Hedge Fund Investors Starting to Push Back Against Big Fees for No Performance

Bloomberg reported on Wednesday that hedge fund investors are finally getting serious about reining in hefty fees when investment performance is underwhelming, particularly since that has been the case for the industry as a whole in recent years. But regular readers of this blog can tell how serious this initiative really is from the very first paragraph of the article:

Hedge fund investors are catching up with their private equity peers. Five years after clients of leveraged buyout firms released a set of best practices for the industry, hedge fund clients are following suit.

If the deferential attitude of limited partners towards private equity general partners is the model for toughness, hedge funds have nothing to worry about.

The very fact that this proposal has been so slow in coming is another big tell about how willing investors are to demand a better deal. Consider the next paragraph in the story:

The Teacher Retirement System of Texas and MetLife Inc. are among those that yesterday called on managers to produce “alpha,” or gains above market benchmarks before charging incentive fees in a range of proposals that address investing terms. Funds should also impose minimum return levels known as hurdle rates before levying the charges, said the Alignment of Interests Association, a group that represents some investors in the $2.8 trillion hedge fund industry.

It is hardly a secret that most hedge funds don’t generate alpha, or manager outperformance. CalPERS acknowledged that in 2006, pointing out that hedge funds had underperformed the stock market for the preceding three years. The giant California pension fund nevertheless rationalized staying with hedge funds because their return profile differed from that of other asset classes, offering useful diversification. But the fact that the most the industry really produces was not alpha but “alternative beta” had been recognized by 2005, if not earlier. And it took CalPERS nearly eight years after its admission that hedge funds didn’t outperform (and thus their fees were not justified) to pull the plug on the strategy.

We’ve written about this issue from the very inception of this blog. For instance, from a March 2007 post:

Supposedly, the reason that sophisticated investors like pension funds and endowments pay 2% management fees and 20% upside fees (and sometimes more) to hedge funds and private equity funds (and higher-than-index-fund fees for long equity managers) is that they are buying “alpha,” which is the manager’s ability to beat the relevant market. (To be more precise, it’s the risk-adjusted return over a benchmark, also referred to as “excess return.”)

As we have discussed, the problem is that a lot of fees are being paid, but not a lot of alpha exists. In fact, the gap between expectations of hedge fund performance and actual performance has grown so large that the salesmen have come up with a new rationale: “synthetic beta.” You are not paying for alpha, you are paying for a very particular combination of market exposures.

The problem with that is there is no reason to pay a 2/20 fee structure for that. A customized exposure, no matter how exotic, could be designed and implemented more cheaply.

An article in the current Economist, “What’s it all about, alpha?” covers some of the same territory, namely the seeming lack of real alpha, the claims made for the virtues of specialized profiles (the article doesn’t use the term “alternative beta”) and the rise of hedge fund clones based on the view that a lot of hedge funds are charging a lot of money for strategies that can be replicated more cheaply.

The piece is more than a bit distressing, because it serves up arguments that are bunk. The first is that even if hedge fund’s attractive (or seemingly attractive) is simply making the right mix and match of market returns (or betas) that’s worth paying for.

Uh,no. Any investor in a hedge fund has other investments (unless he is a fool). Institutional investors like pension funds hire fund consultants to help them determine asset allocation (as in what markets to be in, meaning what combination of betas to buy, as in how much in domestic stocks, foreign stocks, domestic bonds, etc.). So any “beta mix” decision by a hedge fund could run counter to other investments being made. Put it another way: the hedge fund isn’t being hired to choose which betas to invest in. That’s someone else’s job.

Put it this way: when the Economist feels compelled to run interference for hedge funds, the matter at hand is hardly a state secret.

And it’s also clear long been clear that hedge funds have cost structures that are out of whack with the performance they could deliver. This from a February 2007 post, quoting FT Alphaville:

Transaction costs run to 4 per cent of the $1,300bn of hedge fund assets under management. Manager salaries and performance fees take another 4-5 per cent, meaning hedge funds need to generate average annual returns of close to 20 per cent to keep everyone (including their investors) happy. Yet the strategies employed to produce these returns are not necessarily sustainable.

Notice despite this fundamental problem, the assets under management in Hedgistan have grown, per the Bloomberg story, to $2.8 trillion. More money pouring into existing strategies is not a formula for better returns.

So given years of inaction in the face of a widely-recognized problem, what are we to make of the supposed show of resolve by this investor group known as AOI, which has $75 billion of hedge fund assets among its 250 members?

