Hedge funds hit by fall in management fees

By:
Helen Avery
Published on:

Pressure from large investors to lower costs; performance flat but few alternatives.

Hedge fund managers are known for their 2% of assets management fee and 20% of profits remuneration structure but according to recent research that is no longer the standard.

Average management fees in the second quarter of this year declined to 1.53% while average incentive fees have dropped to 17.78%, HFR’s latest data show.

Don Steinbrugge-160x186
  As long as hedge funds return more than fixed income then money will continue to be diverted into hedge funds

Don Steinbrugge,
Agecroft Partners

Don Steinbrugge, chief executive of hedge fund third party marketer, Agecroft Partners, says even those figures are not accurate. "While standard fees are in the ballpark of 2-and-20, a lot of the assets flowing into hedge funds are being charged much less."

Investment consultants and pension funds that make large investments can negotiate discounts of as much as 50%, he says. The argument is that why should they pay more when it costs the same to manage $100 million as it does $750 million?

"That kind of negotiation didn’t happen 10 years ago, but pressure from large institutional investors is likely to increase," says Steinbrugge. Last year the California Public Employees’ Retirement System (CalPERS) said it was dumping $4 billion of hedge fund investments, in part because of the cost of fees. 

Rethink

A number of hedge funds are rethinking their fee structures. Adage Capital Management is a $28 billion fund in Boston. It takes 20% of profits only if the fund outperforms the S&P500. It is a natural progression for hedge funds that fees became more reflective of their performance over a benchmark like the S&P. 

Last year, for example, hedge funds returned 2.98% as an average, yet the S&P returned 13.65%. That meant managers received an incentive fee of 20% – even though investors would have done much better to put their money in an index fund. Adage Capital also charges only 0.5% as a management fee. 

Ken Heinz, president of HFR Research, says the trend toward lower fees or changes in structure has been slow but steady. "The pressure in recent years has come in part from the low interest rate environment. The standard fee structure was developed in the late 1990s when the interest rate was much higher. Now fees seem more expensive by comparison." 

Small and medium-size funds in particular are having to adopt more flexible fee structures. While net inflows into hedge funds are rising, they are being directed mostly towards large branded hedge funds rather than start-ups. The number of fund launches has been dropping since 2011 and looks to drop further this year. At the end of August, 516 funds had launched this year, compared with 1,040 in 2014. 

 "Hedge fund seeding companies can receive a percentage of the hedge fund management firm’s revenue in addition to the performance on their investment," says Steinbrugge. "A good benchmark on revenue sharing is 25% of the firm’s revenue annually with a buy-out clause after year five."

Other start-up hedge funds are offering founders’ shares, he adds. These give day-one investors better terms than investors who come in later and tend to offer a fee reduction in exchange for the investor committing to a lock-up period on invested capital.

Hurdles

Heinz says funds are also introducing hurdle rates. "Some investors do not feel they should pay 20% of the gain when 2% of profits are simply the risk-free rate of return, so they are asking for the performance fee to start only above a certain level of return." 

This year has not been the best, in terms of performance, for the hedge fund industry either. By the end of August, the HFRI fund composite index was down 0.11%. The biggest losers have been in the energy sector. HFRI’s energy index was down 7.5% for the year. Technology/healthcare and volatility funds have been the best performers.

But in comparison with the S&P500, the average losses of hedge funds are actually outperforming. On September 23, the S&P 500 was down 5.7% year-to-date. That explains why inflows are continuing to increase. In the first two quarters of this year, $40 billion in net new money went into hedge funds. Total assets under management are now at record highs of $2.97 trillion.

Where else are investors going to put their money? asks Steinbrugge. "Equity markets might tank. Real estate looks iffy. And as long as hedge funds return more than fixed income then money will continue to be diverted into hedge funds."

Worries

A rotation in strategies is occurring however. "A lot of people are worried right now," he says. "They are worried about interest rates rising, spreads widening and equity markets selling off. The next six to nine months there will be more demand for strategies not correlated to capital market so very different to last three to four years where money was going into distressed debt, structured credit, event-oriented strategies and long short equity." 

There will be more interest in lower net long short equity, CTA, global macro, relative value fixed income and maybe volatility and direct lending and reinsurance, Steinbrugge says. 

Given the challenging market, HFR’s Heinz says fees are unlikely to continue to decline at a faster rate. "Demand for hedge funds is likely to increase," he says. "This year was a reminder to investors that equity markets are not going to produce 20% annually, and that means more money will move into hedge funds. As such, pressure to reduce fees will slow for the largest funds that have demand. Indeed, if interest rates start to rise they may even be able to justify a higher fee structure. But they will be in the minority."