Special Report, Fees & Costs: Selling fees short
“There has been an evolution, possibly even a revolution in hedge fund fees,” says Chris Jones, head of public markets and alternatives at the consultancy bfinance, and himself a one-time fund-of-hedge funds CIO.
To a great extent, this reflects the success of the hedge fund industry’s move to attract institutional investment. As Jones adds: “Twenty years ago, hedge funds were very different to anything else. Now they have been brought into the fold as an established area of investment.”
Better understanding and recognition of the underlying return drivers behind the many hedge fund strategies has also led to an increasing reluctance to pay high fees for accessing ‘alternative beta’ marketed as ‘alpha’.
“The core trend-following strategies are now priced at closer to a 50bps management fee with a 10% performance fee, rather than the traditional 1-2% and 20%,” Jones says. “Managers recognise that many investors just want core trend-following CTA strategies utilising straightforward methodologies without any bells and whistles, and they want them priced accordingly. One major firm has amassed $10bn (€6.8bn) with this approach”.
Ultimately, fee levels are based on a combination of what investors perceive are the resources required to run different strategies and their own bargaining power relative to that of the managers. The structure of 2% management fees plus 20% performance is by no means a standard that investors should pay, argues Ken Heinz, president of data and index provider Hedge Fund Research.
“Established managers with a six-month long waiting list and limited capacity will not have to go down from a two-and-20 structure, and there are still some managers who are able to charge 3% management fees and 30% performance. But the average for the whole hedge fund industry is closer to 1.5-2% management fees and 17-18% performance fees,” he says.
Fee values do differ significantly across strategies.
“Relative value fixed income arbitrage is seen as a substitute to fixed income investment, so fee negotiations start off with a baseline of fixed income fees,” notes Heinz. “In contrast, event-driven and macro strategies are thought of as having a greater degree of idiosyncratic factors, particularly event driven which relies on the skill set of individuals with capabilities that have not been commoditised.”
Candriam runs both a portfolio of hedge funds internally and a fund of funds strategy. The CIO of alternative investments Fabrice Cuchet says that fees should vary according to the risk profile of the strategy.
“We have low-volatility strategies where volatility varies between 1% and 5%, and those have a fee structure of, on average, 0.6% management fee and 20% performance fee,” he says. “On higher-risk, higher-return strategies, we have a base fee closer to 1.2-1.4% with, again, a 20% performance element.”
But further than this, in an environment of low interest rates and low asset class returns, the overall trend is inevitably downwards, regardless of strategy. “Some managers are willing to negotiate on fees now who were not [so inclined to] six or seven years ago,” Jones observes.
Investors should not focus on fees alone as their returns may also be diluted through the costs charged to their funds and the type of clawback provisions and hurdle rates in the management contracts.
“You need to crawl all over the accounts and ask questions,” says Jones. “Some funds charge far more than what an investor expects to pay – with IT systems and the like being charged to the fund. Others charge nothing. It is very much caveat emptor.”
Hurdle rates can be a problem in low-interest-rate environments because they are often set against money market rates. That means hurdles might currently be close to zero, whereas institutional investors are often looking for hurdle rates of 3-4% in order to achieve the net returns they need.
The issue of alignment of interest comes up around performance fees. If a manager takes on too much risk in order to collect their performance fee, and that risk does not pay off, it is clearly not fair that the manager should keep the performance fee for the period during which he took too much risk. A high watermark – which stops the manager from taking any performance fee until the fund NAV has regained its earlier level – addresses this problem to some extent.
But this does not deal with the full extent of the misalignment of interest, and many investors would prefer to have the right to claw back paid performance fees in the event of significant subsequent underperformance. However, fund managers can point to reasonable objections to this kind of system.
“If an incentive allocation has been accrued for the benefit of the manager, they would generally need to pay taxes on it, which typically cannot be clawed back,” as Lisa Fridman, head of research at fund of funds house PaAmco, explains. “It may also be difficult to accurately estimate contingent liabilities related to clawback provisions in the accounting statements.”
Deferred fees, escrow accounts, and specially designed structures like ‘shock-absorber fees’ have been mooted instead, but all of these add complexity and, as yet, have failed to take off.
It might be observed that the easy battles have been won, as evidenced by the general reduction in headline fee levels being charged to institutional investors across the hedge fund industry. Further steps – paying per unit of alpha, dealing with the misalignment problems around performance fees – will demand much deeper thinking and greater engagement.