Annus horribilis for hedge funds illustrates benefits of performance-based fees

Fees 25 Sep 2008

Cynics often describe the hedge funds not as a unique asset class or investment strategy, but as a unique “fee structure“.  To some extent, they are correct.  After all, mutual funds now use hedge fund strategies (long/short, 130/30 etc.) and yet we still call them mutual funds.  Conversely, many hedge funds pursue high-beta long bias (a.k.a. mutual fund) strategies, yet we still refer to them as hedge funds.  And indeed, one of the main regulatory differences between the two types of funds is the ability to charge a performance fee.

Hedge fund fees are generally viewed by the media with a jaundiced eye.  Many people have expressed frustration that hedge fund fees don’t seem to budge – even as hedge funds have been producing lackluster absolute returns.

Take 2008 for example.   A recent study by Eurekahedge recently found that 90% of hedge funds are currently below their hurdle rates or high water marks and are therefore at risk of earning no performance fee this year.  And that was only as of July 31.

As Financial News reports:

“The absence of these fees is helping to put the industry under pressure as never before…”

You’d think this would be welcome news to investors who are unimpressed with results this year.  As one Lipper official quoted by Financial News noted:

“Performance fees have been set up with investors’ interests in mind…”

The big concern seems to be that hedge funds either won’t be able to retain people without those huge bonus pools are worse yet, that they will shutter their funds altogether.  Yet closing a fund due to poor prospects isn’t such a bad thing for investors.   With little marketing momentum and a relatively small number of investors, it’s a lot easier to shut a hedge fund than it is a mutual fund.

As we reported in August, one leading academic recently warned that:

“Managers who gain from the size of their portfolios rather than the profitability of their investments will face strong incentives not to inform investors of deteriorating opportunities in the marketplace and not to return funds to investors when the return relative to risk of their asset class deteriorates.”

So it comes as no surprise that rather than continuing to charge a management fee when the manager has soured on the mandated strategy, some hedge funds are doing the right thing and shutting down – forcing investors to find a more profitable strategy somewhere else.

The FT contained a great example this week.  Writes the newspaper:

“The best-performing hedge fund manager of the past two years has closed down his funds and is returning money to investors after concluding that the danger of losing money from a bank collapse is too high.”

Far from being inelastic, overall hedge fund fees are actually very flexible – responding to every uptick and draw down faced by the fund.   In 2008 – the hedge fund industry’s annus horribilis – most hedge funds are currently below their high water marks.  This means their performance fees are likely to be zero.   Most hedge funds will likely end up charging only a management fee (on average around 1.5% according to research, not 2% as commonly cited).

Last year, the industry posted returns of around 10%.  Ignoring hurdle rates for a moment, that performance would add another 2% to hedge fund returns, meaning the average fee last year was close to 3.5%.  In other words, 2008 may see a 57% drop in fees.  Mutual fund fees, since they are not based on fund performance, have not responded at all to this year’s poor performance.

In fairness, this argument can only be made when one compares overall mutual fund fees (which are management fee only) to overall hedge fund fees (management fee plus performance fee).  On this basis, hedge fund fees can easily be two or three times higher than actively managed mutual funds fees (3.5%+ compared to, for example 1.25% or much less for institutional clients).

But academic studies have shown than when you account for the fact that actively management mutual funds have a very high market correlation, the fees paid by mutual fund investors for the non-correlated alpha-producing returns (ostensibly the purpose of the fee in the first place) are actually in the 5-7% range.

If true, then hedge funds charge generally the same fees as mutual funds – but unlike mutual funds, their fees are highly responsive to performance.  Same fees and more flexible? As counter intuitive as it seems, the average hedge fund fee may not be that evil after all.

This is especially apparent during periods of horribilis-ness.

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  1. tom brakke
    September 26, 2008 at 9:07 am

    I tackled this a few weeks ago from another angle in my piece

    While I got at least one comment from a reader who believed that I was saying that all hedge fund managers and incentive fee structures are bad, that was not my point at all. I think that there should be experimentation and innovation in the area of fee structures, just as there should be in all aspects of this dynamic business. I find it hard to believe that the basic fee structure that is used by funds large and small — successful at adding real value and not — should be universally embraced, especially when there are open questions about the behaviors that are incented in a variety of environments.

  2. Shelly Jacobs
    October 8, 2008 at 5:16 pm

    Bravo! As many managers are merely asset gathers, with little to no performance concerns, just in business as a depository in order to gather the management fees, and depending upon typical investor inertia to withdraw.

    Let’s applaud the hedge fund managers who at least try to earn excess Alpha for their investor clients.

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