Fees facing downward pressure
Funds of funds are generally the point of entry for most institutions investing in hedge funds. A good fund of funds manager will gather preliminary information on funds, conduct thorough statistical analysis, undertake detailed due diligence, construct portfolios to meet the risk and return targets of the fund and monitor ongoing fund performance.
Experienced and knowledgeable industry professionals and a robust infrastructure don’t come cheap and even if the fund of fund holds fast to its standard fee structure, a minimum size of $50m (E51m) is required for the operation to be profitable. The best individual hedge fund managers are experiencing such strong demand that fee breaks on established funds are hard to come by. Start-ups are more likely to offer equity stakes in return for seed capital than reduced fees, as they need to cover their expenses. New funds of funds operations have been set up by independents, banks and established investment management houses, and to achieve critical mass, some managers are offering cut price deals for significant sized allocations.
Flagship fund of fund fees vary within the boundaries of zero to 3% or 4% per annum annual charge and zero to 20% performance fee. Products aimed at the individual investor generally reflect the highest level of fees, as fees are set so as to allow private banks and financial advisors a retrocession for their distribution services. Within the institutional market, fees typically drop to a maximum of 2.5% annual fee and/or a 10% performance fee, but it would be unusual to find an institution paying the maximum for both. More often, a fund of fund will either charge a high annual fee, or anticipate a performance fee if it is charging a lower annual fee. Very occasionally a fund of fund will waive the annual fee but charge a high performance fee.
There appears to be some divergence of pricing between Europe and the US, with the US fund of funds on average charging lower fees. This could of course be because mandates in the US are typically larger. European consultants reported standard fees for institutional mandates of the order of 1.5% annual fee and 10% performance fees, whereas in the US the mid range was 1% and 5% to 7.5% performance fee. These numbers reflect headline rates, but there is rampant discounting on offer to the savvy institution with a sufficiently large ticket size.
Fees become negotiable from a ticket size of $5m although the discounts are likely to be small. For a mandate of $20m, funds will compete on terms that are typically half the standard fee scale. Significant sized mandates, such as $200m or above, may be accepted on performance fee alone, or a miserly 50-75bps of annual fee. This level of discounting is particularly noticeable from newer entrants into the funds of funds market, and from established funds whose poor performance is making fund raising difficult. Pension plans may be unwise to accept these special offers, as Richard Watkins, chief executive of Liability Solutions, a London-based hedge fund distributor, comments: “This is not a science and it is too early to judge which funds of funds will be outperformers. Some institutions with in-house funds of funds are likely to prove better asset gatherers than asset managers.”
Fund of funds providers will be less open to negotiation if the institution requires any level of customisation to the product that requires additional management resources. In particular demands for transparency or liquidity in excess of the normal reporting and redemption schedule reduce the scope for achieving fee discounts. An alternative in these situations is to negotiate rebates for underperformance. Philipp Cottier, chief investment officer at Harcourt, a Zurich-based fund of funds firm, reports that certain institutions have started to impose fee penalties if their hedge fund portfolio has drawdowns, volatility or correlation outside the set investment guidelines.
Institutions often voice concern over fee layering and question whether the fund of fund has the right to charge an additional performance fee when the underlying hedge fund has already taken its share of fund returns. Industry insiders counter this suggestion by asserting that running a fund of hedge funds is significantly more complex than amalgamating long-only mutual funds.
Watkins concurs, comparing the vetting done on a single hedge fund to the analysis of a micro-cap company. But he counters “holdings within some funds of funds can be relatively static, and once a hedge fund is selected, the work involved is mainly maintenance. Very few fund of funds trade aggressively into and out of hedge funds as a manager of single stocks might do.”
Thomas Zucosky, formerly head of alternatives at Investorforce, and now chief investment officer at Discovery Capital Management, likens a hedge fund operation to a small-sized investment bank, and suggests that the evaluation of such entities demands a level of diligence commensurate with that done by an equity analyst on a financial sector company.
A different argument put forward to justify the higher fees charged by funds of hedge funds versus long-only multi-manager products is that the fund of hedge fund is delivering pure alpha, whereas a product whose main source of returns is the underlying market is charging primarily for beta, a much easier form of exposure to deliver.
There are some funds of funds, although very much in the minority, that apply their own fees to the gross returns reported by managers, and pay the hedge fund managers’ fees out of their own fees. Understandably the fee scales of these managers will be at the higher end of the scale and less susceptible to discounting. Managers of these funds will attempt to secure reduced fees from the underlying managers, which may introduce some element of negative selection.
Fund of fund managers who adopt this method of charging are at risk to excessive charging by the underlying funds, understood to be on the increase, particularly in the area of redemption fees. One fund of fund manager was subjected to an unexpected charge when redeeming a two-year old hedge fund investment, because he had not waited an additional day before putting in the redemption notice. He considers that he had adhered to the spirit of the agreement, even if the fund prospectus dictates that redemption penalties apply to holdings of two years or less. He is particularly aggrieved since the money is received by the managers, not paid into the fund, where it would benefit the other fund holders for any potential loss of value caused by his redemption.
In summary, there is consistent downwards pressure, but it is well-hidden, and although visibility of fund of fund returns is improving, it is difficult to say for sure who is performing well, and deserves the fees they are getting.