Hedge fund fees – a perfect solution

When one thinks hedge fund fees, the phrase “2 and 20” — meaning a 2% management fee and 20% performance fee — usually comes to mind. This wasn't always the case.

In the 1980s, “1 and 10” was not atypical. As more capital came into the space, however, fees initially rose to 1.5/15 and eventually to 2/20. Investors accepted the inertia of rising fees because net returns were still in the midteens and, on a risk-adjusted basis, still compelling compared to long-only investments.

Average hedge fund returns have since declined, yet fees, like an object thrown into space, have continued to levitate without gravity to pull them down. This is now changing as more investors realize the 2/20 structure doesn't make sense at today's return levels. Annual returns of the HFRI Fund Weighted Composite index have diminished to around 5% today from about 20% two decades ago. At this level, less than half (about 48%) of the returns the manager generates go to the investor under a 2/20 fee structure.

Disappointingly, we believe many investors have reacted to this inversely correlated relationship of fees and returns with a suboptimal solution. Many have simply redeemed from their hedge funds and redeployed the capital into passive strategies. On the surface this decreases overall fees. Below the surface, this represents a shift of portfolios out of alpha, making them more reliant on beta and removing the downside risk protection offered by active management and hedging.

Others have pushed for lower fees — seeking to reduce the management and/or incentive fee, but leaving the basic structure in place. While this represents progress, it is an imperfect solution. The current structure motivates some managers to pursue asset growth at the expense of performance, since generating low returns on a large asset base can result in more fees vs. generating high performance on a smaller asset base.

Instead of approaching fees as a situation where one side wins and the other loses, the industry needs to rethink the fee structure to create a “win-win” solution. The solution should be attractive to both managers and investors, and should align their interests and the outcomes they pursue. The solution also needs to be easy to understand and straightforward to implement, and should work for a broad range of strategies and manager types. We believe this optimal approach involves lowering the management fee and creating a tiered performance fee.

Managers should have a modest management fee of 1%. Then managers should charge a 10% incentive fee below a 10% net return, and a 20% incentive fee for returns above 10%. Instead of “2/20” we now have “1/10/20." We refer to 1/10/20 as a perfect balance. Starting from midsingle-digit returns, in excess of 70% of returns go to investors.

This 1/10/20 solution fixes the issues with the current 2/20 structure. By creating a tiered performance fee, it ensures investors are getting an appropriate percentage of returns when performance is low but keeps in place the incentive for managers to receive substantial profits if they outperform. It motivates managers to strive for the double-digit returns that built the hedge fund industry. And by shifting the focus to the performance fee, it reduces the incentive for a manager to raise assets to levels that degrade performance.

Theory aside, there is the practical matter of how a manager's fees would change to reflect this or any new fee structure. We believe that meaningful change in fee structures is more likely to come from the future generation of large managers, not the current one. While it can be difficult for an established manager to change fees, newer ones are much more flexible in trying to ensure their fee structures make sense for today's environment. Newer managers also will view fee structures that better align with investors as a competitive advantage as they vie for investor capital.

We and many of the smartest investors we know believe that risk assets (i.e., beta) are overvalued due to financial repression and easy central bank monetary policy globally. Regardless of whether markets are due for a correction, eight years into a bull market, we don't believe that doubling down on beta and removing alpha should be the investor solution to an unbalanced hedge fund fee environment. Instead, we hope that more investors and managers use this opportunity to move fees toward structures that properly align incentives and provide a firm foundation for the future.

Lastly, we believe alignment of incentives is particularly topical and right out of the playbook from the 2016 Nobel Memorial Prize in Economic Sciences, which was awarded to Oliver Hart of Harvard University and Bengt Holmstrom of the Massachusetts Institute of Technology for their contributions to contract theory. When presenting the award, Professor Per Stromberg, chairman of the Nobel Committee for the Prize in Economic Sciences said: “The fundamental aim of contracts is cooperation. A well-written agreement creates a golden compromise between parties with partly divergent interests. … Poorly designed agreements can lead to deception and unnecessary conflicts. Well-drafted contracts, however, encourage each party to act in a way that benefits everyone.”

We believe this is exactly what 1/10/20 does for the hedge fund industry.

Adil Abdulali is portfolio manager; Jeffrey Tarrant, CEO, CIO and co-founder; and Michael Oliver Weinberg, chief investment strategist with Protege Partners LLC, New York. This content represents the views of the authors. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.