Admittedly, some of its ideas sound promising, such as requiring funds to disclose if they have in-house pools not open to outside investors, or if they are subject to non-routine regulatory inquiries. But their key proposals are around fees. As readers probably know from private equity, the devil for this sort of thing lies in the details.

One of this group’s Big Ideas is requiring funds to meet benchmarks before profit shares are paid out, meaning the famed prototypical 20% upside fees. And they do sensibly want those fees to be based on annual rather than monthly or quarterly performance (with more frequent fees, an investor could have a lot of performance fees paid out in the good periods more than offset by underperformance or losses in the bad ones, and not see a settling up until he exited the fund or it was wound up. Longer performance periods reduce the odds of overpayment for blips of impressive results). But private equity funds have long had clawbacks. Yet as we’ve discussed at length, those clawbacks are virtually never paid out in practice. One big reason is the way the clawbacks intersect with tax provisions that serve to vitiate the clawback. It would be perfectly reasonable for hedge funds to ask for provisions similar to those used by private equity funds, with those clever tax attorneys modifying them to the degree possible to make them work just as well, from the perspective of the hedgies, as they do for private equity funds.

Hedge fund investors also want management fees to scale more with the size of fund. Again, that exists now to some degree in private equity funds, with megafunds charging much lower management fees. But it isn’t clear how much the hedge funds investors will gain. Bloomberg reports that the average management fee in the second quarter of this year was 1.5% of assets. That’s lower than typical private equity fees, which according to Eileen Appelbaum’s and Rosemary Batt’s Private Equity at Work still averaged 2%, and for funds over $1 billion, 1.71%. And of course, the fact that hedge fund agreements are treated as confidential, just as private equity agreements are, impedes fee comparisons and tougher bargaining. If this group really wanted to drive a tougher bargain, they’d insist on having the contracts be transparent. That proposal is notably absent.

In keeping, the AOI also calls for better governance. We’ve seen how well that works from private equity land. “Governance” in private equity consists of an advisory board which is chosen by the general partner from among its limited partners. You can bet that the general partners choose the most loyal and clueless investors. The only way one might take oversight arrangements seriously is if these funds had far more independent boards, as is the case with mutual funds.

So while I would be delighted to be proven wrong, history says that there isn’t much reason to expect this effort to get tougher with hedge funds to live up to its billing. And with new investment dollars continuing to pour in despite mediocre performance (assets under management rose 13% in the last year, with roughly half the increase coming from new contributions/a>. As long as investors are putting more money into hedge funds despite dubious performance, there isn’t sufficient negotiating leverage to push for more than token reforms.

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  1. Jim Haygood

    ‘There is no reason to pay a 2/20 fee structure for that. A customized exposure, no matter how exotic, could be designed and implemented more cheaply.’

    It’s taken awhile, but the one-two punch of the internet and low-fee ETFs (Exchange Traded Funds) is finally eroding the foundations from under costly active managers, with hedge funds the most exposed to being disintermediated.

    In particular, robo-advisors are eating the lunch of hedge funds, simply by virtue of lower fees. Wealthfront, for instance, charges only 0.25% annually to put its clients into a mix of commission-free ETFs. That’s putting the fear of God even into investment advisers who charge only a more typical 1 percent.

    With hedge funds having returned only 3.5% for the past five years, versus nearly 17% for the S&P 500, hedge fund investors no longer trumpet their gains at cocktail parties. Instead, having been foolishly suckered into a hedge fund is a guilty secret to be concealed from family, friends and neighbors, lest it leak into the press.

    But privacy is not an option for public pension funds, whose only out is to fire the old management and then blame the hedge fund debacle on ‘the previous administration.’

    Hedge fund managers’ mansions in Greenwich CT are like the flashy casinos in Vegas: they’re so opulent because the house always wins. Where are the customers’ yachts?

    1. MLS

      Agree that hedge fund fees are too high, but so what? That institutional investors (supposedly “sophisticated clients”) continue to shovel money into these strategies says more about them, their due diligence, and their expectations for what they’re paying for than it does about HF manager. Simply put, no one is forcing these guys to invest. If HFs want to charge 2/20, let them. Over time, they’ll be out of business.

