The “No Arbitrage” Rule Applied to Hedge & Mutual Fund Fees

Fees 09 Nov 2006

If a mutual fund is essentially a marketing package that delivers beta and alpha in a specific proportion (as we have argued here), then what should be the relationship between the (effective) fee for the alpha portion of a mutual fund and the fee for a real hedge fund with similar risk/return characteristics?

We propose the following line of thinking to link hedge fund and mutual fund fees…

The No Arbitrage Rule (applied to active management fees):
The appropriate fee for active management is the fee at which a physical market neutral hedge fund and the comparable market neutral overlay embedded within a mutual fund are equally priced (ceteris paribus).

Sure, friction and lack of liquidity means you can’t really arb funds like you can stocks.  But the implications of this notion are profound nonetheless.  For example, fees for index-hugging equity funds must fall until their embedded market neutral overlay is priced to equal a real market neutral hedge fund.  Similarly, a market neutral hedge fund fee must rise until it reaches the fee that the market has already determined for the embedded market neutral overlay in index-hugging mutual funds.

This would be straightforward in the absence of different fee regimes (eg. flat management fee vs. 2 and 20″).  But the no arbitrage rule can still apply as long as you treat the performance fee as a negative option.  A simple example: a 1.7% (MER) mutual fund that can be 80% replicated with an ETF (@0.2% MER).  The MER of the embedded market neutral overlay therefore comes out to 7.5% ([1.7%-0.2%]/0.2).

This sounds very high compared to a hedge fund with a 2 and 20″ fee.  But let’s say the hedge fund had a beta of 0.5.  Its 2% management fee is therefore actually 4% for the active portion of the fund.

Then we must account for the 20% performance fee.  Assuming a zero hurdle, the performance fee could tack on another 2% if annual return was 10%, or another 4% if annual return was 20%.  While we can’t predict returns with any certainty, we could determine the expected value based on historical return distributions and derive a total MER from that.  And since that distribution is asymmetric – i.e. you never pay a negative performance fee – you’d have to price it as a negative option.

For example, if the underlying security (the fund) goes up, your performance fee position depreciates into negative territory (from your perspective).  But if the underlying security goes down, your performance fee position does not appreciate above 0%.  In other words, the manager doesn’t give it back.  So you have to model the performance fee as an option and then add it’s expected value to the flat management fee for a true apples to apples (alpha to alpha) comparison.

Today, hedge fund fees are highly standardized with most arbitrarily set at 1%, 1.5%, and 2% (with a 20% performance fee).  But we at All About Alpha believe that the increasing liquidity of mutual funds, hedge funds, ETFs and derivatives will eventually lead to more nuanced view of fees by investors and more accurate pricing.

How?  At the end of the day, we are really just talking about a fee-for-alpha model here as the market becomes more efficient in pricing alpha.  Whether or not that alpha comes pre-bundled with beta (or betas) is a marketing decision, not a portfolio construction decision.

– Alpha Male

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