Even allowing for greater overheads and the effect of tighter regulation and compliance (which, according to one senior hedge fund figure, has raised operating costs in the region of 20%), the manager is still likely to be clearing way in excess of total operating costs. The management fee therefore becomes a very significant profit centre, which changes a hedge fund’s incentive away from taking more risk (which investors say is exactly what they want them to do) towards maintaining the status quo.
Beer believes one solution is that, as funds grow, management fees should not only come down, but fall further for investors who have been with the fund for longer. This sliding scale rewards early investors, giving them incentive to maintain their allocations.
Beer also points to the inherent weakness of consultants’ pre-selection process when approving hedge funds for their buy-lists. “Consultants ‘approve’ a fund before clients actually invest and do so at maximum fees,” he explains. “It’s hard to go back to clients and say, ‘we loved the fund at 2/20, but they’re not nearly as good as we thought so unless they drop fees to 1/5 we think you should pull out.’ It raises too many questions about why they didn’t see this coming.
“Consultants generally only ask for fee reductions to offset their fees, if at all,” he continues. “This generally is 5% or so of overall fees, so it’s like rearranging deckchairs on the Titanic.”
Aon Hewitt’s Towsey points out that, while the firm does pre-build a buy-list of hedge funds, the fee structure forms a very important part of their review of funds’ terms and conditions.
TAKING A DIFFERENT APPROACH
Towsey also observes that the hedge fund industry is beginning to innovate where fee structures are concerned. Smaller or newer funds are more open to investor input and have begun offering structures that include performance fees only, flat fees, or lower fees for longer lock-ups.
“Ideally,” he says, “we would want to see funds offering a range of different fee structures so clients can choose a format that suits their individual needs. Choice is one of the main things we look for along with evidence there has been a lot of thought put into the fee structure.”
But consultants and hedge funds are not the only players in the game. Investors too play an important role in determining what fees hedge funds are able to charge. Some in the industry believe allocators need to spend more time understanding hedge fund returns and how fees are levied. Getting a clearer understanding of exactly how much alpha a fund is generating and comparing that to fees can give investors a good indication of the value hedge funds have to offer.
Peter Coates, CEO of Omni Partners says: “Looking at general hedge fund index returns versus fees, it is understandable that investors feel they are giving up a lot of alpha in fees. As an allocator, I would look at the unlevered alpha versus the fees paid.”
Getting the measure of unlevered alpha involves stripping out the ‘static’ returns – i.e. returns on cash – as well as the beta. Once that is done the leverage needs to come out. “If a manager earns 20% gross with no beta but is 2x levered, his alpha is half of 20%,” Coates explains. “This can be done for any manager and any strategy in order to allow easier comparisons.”
Coates also points to the important difference between realised and unrealised returns – in other words, those where a manager has bought and sold a security to actually achieve a return, and those that exist purely on paper where a manager is still holding a security that has increased in value.
“Investors may have paid performance fees on something that isn’t tradeable,” he warns. “This needs to be addressed and changed across the whole industry, which means more transparency from hedge fund managers and a greater depth of understanding among allocators.”
