Hedge fund fees are just one part of the cost equation. The real discussion should be about value for money and not headline fees, argues Niki Natarajan
At a glance
• The subject of hedge fund fees has prompted an almost visceral response since the financial crisis of 2008-09.
• Prior to the crisis, in the days when double-digit returns were common, a 2% annual management fee and 20% performance fee were common.
• The average management fee has dropped to 1.35% according to EY.
• Experienced allocators say that simply cutting fees will destroy the true-value proposition of hedge funds.
When Oliver Hart and Bengt Holmström won the 2016 Nobel Prize for economics for their contributions to contract theory, the hedge fund industry was thrown new theoretical tools. It might finally be able to see the real alignment between managers and their investors. At least that could be true for those smaller funds where the management/incentive fee dynamic means performing is more important that asset raising.
Since the financial crisis, irrespective of net risk-adjusted returns, the topic of hedge fund fees has brought out an almost visceral reaction. Today, even if a hedge fund could consistently return an average of 40% a year after fees (proven since 1988 with only one down month), many would quibble about a management fee of 5% and performance fee of 44%.
Access to such a manager is a moot point, as the vehicle in question is the now employee-only Renaissance Technologies’ Medallion fund. That said, despite the fierce fee debate, there are still hard-closed, high-fee performing funds that some would gladly pay additional fees to access. In the end, the real discussion should be about value for money and not headline fees.
Prior to the financial crisis and the subsequent demise of performance, the typical management fee was 2% with a 20% performance incentive. “The problem is, as performance declines, fees become a larger part of the gross return. In the days of double-digit returns, two-and-20 did not show up quite as much,” explains Stephen Oxley, vice-chairman of PAAMCO.
“On a 5% gross return, just 48% goes to the investor when fees are ‘two-and-20’. No wonder investors are redeeming,” adds Jeffrey Tarrant, CEO of Protégé Partners in New York. After the California Public Employees’ Retirement System exited hedge funds in 2014, on the basis of cost (and complexity), others have followed suit.
Today, the average management fee has dropped to 1.35% from 1.45% in 2015, according to EY. In 2015, 40% of managers offered funds with customised fees and terms, but by 2016 this had spiked to 63%, EY finds.
The reasons for the downward fee pressure are simple. “There are three macro forces driving fees down: the zero-rate environment; the rise of passive and lower-cost alternatives; and performance pressure,” says Omar Kodmani, senior executive officer at hedge fund multi-manager EntrustPermal.
“One-and-20 was the industry standard when I first allocated to hedge funds 30 years ago,” recollects Tarrant. This rose first to 1.5-and-20 and eventually to two-and-20, he adds.
Now, to attract allocations and retain existing clients, even some of the larger managers, such as Caxton Associates, which was charging 2.6/27.5 in March last year, Och-Ziff Capital Management and Tudor Investment Corporation, have resorted to trimming fees.
“The [fee] discussion is an emotional debate because, logically, what should matter are the risk-adjusted returns net of fees,” says Patrick Ghali, managing partner of Sussex Partners. “If fees are high but the risk-adjusted net returns are higher than a fund with lower fees, one would expect to select the higher returning fund on a risk-adjusted basis. This, however, is not always the case and some investors literally prefer to leave returns on the table for lower fees,” he adds.
One example of this is New Jersey Division of Investment. In July 2016, the fund agreed to a $1bn separate account to be managed by BlackRock Alternative Advisors, to be run in accordance with the division’s guidelines.
BlackRock must keep the average management fee to 1% and incentive fee to 10%.
According to the state’s 2015 annual report, the existing portfolio of 44 managers returned 4.21% after fees of $141.7m. The net profit was $390m after fees against a gross profit of $660m.
Highlighting that funds of hedge funds are not immune to the downward pressure, BlackRock will be paid 30bps for this ‘bespoke’ service.
The realm of expenses is another area where experienced due diligence teams can add value. Technically, operating expenses related to the fund such as audit and directors’ fees, administration, custody or legal charges can all be expensed, but other items such as research-related travel can be a grey area.
Experienced allocators say that simply cutting fees will destroy the true-value proposition of hedge funds. “Fixating on just headline fees misses the point. They are just one part of the equation. Investors need to ask themselves ‘is this a good investment going forward?’,” says Robert Howie, principal at Mercer Investments.
“There is [also] greater need to understand the underlying sources of return. Sophisticated investors will pay for alpha but no-one wants to pay hedge fund fees for beta,” says Peter Wasko, senior investment manager at Aberdeen Asset Management.
New Jersey’s move was intended to “send a message to the hedge fund community that fee structures must be more closely aligned with the interests of beneficiaries”. But are there other ways to achieve this? AIMA’s research paper ‘In Concert’ explores the alignment of interests between managers and investors and the various mechanisms that can reduce fees, including high-water marks, hurdle rates, longer-term capital for lower fees, as well as tiered fees where the management fees come down as the fund grows.
“Incentive mechanisms that align performance with return and take away free call options from managers are definitely in the investor’s best interest. Lower management fees, hurdle rates, and back-ended incentive fees are the best ways to structure fair agreements with better alignment. And there has definitely been progress in these areas,” says Greg Fedorinchik, senior managing director at Mesirow Advanced Strategies.
Mercer’s Howie is an advocate of hurdle rates in particular, where the performance fee is only paid after a certain return over a pre-agreed benchmark is reached. “We would love to see hurdle rates become more prevalent. They make a lot of sense and are another way to get a discount on the performance fee,” Howie says.
For New Jersey, BlackRock has flexibility to achieve the lower fees, according to the state’s annual report. “[The fees will have] hurdles at the individual underlying hedge fund level if possible. The lower fees are achievable as a result of locking up capital, utilising the managed account/fund of one structure or custom share classes within a commingled fund, leveraging existing hedge fund relationships of the manager, and other negotiation levers.”
Both Howie and Protégé’s Tarrant agree that investors should club together to use their collective bargaining powers to push fees down. But, in what he hopes will be an industry-changing move, Tarrant believes he has found the perfect solution to align managers and investors, which he terms ‘120/10/20’.
As he explains, the management fee is reduced to 120bps (but may range from 100-150bps), a 10% incentive fee is applied for net returns below 10%, which rises to 20% for returns above 10%.
“With the 10/20 incentive structure, the majority of returns go to the investor at mid-to-single-digit rates of returns as well as higher ones, and managers who perform at the return levels the industry was once known for will receive fees commensurate with their efforts,” he adds.
“Contracts must be properly designed to ensure that parties take mutually beneficial decisions,” says Tarrant, citing the work of the 2016 Nobel Prize winners. Having adopted the new fee structure on the founders’ share class of Protégé Partner’s newest seed, Tarrant accepts that larger established managers are unlikely to embrace this structure.
But as a seeding specialist, Tarrant says that 120/10/20 lends itself perfectly to small and emerging managers, which could be the future path to healthy returns in overvalued markets. That is only if the value proposition of hedge funds and alignment of interests with both parties become mainstream.