Hedge Fund Fee Cuts: Benevolence or Conflict of Interest?

Fees 29 Aug 2007

What’s the quickest way to goose the alpha of any fund – mutual or hedge?  Easy.  Slash fees.  Sure it hurts revenues, but it can also provide a desperately needed boost to alpha.

As we’ve discussed a few times on these pages, fees are quite literally the corollary to alpha.  Management fees amount to a charge against the alpha bottom line, if you will.  So, like cutting any expense on an income statement, the benefits of fee reductions accrue right to the bottom line.  Fees (like alpha) are uncorrelated and consistent sources of returns – in this case though, they’re negative returns.

Mutual funds are aware of this.  That’s how some of them manage to charge a stealth performance fee under the guise of benevolence (or at least fairness).  In a posting last winter, we told you about a family of Fidelity funds that offered a “fee adjustment to management fees”.  Essentially, Fidelity would charge a higher fee if the rolling 36 month performance beat a benchmark and would give back fees when performance stank (note: at least it’s symmetrical).

The effect of this is strategy, aside from adding volatility to the fund manager’s revenue stream, is to dampen volatility of the fund itself – particularly its alpha.  It’s the fund management equivalent of earnings management by CEOs.

There’s nothing overtly wrong with funds doing this.  But when a manager strays from pre-defined rules regarding fees, new issues arise.  Arbitrary fee cuts can actually be beneficial to the manager in the long run if the resulting smoother performance (or mitigation of a drawdown) stems outflows or increase the fund’s marketability.

For example, today we hear about hedge fund Deephaven’s plans to give back as much as $68.4 million in first half performance fees if it doesn’t meet a yet-undefined performance bogie the second half of the year.  The firm’s 8-K filing on Monday did not provide details as to whether the cash will be given back to the fund or to its investors, but since it was taken from the fund, one might assume its going back into the fund.

Giving back these fees would be good for investors, but would also make results look better than they would have otherwise.  Sure, no one would be fooled by what appears to be a possible lump sum on December 31, but the fund’s multi-year results would naturally look much better in such a scenario.  Maybe the firm will add a footnote highlighting the one-time benevolence.  Or maybe it won’t.  Or maybe prospective investors will be left thinking such benevolence will also be forthcoming during future drawdowns (talk about moral hazard).  Who knows?  They’re making it up as they go.

In any event, dangling $68.4 million in front of current investors is certainly an effective way of engendering loyalty (at least, until New Years Day).

Goldman Sachs, did something similar recently when it cut management and performance fees in half and added a 10% hurdle rate to their Global Equity Opportunities Fund.  Removing the fee headwind will make performance look a lot better over the next several months.  Will they footnote this in their marketing?

Goldman was obviously trying to bring in new capital with its “don’t pay a cent event” and Deephaven is apparently trying to incentivize investors to stick it out until the end of the year with its pair of golden handcuffs.  But both firms have essentially achieved the same result – making themselves part of their portfolios.  Imagine the return attribution analysis on these funds: x% from stock A, y% from stock B, and z% from the manager’s own arbitrary decisions.

Don’t get me wrong, giving money back to investors isn’t a bad thing.  But being able to arbitrarily choose the form, amount, timing and even the recipients of such adjustments can lead to a conflict of interest for managers – especially when those significant fees are compared to the already small portion of returns that are true alpha.

Addendum: The hedge fund fire sales continue

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