and only super-liquid investments. So we don’t go to developing markets—and in developing markets we include China, for example, because we have a feeling that one never gets compensated enough for illiquidity risk. We had this problem recently with mortgage-backed securities—there was just a liquidity problem…and the Chinese government still has the power to just stop any flow of money and they may use it, so we feel that that’s not worth the risk. We make decent returns outside of China without running that risk. If you invest in companies that do business in China, you can avoid having that risk and yet still participate in Chinese growth…We would invest in Taiwan and perhaps Japan and Hong Kong to participate in China, for example. We would invest in a group of companies that participate in Indian growth, but we don’t go down to specific companies, we would just invest in an index… So, for us, liquidity is really important—investors can have their money back at any time—and the actual evaluation of our portfolio reflects the real value. So we don’t have things that are valued more or less on an accounting basis.
Our model is a statistical model rather than a fundamental analysis thing, so, a lot of our investments are related to correlations, relativities, relative market caps, inflation, that sort of thing—bets [based] on current and past conditions rather than on predictions of where the future is going to go.
I want to ask you your views on management fees, so I thought I’d start with a quote from Millennium Management founder Israel Englander who recently spoke out against them, saying 2% is “an arbitrarily pre-established” fee that has hurt the hedge fund industry’s entrepreneurial instincts. What is your response to that?
We charge a flat 2% fee and the reason we do that is because we’ve found no way to reasonably charge a performance fee. So we stand in exact contrast to Mr. Englander who says performance fee is the only way to go. The reason for that is that a performance fee is an option really…if the return goes well, you make a lot of money and if it doesn’t, the investor loses.
There are only a few things that go into [calculating] the price [of that option]—one of them is interest rate, one of them is time to expiry, and one of them is the volatility of the underlying security and the volatility of the underlying security is the most important factor in the price of an option. Nowhere in there is the return—so, the incentive for an investment manager is to run as much risk as possible, make his option worth as much as possible, and that’s really in the end what they do. They will either find a way to run very high risk or they will find a way to charge a performance fee at a very low level—let’s say, treasury bonds +—and then they will buy a corporate bond which more or less guarantees them a performance fee and only when the company goes bankrupt does the investor lose out.
There are two different types of return characteristics that hedge funds generally exhibit: either they are very high returns and fairly volatile or they have steady, low returns that out-perform treasury….So, you get a steady return and then one day, trouble comes up, and everyone loses their shirt except for the investment manager. And then the second type has very high, volatile returns where the option is worth a lot. [But] in neither of these two alternatives does the investor actually benefit.
We’ve been running our operation for 12 or 13 years and, in the beginning, we also figured we were going to charge a performance fee, but we couldn’t figure any way to unite the interests of the investor and the fund manager in that way….And yes, of course, any flat fee in some ways is arbitrary … but the only way to make sure the investor interests and the client interests are aligned is to charge a flat fee. If the client is happy he’ll invest more money and stay with you. If he’s unhappy he leaves. In that way, the investor interests and the money manager interests are much more closely aligned…than with the performance fee, even though that seems counter-intuitive.
The reason why these performance fees exist is because, intuitively, it seems to make sense. Intuitively, if someone says very loudly, ‘Performance fee, I participate only in your profits!’ this sounds great. But he doesn’t participate in the downside so, yes, fine…if the performance fees are symmetrical, meaning that the money is paid back if things go sour, then that’s a fair method. [But] no hedge fund is going to go for that because, let’s say a fund has a few good years—the first year it has $100 million under management, then $900 million, then $1.5 billion—and if the year they have $1.5 billion under management they have a bad year, they [would] have to pay far more out in management fees than they ever made. So, nobody’s going to go for the symmetrical participate-in-the-loss thing.
Your thoughts on management vs. performance fees seem to make you an exception rather than the rule in the industry—why do you take this approach to fees?
First of all, I like doing this business and so I want to be in it for a further 30 years and I figure the only way to ensure that is to ensure that the investors stay with me, so, to give them as high a return as possible. This, obviously, seems natural, but performance fees work against that incentive because, if I charged a performance fee, I could possibly have retired and I would have taken perhaps more risk, but the investors would be unhappy. Quite a few of my colleagues have done that—left an investment bank, started a hedge fund, lived through the dot.com boom or some other boom, made a lot of money for themselves and then their fund, for one reason or the other, lost enough money that they could not make anymore performance fees and they closed down and are now playing golf. Which is nice for them but it must be irritating in some ways, particularly if you’re a private investor—institutional investors know intuitively the name of the game but we [Coburn Barrett] have only private investors and we figure that, in the end, the private investor will stay with you if he makes a good return. Institutional investors have many different incentives to invest in hedge funds and among them are just rules that say ‘You have to invest 2% or 3% or 5% in a hedge fund or alternative investment.’ So they have no place to go other than performance-charging funds, as yet.