  2. PaulArt

    In 1984 I sat in a ‘General Management’ MBA class in an Ivy League school in India listening to a part-time lecturer who was a big-shot Vice-President in a very successful company. ‘Grow and Live, Stagnate and Die!’ he said in ringing tones. 30 years later I have realized while his words might be brilliant business strategy, it is definitely Donkey Twaddle to overall society in general. Pension funds here in the US are scrambling around trying to find good investments and they are having their pockets picked all the time by the vultures on Wall Street. Do we really need this nonsense? Do we all as a society have to prostate ourselves at the feet of these odious money changers and ‘free market’ idolaters? Look at the Public Provident Fund in India. It is India’s largest public pension scheme and it guarantees 8-9% interest, is assured and locked in from the grasping and prying hands of neo-liberal and capitalist wolves. Why can’t we have something like this here in the USA? It is depressing to see how much we are paying for the intellectual laziness and the greed of the baby boom generation not to mention the ‘Greatest’ generation as well. These are the people who forgot the lessons of the Great Depression, the tricks the money changers and Wall street hucksters played circa 1910-1930. They have collectively ruined the country voting for morons like Reagan, Thatcher and Clinton not to mention every neoliberal Democrat bag-man in Congress and Senate. It seems that it is ALWAYS the professional classes that succumb to the siren song of greed and envy. I remember oh so clearly in 2001 listening to the wife of my cousin, an ENT Consultant in the NHS in England tell me – ‘there are too many bums who get free money from us’. I remember my Manager at GE in 2012 telling me, ‘we cannot have a whole section of the country leaching off of us’. Reverse class envy – how amazing this is. Yes capitalism is definitely better for these people. They prefer to be cheated by their capitalist employers and elitist leaders than anything else. The other day I was listening to my favorite TV Detective, Inspector Morse describing Capitalism in one of the episodes – ‘a bunch of Charlatans running around trying to deceive another bunch of greedy speculators – isn’t that the definition of capitalism?’

    1. Yves Smith Post author

      This generational warfare meme is off base. Is there a Boomer party? Or even a Boomer lobbying group?

      Voting for Reagan did not skew on age cohort anywhere near as strongly as it did on income lines. Reagan promised tax cuts for the upper middle class and the rich and they voted for that. Oh, and early Boomers were NOT pro-Reagan. Younger Boomers and particularly first time voters were.

    2. Lambert Strether

      It takes a very special kind of mind to look at a CEO and think “Boomer.” Personally, I look at CEO and think “CEO.” Thanks for sharing your hate.

      Adding: Bonus points for “these people”!

      1. PaulArt

        Well it could be because you are unaware that most CEOs in this country are older whiter and male? The overall point which I am trying to make and which both you and Yves seem to have somehow overlooked due to your sensitive nether regions which I inadvertently have injured is, public memory seems to be short and the people who seem to find it most convenient to forget the hard won struggles of the past were the boomers. They were handed wonderful gifts on a silver platter, Social Security, Medicare, Labor legislation, Bretton Woods. They just kicked it all into the trash – but not before getting their own, like increasing the eligibility age for Social Security and abandoning the fight for Medicare for all. Look I am not some kind of boomer hater and I have lots of wonderful friends who are boomers and who exactly fit the charge sheet here but it is important to point to the boomers as an example for the other generations and tell them, don’t do what this vacuous lot did. That is what I am doing, that’s all.

  3. Jim Haygood

    ‘Look at the Public Provident Fund in India. It is India’s largest public pension scheme and it guarantees 8-9% interest.’

    ‘The inflation rate in India averaged 9.23 percent from 2012 until 2014.’


    Nothing wrong with a tax-advantaged, gov-guaranteed low fee account offering a -0.5% real yield. But you’re gonna have to invest in shares to earn a positive real return.

    1. PaulArt

      Indeed my dear Mr.Haygood – you prove my point precisely which is that when I retire – even taking inflation into account, I will at least find my capital intact instead of 60% of it being swallowed by Wall Street hucksters promising ‘positive real return’ like yourself.

  4. JMarco

    It seems like nothing has changed since 2008 crisis for most big financial players. They can create their wealth out of manipuation of pension and savings funds. Like no one was willing to admit openly in 2008 that liar loans were going to bring down the economy, today no one is willing to admit that these financial fund manager are just blowing smoke about fund returns. But you also have people on pension fund side getting big paychecks too and have no incentive to stop the profit wheel from rolling on. Wall Street’s backstop is always the Fed with American taxpayers footing the bill for any future collapse with taxes. It is really sad to think that maybe most of America’s GDP growth in last 5 years has really comes from money manipulation and not real growth from its services and industries. Most Americans know something is really wrong with economy but are clueless on how to change it.

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