A paper put out in October by an Associate Director and a Managing Director at Pavilion Alternatives Group says that hedge fund performance can suffer from a performance fee drag as a consequence of rising interest rates, and from the increasing cash rate that comes with that rise. They explain the arithmetic behind the performance drag, how it depends on the established practice of attaching a percentage performance fee to total return, and how that practice might be reformed.
The Associate Director, Dan Covich, and the Managing Director, Alex Da Costa, begin by disputing a common hypothesis as to the consequences of higher interest rates. Some investors, they say, expect that hedge funds do better as interest rates increase simply because they reap a short rebate, which acts a lot like a cash-like security.
But Covich and Da Costa caution that such an expectation is hasty. It ignores the fact that higher interest rates can make it more difficult for hedge funds to outperform liquid markets, which is a key part of the raison d’etre of hedge funds.
The Drag and the Fee Model
Consider a long/short hedge fund that is 100% long on one equity ETF and 100% short on another. Both ETFs, we will suppose, are tied to the S&P 500. This results in a situation “remarkably similar to a cash investment,” as the fund earns a rebate on the short position, while the performance of the one position almost exactly zeroes out the performance of the other. The managers will charge a performance fee on total performance, meaning in many cases a 20% fee. This would be a cash yielding fund that would give investors 80% of the yield and keep for itself 20%: not a product that investors will find attractive for long.
As interest rates rise, then, there develops a performance fee drag from the cash rate.
Interest rates are rising from the historic lows that many central bankers around the world introduced in order to combat the global financial crisis (or crises) of 2007-08 and to provide a stimulus around the time of the bottom in 2009. Repeatedly, in the years since, central bankers have talked about tapering down their stimulus, but then have faced “taper tantrums” from the markets, and backed off. They may have conveyed the impression that basement-low rates were forever. But now we are all discovering that, though diamonds are forever, interest rate conditions cannot be.
Thus, the threat of drag resulting from interest rate increases is a real one. Covich and Da Costa use it to argue for a change in the fee model, one that will serve both investors and managers better by aligning their interests. A cash hurdle before the receipt of performance fees is an obvious solution, and it works well for market-neutral funds.
For beta oriented funds a better idea is the use of a market oriented benchmark as a hurdle.
A Related Report
Dan Covich co-authored another report on overlapping subject matter (benchmarking and absolute returns) in March of this year. The other author of the March paper was James Fisher, also an associate director at Pavilion.
Covich and Fisher asked, “How can we test whether a hedge fund programme is adding value to large institution investor portfolios?”
The context for the question is the eight year bull market since the market hit its GFC low in early 2009. Measured against the returns investors could have gotten for themselves investing in stocks during this period, many hedge fund returns look unimpressive. But surely that’s unfair – a bit like measuring the performance of disco-related paraphernalia in the six months after the release of Saturday Night Fever. If one picks out a period of upswing, one can easily say that anything that would have been hedged the other way during that period would have had less impressive returns.
So what is the right metric? Covich and Fisher proposed a beta matched mix of stocks and bonds as the most appropriate measuring rod for distinguishing the beta from the alpha of hedge fund performance, because it can be customized to compare a specific hedge fund’s performance to the risk profile that investors could achieve for themselves by using those traditional markets.
Pavilion Alternatives Group is a Richmond-Va. Advisory platform, formed after the acquisition of Altius Holdings by Pavilion Financial Corporation in September 2016. Pavilion Financial Corp. then united Altius with its own alternatives subsidiary, LP Capital Advisors.