Insight: Hedge fund haters have a point

Walk around London’s Mayfair or New York’s Midtown at the moment and – if you can avoid tripping over unemployed bankers – you can listen in on plenty of conversations about kicking hedge funds while they’re down.

This is not about punishing flashy fund managers for their worst ever year, although there is no shortage of schadenfreude. Rather, investors are riled about fees, the famed “2 and 20” – 2 per cent a year and 20 per cent of profits – the standard hedge fund charges.

It is now commonly accepted that fees will fall, as hedge funds’ demands for capital exceeds supply from investors, and market forces work their magic. In fact, fees are already falling at many funds, something Bentley dealers and yacht brokers should be watching closely.

But investors are not just worked up about hedgies creaming off too much money. They are also becoming increasingly vocal about the structure of fees.

Changes being demanded include hurdle rates, or minimum returns before performance fees are paid; clawbacks of performance fees if good years are followed by losses; greater transparency; information about who other investors are; and even the right to trade their hedge fund holdings in the secondary markets.

About time too. Hedge fund fees are outrageous, not because of their size– although sensible investors should worry about this – but because they fail to do their job properly.

One of the key differences between hedge funds and mainstream funds is that hedge fund managers are supposed to have their interests aligned with those of investors, thanks to the performance fee.

But there are four areas where the fee structure is broken.

The first is the ability to make money for doing virtually nothing.

Consider a $1bn hedge fund, charging 2+20, which made 5 per cent in 2007 – possible with risk-free government bonds. This would earn the manager a $30m fee, with $20m of profits left to give to investors. The manager could sit on a beach all year and still collect his bonus.

The second problem is connected: even a very successful hedge fund may pay most of its outperformance, “alpha” in the jargon, in fees.

Calculations by actuaries Watson Wyatt show that even where a fund appears to be making money, the scale of fees it takes can be extortionate because so much of many hedge funds’ returns comes from being long equities.

It considers a typical long-short equity hedge fund charging 1.5+20, with full exposure to the market and a 30 per cent short position. If such a fund managed to outperform by 5 percentage points on both long and short positions – a very strong performance if sustained – it would cream off 65 per cent of the “alpha”, the value added by the fund, in fees.

These problems are easily fixed by imposing a hurdle rate: performance fees are not earned until the manager has exceeded a base level of profit.

The third problem is the lack of risk for hedge fund managers. If they do well, they get fat fees. If they do badly the next year, they don’t have to repay anything - encouraging wild risk taking in the hope of getting rich.

Hedge funds have recognised this problem for their own staff, who are typically paid bonuses based on their own performance. Big names such as Tudor Investment Corp and Brevan Howard impose “clawbacks”, holding back part of bonuses until later years and withdrawing them if money is lost.

But none has yet accepted a clawback provision for their fees. They should.

The final problem is the incentive for big funds just to produce moderate performance to hold on to assets. Annual fees are designed to finance the hedge fund manager’s business, with performance fees paying bonuses. As funds grow, though, the annual fee becomes a big source of profit in itself, suggesting it should be lowered as assets expand.

Consider John Paulson, founder of Paulson & Co in New York. He offers a bargain in hedge fund land: fees of 1+20, against the norm of 2+20. But with $35bn under management, that now gives his firm a steady income of $350m a year, without doing anything.

Mr Paulson has, commendably, ignored such issues, making profits last year and producing eye-wateringly good returns in 2007 thanks to his prediction of the subprime crisis.

Fixing these problems is difficult, because investors have different priorities, as a survey of its clients by Albourne Partners, which advises investors with $200bn in hedge funds, showed.

Not all of the above problems apply to every fund, but with thousands of investors clamouring for different fee structures, hedge funds have an incentive to sit tight and change nothing.

Investors should get together, work out what they want and set a new standard for funds to comply with, to ensure they take advantage of what could be a brief period of negotiating power.

james.mackintosh@ft.com