The recent experience of hedge fund fees offers interesting insights into a more generic attitude of professional investors on this issue. As with all services, the buyer is seeking not just the provision of a high quality product that delivers on its stated aims, but also value for money. In investment management, there is an inevitable connection between the perception of the magnitude of excess performance (over a benchmark) that a fund manager can deliver, and the size of the fee that can be charged for this anticipated reward. In the case of hedge funds seeking to renegotiate terms, the downward pressure is coming from a failure to deliver on expected returns, not from a change in perception in the value of the investment management service.
Indeed, there is no evidence that fees for those funds that have made money in 2008 are under pressure. While some of the more egregious terms that a few star hedge fund managers previously got away with will be harder to justify, the standard 1.5 and 2.0 model looks set to endure for those managers who have and are expected to continue to deliver positive, uncorrelated returns. The reality in hedge funds is that money is being reallocated from underachieving managers, who now offer lower fees, to managers with higher fees that investors believe can deliver superior returns – performance is ultimately the most important driver of the intention to hire.
Alpha is a scarce commodity, especially over the long-term, and hence should be able to command a premium price when it can be found and proven to exist. This was always the rationale for the charging structure of hedge funds, but as 2008 demonstrated, having the ability to identify sustainable and true alpha is a tricky proposition. Active long-only management fees are another example of the alpha proposition, as despite the a priori knowledge that the average manager cannot outperform the market after fees, active managers are able to charge substantially higher fees than index managers, based on the hope that the particular manager appointed will add value. As the performance disclaimers on all marketing literature tell us, past performance is no guide to the future returns.
A popular solution to this conundrum is the use of performance fees that align the interests of the client and fund manager. The hedge fund industry has shown a flaw in that argument, as the alignment is only when the semi-variance on returns is positive; performance fees give little protection in the case of falling returns when the losses totally overwhelm the modest saving made on the management fee.
Furthermore, is it even rational to use a performance fee in the first place if a fixed-fee alternative is offered? Is it not more rational, if you believe that you have identified a top-performing manager who can deliver alpha over the long-term, to take the fixed-fee option? This is as the total remuneration paid out will be considerably lower if those return expectations are achieved. As we have seen with hedge funds, performance fees can sometimes have the consequence of encouraging the manager to maximise return at the expense of risk control. In the institutional world this is less of an issue, as performance measurement periods for the incentive fee to kick in are three years rather than one. The measurement period is one area where there might be a change in the fee structure of hedge funds, with a lengthening in the period over which performance fees are calculated, in return for longer lock-ups.
It often seems the incentive to ask for performance fees by institutions is to keep initial charges low, rather than from a genuine belief that they offer a good value proposition. As with all businesses, there is a constant battle to find the right balance of charges that meet the interests of both the buyer and seller. Low management fees are clearly in the interest of the client. They do, however, turn the fund manager into an asset gatherer where scale is the ultimate goal, with an inevitable deleterious impact on their ability to add value as the assets under management grow. It is for this reason that smaller, more nimble boutiques are often able to charge higher fees than the behemoths of the industry, as they are perceived to offer better performance prospects and hence a better value proposition.
Ultimately, fixed fees with scale reductions for the growth in assets will continue to dominate, as they provide the simplest way of balancing out the interests of client and manager. The challenge of differentiating between the managers who only offer the hope of alpha generation and those that can deliver on that expectation will remain. As ever, the marketplace will continue to decide on what is the appropriate fee level on a case-by-case basis, with the ultimate sanction for failure of taking mandates away.
KEY points
■ The fall in equity markets has forced many investment managers to drop their fees to incentivise investors
■ Charging structures are flawed due to the scarcity of alpha and the difficulty of aligning investors’ and managers’ interests in a climate of falling returns
■ Boutiques can often charge higher fees, as they are perceived to offer better performance prospects
Andrew Parry is CEO of Sourcecap International
