UK – Hedge fund managers do not always deserve their high fees, according to a recent research report by Barclays Global Investors.

While hedge funds do have some structural advantages, traditional investment firms also attract talented managers and provide their own set of advantages to institutional clients, according to BGI’s ‘Five Myths About Fees: The truth behind analysing fees in the context of investment goals’.

“Also, keep in mind that the current hedge fund boom has not increased the overall supply of alpha; it was always zero and still is,” said the report.

According to BGI, ‘hedge funds are where the alpha is – they deserve their high fees’ is one of five fee myths. The others include ‘fees should be as low as possible’, ‘incentive fees are better than fixed fees’, ‘high-water marks always help investors’ and ‘you can always separate alpha from beta and pay appropriate fees for each’.

Pension funds today – particularly those, which are “significantly” underfunded – are “in desperate need of alpha”, said BGI. “The demand for alpha has never been higher.”

As a result, hedge funds have seen large asset inflows, the industry has seen an increase in the number of hedge funds, and the flow of investment managers into hedge funds has also risen.

According to BGI, there has also been a “significant rise” in average hedge fund fees. Whereas ten years ago most hedge funds charged 1% of assets and 20% of performance above the benchmark, many are now charging 2% of assets and/or incentive shares above 20%.

Furthermore, fees have risen with the growth in hedge fund of funds, with fund-of-fund fees layered on top of the hedge fund fees.

“We have observed strong and increasing demand for alpha, confronting its limited supply,” said BGI.

“Unfortunately, the increase in supply is an increase in the supply of hedge fund managers offering alpha, not necessarily any increase in actual alpha.”

While hedge funds avoid constraints and have greater flexibility to invest in many non-traditional assets, they also fail more quickly than institutional funds, said BGI, adding that hedge funds “are not all wine and roses for managers”.

This is because they are usually undercapitalized, and are forced to take risks more established managers can avoid, said the report. It also warned that it could be difficult to distinguish between the skilled and unskilled hedge fund managers.

Furthermore, many traditional investment firms offer similar products with the same structural advantages as hedge funds plus transparency and institutional quality demanded by institutional clients, said BGI.

However, it added that there are many talented hedge fund managers.

“Do they always deserve their high fees? The simple answer is no. No manager is great independent of fees. At some price, a manager is just not worth it; the decision to invest in a hedge fund should always include an analysis of the impact of management fees on the net performance delivered to clients.

“This is part of hiring traditional managers, and should be part of hiring hedge fund managers as well,” concluded the report.