This is the seventh article in an ongoing series on managed funds – part one: using the Sharpe ratio to assess fund performance; part two: identifying appropriate benchmarks for private equity funds; part three: evaluating common measures of private equity performance; part four: understanding the negative impacts of pension fund complexity; part five: revealing the perverse incentives of pension fund managers; and part six: demystifying co-investment.
“Competition is the keen cutting edge of business, always shaving away at costs.” – Henry Ford
Within the universe of asset managers dealing in publicly traded assets, no group is more expensive to work with than hedge funds. Hedge funds are the most expensive bunch. How expensive, however, is often underappreciated.
Compounded over time, hedge fund fees eat away at returns. Charging 2% of the fund’s principal as a management fee and 20% of the investment gains as a performance fee has long been a norm of the industry.
To understand the sheer scope of the impact from fees, one can turn to Simon Lack’s excellent book, "The Hedge Fund Mirage." In his study of hedge fund managers operating between 1998 and 2010, Lack found that hedge fund managers earned a staggering $379 billion in fees while delivering their clients just $70 billion in net returns.
Lackluster managers have managed to cloak their poor performances for decades thanks to investors’ use of insufficient performance measurement tools; many have relied on arithmetic average returns or crude ratios like the Sharpe ratio to judge performance, instead of using more effective measures such as net present value calculations to test funds’ track records.
Wake-up call on fees
Due to their high costs and worse-than-advertised performances, hedge funds have faced mounting pushback against their fees. Thanks to growing sophistication among allocators, as well as mounting competitive pressure in an industry getting more crowded by the year, fees have experienced downward pressure. Yet they remain staggeringly high across the industry, and few investors in hedge funds grasp the sheer magnitude of the impact that performance fee structures have on their returns. Once exposed to the cold light of day, the performance fees the hedge fund industry demands look wholly insupportable.
Given the scale of the fees they have been paying for decades, it is astonishing that investors have waited so long to mount a challenge to the industry fee regime. Institutions with large amounts of capital have led the charge. Major pension funds in particular have been taking hedge funds to task. Some have withdrawn their capital from the sector altogether, including California’s massive pension fund, CalPERS. The floodgates are opening as fewer allocators are willing to shell out huge payments for performance that is far less than advertised.
Fund evolution
Another strike against traditional hedge funds has been the emergence of a new breed of fund that operates on a low-cost basis. Similar to Vanguard’s transformational strategy of cost minimization in the mutual fund market, some hedge fund managers have created new fund structures that can implement conventional hedge fund strategies but at low cost. Some even charge investors as little as 50 basis points while providing active management strategies akin to the major hedge funds.
Some of these funds have taken on the “smart beta” brand that has come into vogue of late. Yet some of the funds mimicking classic hedge fund strategies are doing more than smart beta implies. Such funds have been shown to display correlations of 90% or greater with the realized returns of the major branded hedge funds they seek to emulate. The result is similar top-line returns but better bottom-line returns thanks to fees being slashed.
Such products seem to be gaining momentum with investors, but they are still quite new. They also carry some worries since they are mimicking actively managed funds that do charge higher fees. For there to be a fund to mimic, someone ultimately has to be paying those fees. At the same time, many of the dominant active management strategies are sufficiently well known that they can be implemented without a benchmark or traditional fund to shadow.
A low-fee future
The era of high fees seems to be gradually grinding to an end. Yet there remain many active managers, and more emerge every day, who continue to seek investors willing to pay something approximating the traditional fee structures we know and hate. As long as people think there are excess returns to be had with these managers, they will stay in business. But as their strategies become easier to identify and emulate, and as competition wears on, hedge funds will have to learn to live with fees more akin to mutual funds. That day will no doubt be welcomed by institutional allocators and individual investors alike.
