“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients” — Warren Buffett
Hedge funds are a predominant force in the investment management industry. From the television show "Billions" to the films "Wall Street" and "The Big Short," they are often portrayed as savvy investment management talent, able to handily outperform over the long term. The narrative that you can share in the success and benefit from their brilliance is compelling. But it often plays out differently in real world applications.
It is not that hedge funds cannot generate alpha. Many do, and it would be irrational as an allocator to ignore their success. The prevailing issue, however, is that allocators often receive diluted benefits from alpha generation due to the burdensome fees they incur. Quite simply, hedge fund managers are benefiting asymmetrically from fees charged to pension funds, endowments and other large investors, in some cases passing along only 41 cents of every $1 made.
How did we get here? While many advancements in the financial sector have helped to drive down fees — think ETFs and mutual funds — hedge funds have endeavored to maintain the classic 2-and-20 model. Some managers may still deliver outsized returns, but their high fee structures can result in the end investor experiencing muted returns.
A less evident aspect to consider is, in some cases, pass-through expenses further erode the returns the client ultimately receives. Some managers have gone as far as to pass through to the end investor expenses for employee salaries, back-office administration and research fees.
A common defense from managers is that these fees support recruiting and retaining the “best and brightest” investment management talent. While this may be true, it does not negate that, even with the impact of elite talent, hedge funds often underperform benchmarks after factoring in the fees.
As the landscape of investment management continues to evolve there is some good news: (1) fees are generally negotiable and (2) innovative products are emerging that empower all investors, regardless of size, with alternatives to the traditional 2-and-20 model.
Why now?
At the end of the day, hedge fund managers survive on fees. And like any business, customers, in this case allocators, have an opportunity to negotiate what they are willing to pay. Multiple factors are now converging to make this the ideal time to challenge the traditional hedge fund fee structure.
First, interest rates have reverted to an elevated level after years of being zero bound. Many existing allocator contracts were signed during the zero-interest years, when less consideration was given to implementing cash hurdles. The cash hurdle effectively allows for incentives to be paid to hedge funds only if and when they outperform cash. If an allocator can earn close to 5% on cash, it seems reasonable to expect that benchmark should be applied when evaluating the alpha generated by a hedge fund.
Second, after incorporating fees, many hedge funds' returns trail the returns of passive index funds. Allocators should instead incur fees on the alpha, meaning returns in excess of market returns, taking into consideration correlation benefits of the strategies implemented by hedge fund managers. Similar to the cash hurdle described above, it is possible to negotiate fees to apply above a relevant benchmark return stream.
Third, there are an increasing number of alternative investment products that offer access to the return attributes of selective hedge fund strategies but at a lower cost than the 2-and-20. Hedge fund replication, for example, has advanced meaningfully over the past decade, and depending on the strategy, allocators may be able to find index-like products at lower fees, that also offer improved liquidity and better transparency than direct investments in individual hedge funds.
Fourth, it has become increasingly difficult for hedge funds to raise capital. This is largely due to (i) a seemingly persistent public equity market, (ii) years of underwhelming performance relative to other investment options, and (iii) significant rotation into private assets. All told, new launches are now less frequent and are being made at smaller size.
Next steps
As an allocator you have an enhanced ability to negotiate the fees you pay. You have likely picked great managers, but now is time to revisit to make sure the economics are equitable and reflective of the emergent competitive landscape.
So what can allocators do?
Start by addressing the cash hurdle rate. If an allocator can earn close to 5% on cash, it seems reasonable to expect that benchmark should be applied when evaluating the alpha generated. We are not alone in thinking this. A group of allocators led by the $202 billion Texas Teacher Retirement System in Austin recently raised this point in an open letter to the industry.
Next, improve the alignment of interests by evaluating and challenging pass-through expenses related to the manager’s operations. Managers should bear their cost of their operations independently, not dilute the returns the investor achieves. Sometimes these can be difficult to distinguish from valid fund operational expenses, which are important independent control mechanisms (audit, admin, tax, custody, etc.).
Consider employing different firms — how long have you been with your current hedge funds? As with other services, it may make sense to shop around and see what else is out there. Beginning new relationships can provide the opportunity to negotiate new fee structures from the outset.
Finally, initiate an allocation to lower-cost hedge-fund-index replication products. Use it as a benchmark to assess your existing managers and whether the fees they charge are worth it. Take advantage of the liquidity in these products to remain fully invested during transition periods between managers or to increase the overall portfolio liquidity profile.
Ultimately, allocators have the fiduciary responsibility to protect clients’ assets.
Every dollar a manager charges is one less dollar available to the end investor. Hedge funds can play an important role in your portfolio, but teachers and firefighters should not subsidize their operations. Given the competitive landscape and the availability of new replication alternatives, now is the time to push back on high fees.
Bob Elliott is CEO, CIO and co-founder of investment firm Unlimited. He is based in New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.
