Pass it on?
The tension between investors and hedge funds over exactly what should be covered by the management fee or passed to the fund has been, and will likely continue, growing “Investors increasingly believe many of the costs currently passed on to funds should be covered by the management fee,” says Julian Young, EMEIA hedge fund leader at EY. “This will continue to be a contentious issue for the foreseeable future.”
In every category covered by EY’s survey, the number of investors saying costs should not be passed on increased markedly between 2011 and 2012. The number of funds who said directors and officers liability insurance, for example, should be covered by the management fee increased 25% between 2011 and 2012 to 58%. Yet 70% of managers are passing that cost on, an increase of 10% since 2011.
Regulation
The impact of greater regulation is particularly contentious. Some 46% of investors said the cost of regulatory registration and compliance for a fund should be covered by the management fee, but twice as many managers passed that on in 2012 (68%) compared to 2011. Meanwhile, 76% of investors said regulatory examinations should not be passed on, more than twice as many as 2011, but 24% of managers are passing those costs on, a decrease of only 1%.
“Higher regulatory costs are part of doing business today,” says Morten Spenner, CEO of fund of funds, International Asset Management. “It’s not excessive so firms with the proper infrastructure, who can scale up accordingly, should feasibly be able to cover this under the management fee.”
What makes it more difficult for investors, however, is a lack of industry standards. According to Young: “We see a broad range of what is put to the fund and what is paid by the manager. The key is that investors understand what goes where. It comes down to the quality of the due diligence and asking for a great degree of granularity and transparency on what is being charged to the fund.”
“Investors are generally scrutinising more carefully what they are getting and what they are paying,” Loveday says. “That means meaningful analysis of the performance and risk sources of a fund to determine genuine alpha generation, and the audited financials to understand all additional costs.”
Upward trajectory
Where costs and expenses are increasing, that is naturally feeding through in the returns investors receive. And, with little sign the running costs of hedge funds will depart from their upward trajectory, is something investors can ill afford to ignore.
Trading costs, for example, are increasing as both hedge funds and those they trade through face greater regulatory pressure. Hedge funds, as a whole, are naturally more active traders than traditional funds so these costs will have a greater impact on the bottom line.
According to Alan Miller, CIO of SCM Private and previous CIO of Newstar, while mutual funds might have an annual turnover level of around 60-70% of its underlying securities, the turnover rate for a hedge fund would more likely be 100% plus. (Figures from Goldman Sachs Hedge Fund Trend Monitor May 2013 show hedge fund turnover averaged 30% in the first quarter of 2013 alone.) The exact scale of those costs will vary depending on a number of factors including what assets they trade, how often they trade, whether they have borrowed assets and the amount of leverage they employ.
According to trueandfaircalculator.com, a website designed by Miller to help investors understand the true costs of investing, the total cost of ownership for a £1m investment over five years comes to 3.5%. This assumes a 5% gross annualised return, a portfolio turnover rate (PTR) of 100%, trading costs of 0.75% and industry-average management and performance fees of 1.62% and 19.19% (Preqin, Oct 2012). The result is a total cost of £199k for a gain of £77.5k.
If the PTR alone increases 20%, the total cost of ownership rises to 3.65%, pushing costs to £207k while net returns reduce to £69.2k gain.
“High fees and high turnover are why hedge fund returns are so low,” Miller says. “Hedge funds have other costs to consider, such as prime broker charges and paying a margin over the financing rate. For those shorting stocks, there will also be a fee payable to the lender. The trading costs for hedge funds can therefore be immense and investors will see that in the return they are getting from the fund.”
With costs likely to continue increasing, a growing disparity between investors and hedge fund managers on who should pay for what, and little room to negotiate, investors must ensure they have a true understanding of exactly what the total cost of ownership of the fund will involve. If performance does not pick up hedge funds will come under further pressure to reduce fees.
Waltham Forest’s Buckmaster says: “If we get stuck in this market for a while, and the new governor of the Bank of England is saying it could be another three years, we would want to see fee levels come down. Why pay for alpha if you are not getting it? I think pension funds such as ourselves will look at other opportunities. “Hopefully the hedge funds will eventually work out for themselves that their fees are too high, but I am not holding my breath in the short term.”
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