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Hedge Funds: Dose of fee realism

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Hedge fund fees do seem to be coming down in aggregate, but Emma Cusworth finds that if you want good performance you might simply have to suck up those charges

Hedge funds came under heavy fire as the 2008 financial crisis hit and investors were surprised by disappointing performance. In the resulting buyers' market, many managers become more realistic about fees. The industry seemed to enjoy something of a reprieve during 2009 and 2010, but 2011 has again seen an about-turn as performance suffered.

The arguments about whether hedge funds present value for money rages on, and some argue that those who adapt to investor pressure on fees stand to make significant gains. Essentially, the question often boils down to the extent to which good performance and high fees are correlated.

"The huge dissatisfaction with hedge fund returns in 2008 led to a change in investor attitude," says Amy Bensted, manager of hedge fund data at Preqin. "Investors were much more vocal about what they didn't like, which resulted in a drop in management fees in 2009 and 2010. Why pay over the odds for funds that are not performing as expected?"

According to Preqin's research, only 29% of managers still use the traditional ‘2-and-20' fee structure. Carlos Ferreira, director of operational due diligence at fund of funds firm PAAMCO, says: "‘2-and-20' used to be the norm, but that changed when the financial crisis hit. We always try to negotiate hard to align incentives and pass any potential fee breaks on to our investors."

By 2011, mean hedge fund management and performance fees were 1.6% and 19.20% respectively, according to Preqin. This represents a 20% drop in management fees, but only 4% for performance fees (assuming a starting point of all funds charging ‘2-and-20'). Almost four out of five managers still charge a 20% performance fee, and Preqin's survey showed that this is where investors are most dissatisfied: 48% wanted to see improvement in that area, while only 11% felt most improvement had been made in that area over the last year.

The equivalent findings for management fees were 43% and 27% respectively - and indeed, Bensted believes they have bottomed out. "I can't see management fees going much lower than 1.5%, particularly as regulation will add to operational costs."

Despite a decrease of 0.05% in the average management fee between 2010 and 2011, an increase in performance fees from 18.89% to 19.20% means overall fees crept up by 0.25% to 20.8%. Moreover, it is now less of a buyer's market: in 2011, only 47% of investors surveyed by Preqin said they had rejected a fund based on fee structure, compared to 65% in 2010.

But in recent months there has been a considerable reversal of fortune for most hedge funds. The industry posted the fourth-worst performance quarter in history between July and September. The HFRI Fund Weighted Composite index fell 6.2% in the third quarter, bringing year-to-date performance to -5.4%. Total hedge fund industry assets under management declined to $1.97trn (€1.43trn) from a record $2.04trn in the previous quarter. Preqin found that 40% of investors felt returns had fallen below expectation in 2011 - the highest level in four years and an 11% increase on 2010.

"Recent months have shaken relationships," Bensted says. "The level of negotiation has gone back up. Managers who adapt to investor demands will reap the largest rewards."

Jeroen Vetter, founder of Dutch wealth manager Capital Guards, emphasises the importance of negotiation: "Everybody is doing it! Funds that charge ‘2-and-20' have been harder to sell."

Others point to the fact that hedge funds have still significantly outperformed equity benchmarks this year.

"Because of this, and other factors such as liability matching, hedge funds are low on the worry list," says Scott Gibb, partner and portfolio manager at alternatives specialist Cube Capital. "Investors have been better off in hedge funds so there have not been many redemptions across the industry yet."

As ever, the real question is whether hedge fund managers provide value for money: is there a genuine correlation between hedge fund performance and fees? Some believe there is a closer connection between fund size and fees.

"Institutions usually start their hedge fund programme by allocating to the big institutional funds," says Keith Guthrie, CIO at Cardano. "These funds provide greater comfort because they generally invest in safer parts of the world and have a proven ability to protect investors from downside risk, but they also generate more conservative returns. Furthermore, as assets grow, managers are unable to perform at the same level in most cases."

According to Ferreira, larger and more established hedge fund managers are more difficult to negotiate with. "Large funds may not need additional capital and are more able to stand firm on fees," he notes.

This month's Off the Record survey by IPE offers a mixed picture. One Austrian pension fund manager feels that investors could push harder on hurdle rates; and a UK pension fund manager insists that it is harder to get results on hedge fund fees than it is on a standard global equities mandate, for example.

"Fee levels are far too high but due to persistent demand there is no easing in sight," says another Austrian fund. "[However,] On the fund of funds side we see that competition is getting harder and fees and terms can be negotiated much better than three years before."

Others believe market forces mean those able to charge higher fees can do so precisely because they are the best funds. "That is absolutely true," says Dan Mannix, head of business development at RWC Partners. "The market is very efficient and managers are only able to charge an appropriate amount given their capacity and demand for that capacity. There is no evidence that average managers, even with low fees, will be able to raise money. There is no room for anyone but the best fund managers in the industry."

Nicholas Campiche, CEO of Pictet Alternative Investments, agrees: "Even among the larger asset managers, if they take on too much money so that returns start to come down, then money will start to flow out."

Nobody likes to think they have taken on an average manager but, by definition, most have. So is the market efficient enough that even average managers' performance justifies higher fees? The market appears to be moving in that direction.

One of the most pronounced changes in investor sentiment since the crisis has been a much sharper focus on alpha and intolerance at paying hedge fund level fees for beta performance. According to Pawel Kiesielewski, partner at Hermes BPK Partners: "The debate among large institutional investors is now very much about being willing to pay for genuine alpha, but not for disguised beta. In the long term that will mean a greater alignment of performance with fees."

Increasingly, only hedge fund managers that provide genuine value for money can charge high fees, while those that do not, can not. As Sara Malak, chief compliance officer at The Alpha Cooperative, says: "The best performers will generally be attracting capital at a rate that would allow them to snub any fee-negotiating investor."

The real lesson for investors is therefore not the one they might expect: ensure the managers you select are consistently able to charge above average fees.
 

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