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.