In effect, a net-long hedge fund has two components: an actively managed long fund and a market-neutral fund. One can measure the fees on both parts as a percentage of either assets or of alpha — value added. Measured as a percentage of alpha, the fees might be exorbitant.
Suppose a long-short stock hedge fund is $3 million long and $2 million short. In effect, this vehicle is a combination of two separate funds: A market-neutral fund with $2 million long and $2 million short; and a long-only, with $1 million.
Combining the two compels investors to pay hedge fund fees on both. Assume fees are 2% of assets and 20% of gains. In a bull market, part of the return on the long-only portion would be beta, the result of movement in the broad stock market. The manager would receive 20% of beta, appreciation the manager did not create. These fees could swallow most or all of the alpha remaining after other fees.
Suppose the $2 million market-neutral portion generates a return (before fees) of 4% pure alpha, or $80,000 (2% on the long side and 2% on the short side). Two percent of assets plus 20% of the 4% gain produces fees of 2.8% (2% plus 0.8%) of assets, or $56,000. Net returns are 1.2% (4% minus 2.8%) of $2 million, or $24,000.
On the market-neutral component, the manager takes 2.8%/4% ($56,000/$80,000) or 70% of gross alpha.
On the $1 million long-only portfolio, assume the market is up 7%, and the portfolio is up 9%, or $90,000 (an alpha of 2%). Fees are 2% of $1 million ($20,000), plus 20% of the $90,000 gain ($18,000). Total fees on this long-only part are $38,000.
On the long-only portion, by itself the fee of 2% of assets exactly offsets the gross alpha of 2%. The additional fee of 20% of gains ($18,000) produces a negative net alpha (value subtracted) of $18,000 (1.8%).
Of the gross appreciation on the long-only portfolio, 7% of $1 million, or $70,000, is beta, appreciation due to the overall market rise and for which the manager is not responsible. Fees on that gain are 20% of that $70,000, or $14,000.
Before fees, total alpha is $80,000 on the market-neutral part and $20,000 on the long-only portion, a total alpha of $100,000. Because total fees are $94,000 ($56,000 plus $38,000), the manager has added only $6,000 in value after fees, or 0.2% of $3 million.
On the combination, the manager takes $94,000/$100,000 or 94% of the gross alpha. With a somewhat lower gross alpha on the mixture, the manager would subtract value after fees on the combination of the two parts.
In sum, with fees of 2% of assets and 20% of gains, the manager of a net-long hedge fund might take a disproportionate share of alpha. In a rising market, because the manager gets 20% of beta, total fees may swallow most or all of the alpha, leaving the clients with little or none of the gross value added.
William K.S. Wang is a Raymond Sullivan Professor at the University of California Hastings College of Law and a member of the board and investment committee of Access Lex Institute, a non-profit organization. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I’s editorial team.