hedge fund fees decrease

The Downward Trend in Hedge Fund Fees

hedge fund fees decrease

There’s been a general downward compression of hedge fund fees as investors start to demand better returns and funds face the growing demand to compete in a crowded marketplace. Added compliance costs associated with Dodd-Frank is a further challenge for funds as investors push fees down. Typical hedge fund fees are structured around a management fee, which is a percentage of assets, and performance fee, which is a percentage of profits. The standard model is a 2% management fee and 20% performance fee, or what is commonly referred to as carry or carried interest.

Are Hedge Fund Fees Too High?

There’s a general sentiment that these fees are oftentimes not worth the potential upside, particularly with the below average performance of hedge funds over the last few years. In a research report by Hedge Fund Research Inc, an investment in an index of equity hedge funds in the last five years returned 4.38% a year, while the S&P 500 earned 14.31%. On the other hand, the market has been bullish for the last 6 years so the S&P 500 would be a very difficult index to beat.

Relative returns of hedge funds will certainly be better when the market turns down, as many fund strategies seek to provide uncorrelated, market-neutral returns. During the bear market of 2007-2009, hedge funds clearly outperformed the S&P 500. Many defenders of hedge funds point out the short-sightedness of investors during bull markets, where investors become greedy for even better returns, which can be a sign of incoming turbulent times. Hedge funds hedge, and investors pay for this trade-off as funds provide stability in bear markets, but sometimes trail behind market indexes during bull markets.

To be sure, some top hedge funds are well worth the high fees. As was stated above, in down markets hedge funds serve as a strong income preservation tool. In the early days, hedge funds maintained the 2/20 fee structure because they were unique and good enough to merit those fees. Now there are over 8,000 hedge funds overseeing about $3Tn. Returns are naturally going to normalize as more industry players come to market, certain funds perform poorly, and mean returns decrease. So why should investors pay for average returns, and why should fund managers earn significant fees for average performance? Investors are starting to catch on, and in today’s market it will be very difficult for a startup hedge fund to attract investments utilizing the 2/20 structure.

The increased allocation of institutional money into hedge funds can provide a reason for why fees are still being paid for mediocre results. It is estimated that over 50% and possibly up to 70% of hedge fund assets are institutional including pension funds, endowments, and insurance companies. These institutional clients have extremely long investment horizons and are concerned more with preserving money than earning huge returns. In this respect, hedge funds are great instruments for institutions seeking to preserve capital with market-neutral strategies.

lower hedge fund fees


The Concern With Hedge Fund Fees

Fees are also being brought to light by industry studies supported by powerful fee dissenters. A great study by Keith Goggin measured return calculations of Berkshire Hathaway, Warren Buffett’s company. The returns illustrated a hypothetical scenario in which Berkshire Hathaway was run as a 2/20 hedge fund. Berkshire Stock has risen 17.4% since 1987. If Berkshire was run as a 2/20 hedge fund the investor would have earned 12.4%. This is a significant decrease in investor returns. Warren Buffet is also famous for making a bet with Protégé Partners, a fund of funds hedge fund manager, that the S&P will beat the hedge fund over a 10 year period. Buffett is obviously skeptical about the cumulative effect and costs of running a hedge fund while taking into account management and performance fees. Evidence suggests that Buffett will probably win that bet.

Another problem with fees is the imbalance of incentives. A study by consultant Tower Watson determined that the returns generated by a managers’ skill, not market related movements, rewarded hedge funds with 66% of the upside. This is meant to show that the most skilled managers will enrich themselves more proportionally than the upside that’s enjoyed by the investor. So even when a manager beats the market, most of the spoils will enrich the manager. Tower Watson was also instrumental in advising CalPERS in its eventual decision to terminate its $4Bn hedge fund position. These large investors are starting to feel that the risks and high costs associated with funds will not be worth the sometimes average, and sometimes dismal, hedge fund returns. Data from Preqin shows that the 2/20 model is slowing dying. Base fees have fallen to 1.5% while average performance fees are 18.7%.


The Future of Hedge Fund Fees

Fee structures are starting to innovate to further align the interests of investors and managers. This has been the general trend, particularly with emerging managers to attract more investment. Some of these fee changes include implementing a sliding scale for fees where management or performance fees decline as the AUM increases, longer measurement periods for performance fees, and hurdle rates based on benchmark indexes. These structures create a more balanced environment where the success of the hedge fund is more directly proportional with the returns earned by the investor, and fees can be more properly justified.


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