Fee Squeeze: A Tale of Two Greeks

Fees 10 Jul 2007

When it comes to fees, it’s the best of times and the worst of times for hedge funds – depending on their alpha and beta.

The Financial Times provides a good overview of this phenomenon in a story last Monday.  We haven’t always agreed with the FT’s view of the hedge fund industry (see related posting).  But Alphaville, FT’s excellent blog-esque news service, has made up for it by enthusiastically welcoming opposing views.  Says the recent FT piece:

“Who cares when it is surely the total returns that really matter? Well, it is all about fees. Genuine alpha is worth a lot to return-starved investors. It certainly merits the standard 2/20 fee structure, and the best funds charge substantially more. Beta, on the other hand, is a commodity item worth only a few basis points.”

The article comes to a dire conclusion for hedge funds:

“We know from the long-only sector, where alpha is more easily measured, that disappointing performance over many years has caused a large-scale switch by investors to passive products amid allegations of closet indexing and a proliferation of risk control techniques. When the costs of active management outweigh the benefits investors go passive. It could now be the turn of hedge funds to suffer.”

As we mentioned earlier last week, hard-bargaining institutions are making their mark on traditional hedge fund fee structures.  Lamare Villere of The Teachers’ Retirement System of Illinois told Pensions & Investments:

“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.”

But according to some pundits, there is actually no fee pressure on hedge funds.  Says a Reuters report from the Fund Forum in Monaco earlier last week:

“‘Clearly there is no fee pressure at all, despite many wishful articles to the contrary,’ said Hugh Willis, chief executive of fixed income investment firm Bluebay Asset Management Ltd., which floated last November. ‘Demand for well-managed hedge funds exceeds supply of the same by a very wide margin … People are prepared to pay for alpha.'”

Willis is half right.  Investors are prepared to pay for alpha.  However, there is obviously fee pressure brewing in the industry – where there is less alpha.  The point is, you can’t talk about fees unless you also talk about alpha.

Even in the often-cited opinion of CalPERS’ Russell Read (“Calpers assails fees that outperform results“), there is a time and place for high fees.  After chastising those who sell beta at alpha prices, Read also told the media:

“We have no problem paying high performance fees for a manager’s selection, but we find taking on average market risk inherently unsatisfying.”

Fees: they’re all about alpha.

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