Fees - a price worth paying?
The last couple of years have seen explosive growth in the hedge fund industry. Two consecutive years of negative equity returns have prompted investors to cast around for alternatives.
In this environment, the hedge fund story of ‘absolute returns’ that are uncorrelated to quoted indices is compelling. At present, the new money going into hedge funds is still largely sourced from high net worth individuals and endowment funds, but there is increasing interest from other institutions, including pension funds, across Europe.
We have seen some of the largest pension funds in Europe making initial, cautious forays into this market. In the rush to invest in hedge funds, it is easy to overlook how much these investments are costing the investor.
So what sort of fees do hedge funds charge? Most hedge funds will charge an annual fee based on the value of the assets, plus a performance related fee. This structure is not so different from that paid by many institutional funds. However, the level of fees paid is much higher than for institutional mandates. A typical fee for a standalone hedge fund might be 2% per annum of the value of assets, plus a performance related fee of 20% of outperformance.
Performance fees are desirable for hedge funds, as they align the interests of the hedge fund manager with those of investors. However, the structure of the performance fee can produce undesirable incentives for the hedge fund manager. If there is no cap on
the outperformance fee, the fund manager may be tempted to take on unacceptable levels of risk, as they
will share in the upside but not the downside.
For hedge funds investing in equity markets, the performance related fee structure may provide an incentive to have a net long bias, if the manager believes that equity markets are on average going to outperform the performance benchmark (eg cash, or a fixed performance target). This can be unfortunate for those investors looking to invest in a ‘market neutral’ equity long short fund, precisely to provide diversification away from their other holdings in quoted equity markets.
Another feature of hedge fund fees is that performance fees are sometimes designed with no hurdle rate. This means that the fund manager takes a share of all positive performance of the fund. A cynic could argue that the hedge fund manager might keep all the assets invested in cash, and still take a performance fee. If the share of performance taken by the manager was 20%, and interest rates were 5% per annum, this could mean the manager was taking a performance fee of 1% per annum for holding cash!
As an investor, I would prefer an arrangement where the manager only took a profit share for producing
outperformance above a reasonable hurdle rate.
For a hedge fund that aims to be market neutral, the most obvious hurdle rate might be the risk fee rate (ie cash rate) of return. You might still have a performance fee arrangement where the manager also shares underperformance below the hurdle rate. However, under such an arrangement, I would think of the base fee as the fee that was paid at the hurdle rate, not the fee for zero performance in absolute returns.
Many of the new investors considering hedge fund investment, including pension funds, are focusing on a fund of funds route. A fund of hedge funds can offer diversification of risk across a range of different hedge fund strategies, and limits the exposure to the risk of one hedge fund investment ‘blowing up’.
One disadvantage of the fund of fund approach is that it involves layering of fees. The fund of fund manager will typically charge their own annual fee based on the value of the assets, plus a performance fee, on top of the fees of the underlying managers. The annual fee might typically be 1–1.5% per annum, and the performance fee structures vary but might typically be around to 10–15% of outperformance. This means that within a fund of hedge funds, the overall fees paid by the investor may be as high as 5% per annum, for relatively modest outperformance . This might be ten times as much as an institution is paying its long only managers!
Another aspect of fund management costs attracting greater attention is third party costs, including brokers commissions. This is particularly true in the UK where, as Paul Myners pointed out in his review, these costs can be as high as the fund management fee, but are generally not subject to disclosure. Within the hedge fund industry, dealing costs will vary considerably, depending on the type of strategy (some strategies require more frequent trading than other strategies). Hedge funds will usually enter into a prime broker relationship, where they agree to pay premium commission rates, in return for guarantees about access to liquidity (which can be crucially important for hedge funds during difficult market conditions). Unless the market changes radically in terms of disclosure, it is hard to see how a hedge fund investor can get a good handle on these costs, and in practice investors often just have to accept that these costs are an unseen drag on performance.
Having drawn attention to the high level of hedge fund fees and some of the less attractive features of hedge fund fee structures, perhaps we should now consider the case for the defence.
Hedge fund managers argue that they have to charge high fees to attract the most talented investment managers, who can add value within this demanding environment. Perhaps more importantly, many hedge funds are subject to severe capacity constraints. Many hedge fund strategies exploit small niches of opportunity within the markets, or are very dependent on having the liquidity to deal in and out of markets very quickly. Hedge fund managers often argue that it is better to charge high fees, and to close their funds to new money when they reach a size (which for some strategies may be as low as $100m (e114m)) beyond which the ability of the fund manager to add value decreases.
Hedge fund managers also argue that charging high fees is acceptable, providing performance is always quoted net of fees. This may be true up to a point, but there is still a risk if investors do not understand the impact of fees. As the hedge fund industry continues to grow, there will be more funds chasing a limited set of investment opportunities. It seems likely that average returns from hedge funds will decrease if the industry expands too much, and many funds may deliver very poor returns net of fees.
So where does this leave the investor? Unfortunately, institutional investors are in a relatively weak position. Scope for negotiation of hedge fund fees is often very limited. In most asset classes, institutional pension funds can negotiate good fee deals based on the amounts of assets they are able to place with fund managers. The capacity constraints within the hedge fund industry means that this is not the case for hedge fund investors.
As the industry grows, selecting the best hedge fund managers will become more important, but those managers that have a good reputation will have little need to negotiate on fees. One trend we are starting to see is of more institutional fund managers launching hedge fund type products. It will be interesting to see how they approach some of the issues raised in this article.
My advice for the pension fund investor considering hedge fund investment, is to approach the fee issue with open eyes and make sure you ask the right questions. It may be that you need to pay high fees to access the best managers, but you should seek to be clear just how much you really are paying.
Alvar Chambers is senior consultant and actuary at Aon Investment Consulting in London