Some said it was bound to happen. P&I now reports that hedge fund fees are heading down – at least for funds of funds (but only for hard-bargaining institutional investors). It may not be the wholesale revolt than many have been expecting, but the evidence is apparently mounting. Says P&I:
“Lately, institutional investors with allocations larger than $100 million are much more likely to pay a hedge fund-of-fund management fee in the range of 75 to 80 basis points, although it often requires intense negotiation to push managers into discounting their fee.”
But P&I also cites sources that tell them the story is different for single-managers.
“Hedge funds of funds are being squeezed by public plans that are much more price sensitive. They realize that they need to be really big in order to keep the business scaleable, but because of this, they arenot losing out because of lower fees.”
“We are extremely sensitive to fees and made that clear during the search process. Because the performance differential among hedge funds of funds is very small between hedge funds of funds, every basis point of cost really counts. Price didn’t rule anybody out of this search, but it made a difference, said Mr. Lamar Villere (of the Illinois Teachers’ Retirement System).”
“In what CRA RogersCasey’s Mr. Lynch calls a shootout for capital, pricing is becoming the main distinguishing factor.”
Apparently, some funds of funds are even offering up their services with no performance fee at all.
It makes sense that funds of funds would show signs of pressure first. All along, detractors have argued that funds of funds don’t deserve a performance fee anyway since they don’t face the capacity constraints of a boutique single-manager. In other words, their upside comes from size, not returns per se.
Sensing this weakness, it seems institutional investors are now forcing funds of funds to adopt the volume-discount practices common in the long-only arena. Continues P&I:
“Managers are much more likely to offer better pricing for large separate account investments than for commingled funds, said Janine Baldridge, director of U.S. investments and head of hedge fund-of-funds research at Russell Investment Group, Tacoma, Wash.”
In his recent book, veteran money manager Eldon Mayer argues that the fund of fund industry will likely bifurcate into large commodity players and niche alpha-seeking players (see related posting). It seems to us that these niche players would likely continue to serve traditional hedge fund investors (e.g. family offices, foundations, ultra-high net worth individuals), while the larger players serve the institutions that have recently entered the market.
The trick, of course, will be to bifurcate fees along these market lines – to charge institutions one fee while continuing to offer products to wealthy individuals that warrant another (higher) fee. Economists would say this is an exercise in “skimming the consumer surplus” through “third degree price discrimination“.
Most demand curves are downward-sloping, which means some buyers are willing to pay a lot more than others for the same product. Naturally, a producer would want to offer their wares at the highest price than can be extracted from each buyer or segment of buyers. Anyone who lined up for Apple’s new US$600 iPhone recently is well aware of this phenomenon. The successive release of a movie in theaters, then DVD, then pay TV, and then on network television can also be described as “skimming the consumer surplus” (see related posting).
The challenge now facing hedge funds is how to keep people paying $12 to see the movie in the theater when it’s now available for $5 at your local Blockbuster, and if hedge fund replication works, for $2 on pay-TV. In other words, how can funds of hedge funds hold the line on fees for their traditional clientele while under assault by these hard-driving institutional investors?
One way to do this would be to actually offer traditional clientele a different product – perhaps one with more idiosyncratic risk and commensurate upside return potential (Mayer’s bifurcated industry). Another version of this strategy would be to migrate traditional, less fee-sensitive, clients to more idiosyncratic single manager funds (which, according to P&I, aren’t experiencing nearly as much fee pressure).
Hedge fund managers have already been forced to practice a form of price discrimination known as “second degree price discrimination” whereby they offer the volume discounts that are common in the long-only industry. But so-called “third degree price discrimination” (pricing by market segment) will be a growing challenge as the market for hedge funds becomes more mature and transparent. In some cases, contractual obligations such as “most favored nation” side-letters, prevent such third-degree price discrimination. In others, fee transparency and product homogeneity will conspire to prevent such differentiated pricing.
In the end, alpha may be the only enduring differentiator that will justify price discrimination. The more alpha, the higher the price. As a result, alpha will become more perfectly priced. So in an ironic way, alpha may eventually become an (expensive, but) easy-to-price commodity.