Ep72 Alternatives vs. Mutual Funds: Where Should You Put Your Money

Fixed percentage fees align incentives perfectly

In public markets, charging a fixed percentage of assets under management is economically optimal because the 'flow-performance relationship' rationally updates fund size based on manager skill, making fund size itself the least noisy measure of ability.

Competition drives net alpha to zero

While skilled managers generate positive gross alpha, rational investors chase performance and flood successful funds with capital until decreasing returns to scale drive the net alpha (after fees) to exactly zero for investors.

True skill is measured by value added

Manager ability is properly calculated as gross alpha multiplied by fund size (value added), not by returns alone; empirical evidence shows this skill persists over decades, even though investors capture none of it as excess returns.

Positive alpha compensates for due diligence costs

Unlike mutual funds, alternatives exhibit positive average alpha because investors must incur significant costs to investigate managers before committing capital that is locked up for years in illiquid assets; the alpha represents compensation for this investigative effort.

Fee discrimination solves the free-rider problem

Sophisticated investors like university endowments who conduct due diligence receive fee breaks, while passive investors pay full fees and earn zero net alpha; this prevents free-riding on others' research and explains why the same investors consistently get better terms across different funds.

Data biases mask true performance

Alternative fund data is suspect because successful funds voluntarily report while unsuccessful ones disappear from databases, creating survivorship bias; however, the consistent outperformance of investigating endowments over 30 years provides indirect evidence that positive alpha exists.

The '2 and 20' structure signals optimal scale

The option-like performance fee (20% of upside) aligns the manager's incentives with the investigating investor's capital commitment, allowing the manager to infer their own ability from the investor's investment amount and cap the fund at the socially optimal size rather than maximizing assets.

Why successful alternative funds stop taking money

Unlike mutual funds that never cap size, alternative managers limit capital because running the fund at the correct scale (determined by their true ability) maximizes their total rent extraction through the performance fee, whereas too much capital would dilute returns.