A new model for hedge fund fees would better align interests

Hedge funds are meant to be expensive.

They're the luxury goods of finance. To be able to justify this expense, they have to provide the performance asset owners expect of them.

There has been growing unease among asset owners that hedge fund fees are too expensive for the level of performance in recent years. Some asset owners have eliminated or reduced their allocation to the asset class or are considering making such moves.

Even so, hedge funds remain a vital component of an overall portfolio due to their ability to provide a return exposure that is unavailable in any other format — also known as alpha. But hedge fund managers should be paid well only if they perform well.

The typical fee structure — a 2% management fee based on assets under management and 20% based on performance — has failed to serve asset owners well.

Because of the challenges, the time has come to scrap the typical fee structure and develop a new fee model.

A new fee framework would better balance the interests of asset owners and hedge fund managers, and better encourage outperformance. It would become a powerful tool to help asset owners choose the right hedge fund manager.

A new framework should charge a lower management fee while subjecting the performance fee to a hurdle rate. Most hedge fund managers do not incorporate hurdle rates in their fee schedules. Under it, they must achieve an agreed upon minimum performance before they start taking a cut of their clients' money from returns.

With a standard fee of 2% and 20%, for a 10% gross return a manager receives 3.6% in fees, leaving the investor with 6.4%. If the manager were paid purely on performance, to earn a 3.6% total fee from a 10% gross return, the performance fee would have to be 36%. Such a fee is too large. In ideal world, a hedge fund manager would be paid only based on their performance, but such a model is not realistic because hedge fund managers have fixed costs and must pay bills throughout the year.

The management fee should really be seen as an advance on the performance fee rather than in addition to it. It would be good to do away with the management fee altogether, but in practice this would not work because it is necessary to cover a hedge fund's running costs. It should not be enough on its own to make a hedge fund manager rich. A thorough due-diligence process should be able to identify the running costs of a manager's strategy and hence an appropriate management fee.

Encouraging good performance

Lower management fees and higher performance fees — with appropriate hurdle rates — are an important means of encouraging hedge fund managers to perform well for their clients.

This fee framework works only for hedge funds seeking to achieve an absolute return. If a fund has a high beta to the equity markets it makes no sense to pay the manager 20% of the MSCI World index's rise if equities gain in value but nothing if the index falls. So this framework can only apply to strategies with a large alpha contribution: the value that a manager adds through their skill rather than exposure to the market beta, because asset owners can access such sources of return much more cheaply than through hedge funds. Examples of strategies with high alpha potential include market-neutral, arbitrage and long-short equity strategies that can dynamically manage their beta or indeed have close to no beta at all.

The new fee framework is all about asset owners saying that they're not going to pay a manager a high management fee up front, but will pay based on a manager's performance — and the quality of that performance. In essence, an asset owner is making a deal with the manager. If the manager delivers exactly what is expected, the manager can potentially receive exactly as much money as it would have with its initial fee schedule. If a manager does better, the asset owner will pay more. But if a manager's performance is disappointing, it will receive less than it would have under the current typical fee structure.

For asset owners unsure about which hedge fund managers to choose, this alternative fee schedule represents a marketing opportunity for a hedge fund manager.

If the manager has confidence it can achieve the results it claims, it should take up an offer to transform its fees to skew more toward the alternative performance fees, a framework that promises to provide higher fees through higher performance. But if a manager lacks confidence in its skill, it is likely to turn down the new fee schedule. So this alternative fee framework becomes a useful way to ascertain the conviction a manager has in its achievable return. That choice in fee structures — traditional or alternative — would help asset owners screen hedge fund managers to make better selections.

Brian Johnson is director and head of investment solutions for the hedge funds team and a member of the hedge funds investment committee at Unigestion, SA, Geneva.