Do Managers Take Too Much of the Pie in Hedge Fund Fees?

Rethinking Hedge Fund Fees and Performance

Historically, the standard hedge fund fee structure has been “2 and 20,” or a 2% management fee and a 20% performance fee (the management fee is a percentage of the fund’s net asset value, whereas the performance fee is a percentage of the fund’s profits). But growing frustration from investors and lagging hedge fund performance is altering the fee structure and allowing more room for negotiation.

Investors often measure hedge fund performance directly against an equity index which, considering the broadly diversified, multi-asset class mix of investment strategies, is probably a poor reference point.

Nevertheless, since hedge fund indices have underperformed the S&P 500 Index every year since the Great Recession of 2008, these comparatively disappointing returns, combined with high fees, are causing investors to increase pressure on their hedge fund managers.

It is worth noting that if a hedge fund loses money or cannot surpass its high-water mark, the manager does not receive a performance fee. This structure is designed to align the interests of hedge fund managers, who typically invest their own money alongside their investors.

An Evolution in Hedge Fund Fees

An investment survey by JP Morgan references an interesting statistic in hedge fund fee structure: 17% of funds now use a “1 and 30” model (i.e., 1% management fee and 30% performance fee).

Still, only 38.8% of hedge fund managers negotiated their management fee as of September 2019, while even fewer managers were willing to negotiate their performance fee (11.3%).

Despite some managers feeling the pressure, investors are still looking for greater evolution of hedge fund fees. JP Morgan reports that more than half of surveyed institutional investors are looking to negotiate fees with hedge fund managers.

While this fee pressure is positive for investors, research by Cliffwater shows that higher performing hedge funds often have higher fees, suggesting that fees tend to be commensurate with talent. Creating arbitrary fee limits could have unintended results, such as leading to suboptimal hedge fund selection.

Rather than focusing on absolute fees, investors should examine returns net of fees to ascertain value provided by hedge fund managers.

Hedge Funds and Risk Mitigation

Hedge funds have the ability to go both long and short stocks, bonds and other investment securities, thereby hedging their market risk. Historically, they have earned a return close to stocks at a risk level closer to bonds.

Despite recent hedge fund performance, investors are still incorporating hedge fund investments to reduce portfolio volatility. That same JP Morgan survey found that investors anticipated an increase in allocation towards volatility-related strategies, including a 44% increase in volatility arbitrage strategies and a 34% increase in equity market neutral strategies.

Given current market conditions, as well as the potential equities bubble created by historically low interest rates, investors should consider allocating a portion of their portfolio to hedge funds.

California State Teachers’ Retirement System (CalSTRS), one of the nation’s largest public pension plans, established a new asset class in 2015 called “Risk Mitigating Strategies” to hedge against volatile stocks that represent more than half its portfolio. The allocation includes global macro and managed future strategies, both uncorrelated hedge fund investment strategies. Since 2015, CalSTRS has maintained 9% of its portfolio in the strategy (roughly $20 billion of its $219.2 billion portfolio).

Calstrs’ CIO Christopher Ailman noted, “We have a very large bias to growth in GDP in our portfolio. We want to hedge that. We actually want the hedge-fund strategies not for extra return. We are doing the opposite. We think that they actually can be a defensive strategy.”

Despite concerns about performance and hedge fund fees, 80% of institutional investors believe that if they were to remove hedge funds from their portfolios, their overall level of risk would increase. Particularly with fees coming down, the short exposure offered by hedge funds is attractive today in the context of inflated public stock markets.

If improperly executed, hedge fund allocations can result in high fees with little value generated. Simply adding hedge funds is not enough—allocations must be managed, fund selection is critical and access to a diverse range of strategies is key.

In addition, strategy risk and levels of liquidity may make certain hedge funds inappropriate for certain investors. However, with the inclusion of high-quality managers, proper allocation of funds, and alignment of interest with respect to hedge fund fees, hedge funds can make substantial contributions to a portfolio.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Options for the Accredited Investor and Basic Investment Principles 101 – From Asset Allocations to Zero Coupon Bonds 2019. This is an updated version of an article originally published on November 16, 2016.]