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Hedge fund fees rise as industry demand returns

Date: Thursday, September 27, 2012
Author: David Walker, Investment Europe

Hedge fund fees have been the focus of intense discussion in recent times, but certain investors say that better managers deserve the fees they earn

These are possibly a hedge fund manager’s favourite words: “Two and twenty”.

Together, they explain how hedge funds charge their clients – by taking 2% of fund assets plus 20% of profits. Just as important, though, they also explain why some successful managers are among the world’s richest entrepreneurs. But during the financial crisis, you could almost make an allocator’s blood boil, just by saying ‘two and 20’.

For decades before, allocators had accepted paying the fees that made managers rich. Day-one investors in AW Jones & Co, the world’s first hedge fund, did not mind as Alfred Winslow Jones made over 5,000% in his first 20 years, according to industry biographer Sebastian Mallaby.

Performance fees

Many hedge fund allocators accepted that, up to 2007, you had to pay for talent.

“We were happy to hand over 20% of the gains, because the gain in 2007 was 10%, and that was double what we made on the S&P 500 and better than fixed income, too,” says one.

But then in 2008, managers lost 19% on their investments, so fees and how they are collected came to the top of some investors’ agenda. Managers moved quickly, by cutting fees in many cases.

Ansgar Guseck, senior partner at Cologne-based allocator Sauren, says: “The performance fee should give the right incentive to the manager. It should not be a tool to maximise only the profit of that manager.”

For funds in the most trouble, a quick shift to ‘one and 15’ was not unusual, although sometimes investors had to agree to commit for long periods at the same time.

Other managers cut their incentive fees even more sharply, but unusually asked investors to pay them before the fund had made up for all past losses. Some funds – and funds of funds – installed mechanisms that would release charges back to clients if the products later underperformed.

By the start of this year, database Eurekahedge found that the industry’s average fee levels had dropped to 1.5% and 17.7%.

There has been further poor news on performance this year. By August, managers had not even managed to make half the gains of the S&P 500 (4.6% versus 12%), so investors would have made more in US shares by buying far cheaper ETFs. Furthermore, according to analysis published by Goldman Sachs, hedge funds lagged the average large-cap mutual fund’s gain of 9.9%.

Only one in every 10 hedge funds has beaten the US market, and one in every five lost money.

By August, the 50 US stocks that hedge funds were relying on most heavily – as suggested by frequency of mentions in managers’ June 13F filings analysed by Goldman Sachs – were up only 9%. They fell twice as sharply as the S&P 500 over the second quarter.

After all this, you might expect there to have been further widespread pressure on fees this year.

But the result has not been irate investors – quite the opposite, in fact. Analysis Eurekahedge conducted found by May fees were actually on the rebound, at 1.6% and 18.3%.

Analysis of the eVestement/HedgeFund.net database finds almost $1 in every $10 in the industry now attracts an incentive fee of more than 22%. Morningstar’s tables show at least five funds retain 50% of their gains. One, the Lyxor/Weiss Multi-Strategy Fund Ltd, increased to this level in April, although it eliminated its fixed fee at the same time.

But paying 50% is far too hot for some. When the head of one Swiss family office saw the 50% rate, he simply said: “Wow!”

Ronnie Wu, Asia CIO at Swiss allocator Gottex, says: “It is hard to imagine paying such fees, as the risk reward is not favourable. We do not rule it out, but we would need to see a really unique strategy, or a highly capacity-constrained fund, to justify such fee structures.”

But generally, it seems, allocators are comfortable with their managers, and fees.

Worthy investments

François Savary, CIO at Swiss private bank Reyl & Cie, says: “The hedge funds in which we are invested in have been worth the money so far this year.”

He cautions against judging managers over too short a time period, and against judging them too harshly for 2008. “We should keep in mind that during the 2008 financial crisis, hedge funds continued to outperform traditional investment styles in bonds and stocks with much less volatility. We have seen a similar situation during the second part of 2011, and we remain convinced that hedge funds will resume their uncorrelated return pattern.

“We should assess hedge funds’ ability to outperform over several cycles. Also, manager selection is instrumental, since within a specific strategy, the dispersion of returns remains high. We believe that long-term investors will benefit from allocating capital to hedge funds and the extra fees paid provides access to the world’s top-tier money managers.”

Allocators agree that, while fees are an important part of decisions about investing, they are not a decisive factor. Guseck says they are “One factor among several to consider in our decision when we look at a fund.”

Hasan Aslan, fund manager and alternative funds analyst at Reyl & Cie, says the two and 20 structure “is not outdated in our opinion. It incentivises the hedge fund manager if, and only if, the client is making money. Most of the funds we invest in still use this model. It is one of the reasons why the hedge fund industry still attracts talented people.”

Reyl & Cie does not automatically bargain to get lower fees as part of its process: “If fees are standard, they are not part of our decision-making process, unlike liquidity which must fit an adequate asset-liability model,” Aslan says.

