Hedge funds: focus on fees

The debate over hedge fund fees is probably as old as hedge funds themselves. As institutions increasingly make direct allocations, there is little sign they are benefiting from reduced fees. As performance continues to prove disappointing for many investors, scrutiny of total costs has increased, raising interesting questions about what management fees should cover and what costs should be passed to the fund.

“Investors increasingly believe many of the costs currently passed on to funds should be covered by the management fee. This will continue to be a contentious issue for the foreseeable future.”

Julian Young

Despite high fees, hedge funds are attracting massive inflows. Hedge Fund Research data shows total hedge fund capital increased by a net total of $40bn in the second quarter of 2012 to a record $2.41trn. Rudimentary maths shows, assuming the average management fee of 1.65% for single manager funds (Preqin, 2012), that investors are paying management fees alone in the region of $39.77bn every year, roughly equivalent to Kenya’s GDP. That is an average of around $4m per annum per hedge fund, not including the costs and expenses of running those funds or performance fees, also borne by investors.

The picture of hedge fund returns is less rosy. Based on the Credit Suisse Hedge Fund Index, average annual returns over the last five years have been a mere 3.61%, considerably lower than the S&P 500 (8.26%). Fees play a significant part in the returns investors experience so recent years have seen a much closer focus on all the costs associated with hedge fund ownership.

As Nick Buckmaster, chairman of the London Borough of Waltham Forest Council pension fund, says: “Recent returns from hedge funds have not been particularly good. It does make me think we are paying a lot for not much return.”

Hedge fund fees have been forced down a little. Research from Preqin shows average industry management and performance fees have come down to 1.62% and 19.19% respectively (slightly up from their lows of 1.6% and 18.69% in Sept 2012). “Over the last few years investors have been much more focussed on fees,” says Amy Bensted, Preqin’s head of hedge fund research. However, hedge funds’ willingness to negotiate raises penetrating questions about what those fees should be used for.

Fee management

“Traditionally, management fees were expected to cover the running costs of the firm,” according to Damien Loveday, global head of hedge fund research at Towers Watson. “When hedge funds were starting up, they had very small asset pools and meaningful set up and running costs which to some extent justified the typically higher management fees charged above that of traditional funds.”

However, as funds have grown, management fee percentages have not changed. In fact, institutional flows favour large funds, negating those funds’ motivation to negotiate, keeping fees high. As Buckmaster says: “The big guys still charge 2/20.”

Not only do those big funds enjoy considerable economies of scale, their ability to negotiate at all suggests significant excess revenue is being generated through management fees.

“Negotiation on management fees reflects the fact hedge funds are going to earn income on those fees,” argues Derbhil O’Riordan, partner at Dillon Eustace. “Where large funds are charging a percentage- based fee, there should be a certain scope for negotiation.”

Research by EY (formerly Ernst & Young) shows 79% of investors surveyed were not offered fee breaks in return for concessions, but 95% of fund of funds said they had been. EY’s figures also show full time front office employees per $1bn of assets tapers down from 27 for managers below $1bn to 4.5 for those with over $10bn AUM. The back-office slope is even more dramatic going from 32.8 to 4.6 respectively. Given the remarkable economies of scale large funds enjoy, coupled with the lack of fee breaks direct investors are seeing, reveals the significant scope of those large funds to generate income from management fees. With more institutions going direct, that income stream could become even more lucrative for hedge funds.

According to Loveday: “As funds have grown into mega funds, the percentage they charge in management fees has not changed, but the revenue from it in cash terms has increased massively. In an ideal world, management fees should scale down as assets increase such that the marginal fee is zero once a fund reaches capacity. That way a manager would not be incentivised to gather more assets unless they felt doing so would increase returns for investors (and performance revenue for themselves). Clearly such a fee structure would not be appropriate for all funds but arguably there should be a much higher incidence of such structures than there is currently.”