Loyalty rewards: A better fee structure for all

Hedge funds have not met pension plan clients' actuarial assumed rates of return.net of fees in the challenging zero-interest-rate policy environment, despite generally producing returns since the financial crisis that met investor expectations gross of fees. One outcome has been an outcry from pension funds for a reduction in fees to raise the performance needle.

The structure of the industry needs a framework that turns a zero-sum game (less for the managers, more for the investors) into a positive-sum game in which both managers and investors benefit.

Allocators to the largest funds generally hold no market power to sway managers. Nearly $3 trillion is invested with hedge funds, every dollar of which represents an existing fee agreement between managers and investors. No matter how much allocators would like to pay less, the managers of these funds are unlikely to change without some give and take.

A resolution must create a win-win for both managers and allocators, and we believe the trade-off between fees and duration of investment is a good place to start. A number of established managers offer long-duration share classes that charge below-market fees, but many allocators are uncomfortable or unable to accept illiquidity in a relatively liquid investment area. A better fee structure for more participants might be one that rewards investor loyalty with reduced management fees over time.

Consider the following structure for a hedge fund's management fee:

Years 1-3: 1.5%

Year 4: 1.4%

Year 5: 1.3%

Year 6: 1.2% (continuing to decline 10 basis points per year)

Year 14 and beyond: 0.5%

In this “loyalty rewards” arrangement, allocators pay less over time and managers build subtle incentives to promote lower client turnover. Most allocators enter new manager relationships with the intent of investing for the long term, but in aggregate allocators collectively fall short. The current structure of the industry carries few incentives to elicit long-term behavior from allocators.

Allocators do not have staying power because unanticipated change tends to throw a wrench in their plans. Investors dedicate tremendous effort to their new investments, conducting exhaustive searches, spending countless hours in meetings and due diligence, writing lengthy reports detailing their work, and preparing thoughtful presentations for their boards. But all of this work goes for naught when changes in personnel, markets or mindset takes hold, often falling into one of the following categories:

• Change in personnel: new chief investment officer, new consultant, new board members;
• Change in markets: allocation rebalancing, liquidity needs, revised investment strategy;
• Change in mindset: grass-is-greener mentality; response to subpar short-term performance; changing of minds.

A fee structure that rewards loyalty encourages allocators to behave like long-term investors by creating a switching cost to churn. Imagine the difference in a board discussion if an allocator that is considering replacing a long-standing manager with another would incur a higher management fee. Allocators and boards at least would give serious consideration to the cost of changing managers. Other factors aside, the lower headline fee becomes an irreplaceable asset.

This arrangement rolled out across the industry could meaningfully reduce aggregate fees paid to managers and more efficiently allocate capital to longer-duration providers. Were we to assume that investors have roughly the same skill in selecting managers, then those who are more patient with their managers would generate higher returns than their peers over time by the amount of fee savings. These more patient investors might get rewarded through inflows (for for-profit businesses) or bigger roles (for non-profit CIOs), putting more of the industry assets in the hands of those less inclined to churn their portfolios.

Managers also would recognize the benefit to this structure. By creating a positive switching cost for existing clients that does not exist in the industry today, managers would benefit from more asset stability.

Loyalty rewards provide a rare advantage for new funds over established ones. Twenty-year-old firms with billions of dollars under management might struggle to properly reward clients for loyalty since many of their clients have paid full fees for many years. Slashing the base revenue of a business overnight would be too disruptive for these organizations to bear.

Established managers might want to consider how to build in switching costs for their clients over time. Startup managers, in contrast, can structure their business for long-term success by adopting this model quickly.

This modest proposal of a loyalty rewards fee structure could go a long way toward gradually accruing more of the value added generated by hedge fund managers to their long-standing supporters in exchange for promoting long-term investment relationships to the benefit of all. As you engage in your daily investing practice, I encourage you to suggest this fee structure to your legal advisers, managers and prime brokers, those best positioned to enact the innovation.

Ted Seides is co-chief investment officer and president of Protege Partners, New York.