But he adds the bank may pay less when investing in a fund early. The industry’s newer entrants are making across-the-board fee cuts standard on their new funds, via so-called ‘founders’ round’ share classes. (See separate box, page 12.)

Guseck says his firm makes a point of negotiating the best terms for its clients, but it would not invest in a manager only because he offered low fees. Overall, Sauren agrees good managers deserve to be well remunerated by their investors.

David Lashbrook, senior analyst at allocator Momentum Global Investment Management, adds that high-quality managers who run what he terms ‘expensive’ strategies deserve to be paid the industry standard.

“For US residential ­mortgage-backed securities, for example, you need to have people who are good at credit, good at structuring, people with long investment bank experience. Credit strategies need a phenomenal amount of investment to run well, with analysts running Monte Carlo simulations. You need a bigger team, so managers need to charge a bit more to attract the best teams.”

MGIM will also pay industry rates for capacity-constrained or niche funds active in areas such as credit and illiquid strategies. If managers fail to perform, though, pressure is applied on their fees.

Two and 20 summed up

One Geneva allocator says: “They are a natural first point for discussion then, because if you are not making much money in the first place, the last thing you want is to hand over a large part of that in fees.”

John Caulfield, CIO at MGIM, says the direction of charges “depends on the strategy and individual manager”.

But when it comes to the industry’s most popular strategy, equity long/short, he says. “The days of two and 20 are gone: that is where people are overpaying if they are paying two and 20.

“If you are paying two and 20 for a fund, the goal is for [its] net exposure to be a leading indicator of where the market is going. But, in fact, it is almost always a lagging indicator. It is very rare if you see risk reports from managers where they are building their positions into a falling market, or timing the market [correctly].”

(Allocators make one notable exception here – Lansdowne Partners’ Global Financials fund. Over the two years to mid-2009, according to investors, it made clients 35.7% navigating arguably the most hazardous market sector during that period. And what’s more, they said, this was on sub-average fee levels of 1.5 and 20.)

For managers whose performance lacks in some way, however, not just fee levels but also fee structures are scrutinised. Gottex’s allocation team in Asia has moved from managers’ hedge funds to their long-only funds in some cases over the past year where performance has come too much from ‘beta’.

Wu explains: “We have to separate [alpha from beta] and monitor it and make sure we pay accordingly. We look at the portfolio and for people with high beta we will say we can invest with you, but we will not pay hedge fund fees. Sometimes the manager will discount the fees we pay. If they do not, we would move to other providers willing to take a lower fee for what they do.”

He explained that in one case: “The manager may have been able to generate alpha, but it was beta that dominated, so we switched, and in effect voted with our money.”

In May, Consultant Towers Watson called for investors to separate manager ‘alpha’ from market ‘beta’, and pay accordingly. This suggestion was high among a number of ‘discussion points’ it raised for the industry. Another was that managers should only receive one-third of the outperformance from their skill in fees.

Damien Loveday, global head of hedge fund research at Towers Watson, says at present in some cases more than 100% of the ‘alpha’ hedge fund managers make is absorbed by their fees.

Loveday argues hedge funds terms “should be structured to allow for a more reasonable alpha split between the manager and ­end-investor than has previously been the case”.

Founders’ rounds

One development in the industry over the past year has been the emergence of share classes with fees specifically designed for early investors in younger funds – known as ‘founders’ rounds’.

In the past, managers who would reduce fees typically did so with individual investors, but the founders round formalises the reductions for all-comers. Managers say offering it is increasingly important to attract money. Allocators say they might pass over fund managers who fail to offer it.

Paul Graham, global head of hedge funds at Henderson, says: “When the star managers launched in the past they never did deals with founders’ share classes, but today everyone, or at least 80% of managers, are doing them. They may reduce the fees from two and 20 to one and 15.”

But Graham adds that Henderson does not offer fee deals on its established funds, as it believes the alpha its managers generate justifies their fees, of between 1.5 and 20, and 1.25 and 20.

Momentum Global Investment Management’s Caulfield says one and 10 is not unusual for founders’ rounds, “and we have seen 1% [management fee] flat, for the first $50m coming into the fund”.

Gottex Asia’s Ronnie Wu says: “Due to the relatively short history of the Asian hedge fund industry, many funds lacking [experience, assets and track records] are willing to discount fees to raise assets.

“Whether a fund can generate alpha is always an unknown, so it is difficult to predict that and negotiate fees accordingly. Our practice has been trying to compare the fee structure to its peer groups with similar background and strategies, and propose a fee accordingly. There is no fixed formula, just a negotiation process with multiple inputs.”

Reyl & Cie’s Aslan says: “Some new launches are applying a new fees model, however, most of them stick to the initial model as they want to be decently rewarded for their ability to outperform over the mid- to long-term. One must not forget that if the hedge fund does not perform, the manager receives only a 2% management fee.”