Controversial hedge fund fee structure questioned

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The traditional hedge fund fee structure is being questioned by many who feel that its weighting in favour of managers while investors suffer the risks is no longer workable.

According to Andrew Beer, a managing partner and co-portfolio manager of Dynamic Beta at the New York-based Beachhead Capital Management, investors bear all of the risks while managers reap the rewards.

Currently, the average hedge fund earns 1.67 per cent in management fees and receives 18 per cent of investment profits over the course of each year, Mr Beer told the Financial Times. Indeed, over the last decade, more than 50 per cent of pre-fee returns were paid away by investors, while fees took up the vast majority — 80 per cent — of the key active return on an investment.

The main issue is that the hedge fund industry makes a lot of noise about generating these alpha returns, but in fact it almost all trickles to the managers rather than to the investors. To blame for these circumstances is the fee structure linked to the hedge funds.

Go back two decades or more and hedge fund management fees were small, because the majority of hedge funds were small. The management fees sat at around two per cent on a $10 million fund and they covered the basic costs, while the real cash was made from the hedge fund performance fees. Fast forward to the present day, however, and the fee structure remains the same, but the finds have grown hugely in value, with those old $10 million funds now more like $10 billion funds. Indeed, while the hedge fund industry as a whole has moved on, the fee structure has remained stuck firmly in the past.

The fact that the fee structure has not progressed in line with the growth of the funds themselves has led to major issues, including the distorting of incentives as a result of skyhigh management fees. The fees themselves are now generating huge profits rather than merely covering the basic costs, whereas it should be the case that, as the funds grow, the management fees should decline. Early investors should enjoy more benefits from these declining fees and should be rewarded with a sliding scale of decline, suggests Mr Beer.

Performance fees should also provide incentives to outperform, he says, with the idea that investors paid a fortune in incentive fees to long-biased hedge funds as the market was buoyant is long outdated.

Mr Beer also suggests that lock-ups should be aligned with incentive fees in order to guard against situations in which gains evaporate following tough economic times. Those hedge fund managers who call for longer lock-ups should wait to get paid incentive fees, as this will boost the long-term thinking by managers and will also serve to better align incentives.

Mr Beer advocates “low-cost, liquid core allocation with discrete allocations to high value-added (and probably less liquid) satellite funds” in order to end the issue of allocations causing such little progress across the sector. Setting in stone a fee budget and making major investors decide up front which managers should receive high fees is a good starting point, as overpayment should never just be paid out as part of a policy. This method will also allow for benchmarking — it will make it far easier to weed out an illiquid fund that is not outperforming a low-cost alternative on a regular basis.

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