There are any number of avenues of attack open to critics of hedge funds nowadays. Among the more recently fashionable is the accusation that hedge funds have fees out of proportion to their risks. Or, more commonly, an unsophisticated barb that seems to resonate much more sharply with the public even if it avoids the question of risk-adjusted returns, that hedge fund managers simply charge too much.
Clients of hedge funds don't seem to be that annoyed, however. And given the liquidity in the marketplace and the number of funds to choose from, it is difficult for the rational observer to find fault with the holy grail of hedge funds, "two and twenty," given the rather enthusiastic acquiescence of the many "victims" of hedge funds to the structure. But, alas, Milton Friedman is dead. There is no viable moderate political party in the United States clever enough to be socially liberal, or at least socially agnostic, and still possessed of the sense required to be truly fiscally conservative. The second coming of financial paternalism is upon us, dear reader.
Blame for the ills that befall us now will be laid, I suspect, on the shoulders of the easiest targets. Mysterious and envy inspiring hedge funds certainly find themselves on the short list. The only question for me at this point is "how much damage can be done in the next six years and how long will it take to repair it?"
Pretending for a moment that a great outcry for hedge fund fee reform did exist amongst clients, what might such a structure look like?
The Economist points out (subscription required) that non-complaining hedge fund clients are, quite expensively, paying for beta, as well as for alpha. The Economist, as usual, has a point. Should managers be compensated so richly for, say, a strong quarter in the equity markets where their actual "outperformance" of the market was slim? Wonders the Economist:
...hedge-fund returns have been increasingly based on beta in recent years. Hedge-fund managers have every incentive to take this route, since they take a percentage of all profits, however they are derived. But beta can be obtained at very low cost via index-tracking funds. Why pay hedge-fund prices?
The last three months provide as good an example as any in recent memory.
I see via Controlled Greed that The New York Times, for its part, whines at the timing of compensation, (avoid annoying registration with the always yummy bugmenot) and outlines an alternate fee structure, one that seems unduly complicated to me, being adopted by newcomer Lisa Rapuano. Yammers the Times:
Getting paid annually does not always jibe with some styles of managing money like value investing — the art of buying undervalued companies and waiting for them to be properly valued. If managers show poor returns, impatient investors might yank their money before the market recognizes the stock as undervalued. In investing parlance, that is called being dead before you are right.
Lisa Rapuano, a longtime value investor, grappled with these issues and came up with a compensation structure based on the radical notion of delayed gratification. In January, she will start a value-oriented hedge fund that pays her a hefty incentive fee, but only every three years.
Lane Five Capital Management charges a 1.5 percent management fee and takes 40 percent of any profits that exceed her hurdle rate (the Standard & Poor’s 1,500 index) every three years. If the fund has negative returns, she gets nothing — a fact her husband finds very perplexing, according to Ms. Rapuano’s presentation at the Value Investing Congress in New York last week.
Combine this with the now fashionable concept of "portable alpha," and the separation of alpha and beta and it seems reasonable to suggest that separating the fee structures of alpha and beta returns might also be a useful endeavor. The structure described above does a similar thing though I wonder after claiming 40% of alpha returns.
On a long, and otherwise drab, flight back from London, I wondered to myself what such a structure would look like and what the impact on existing hedge funds would be like from a compensation perspective.
The simplest measure would seem to be the isolation of alpha returns and the application of the "twenty" of the "two and twenty" only to these gains. Fees for the remainder, the beta, should logically approximate the fees that might be expected of an index fund. These returns, after all, were hardly the result of managerial acumen, but rather pure good fortune that the investor might well have enjoyed for next to nothing by dropping their capital into a cheap index fund rather than with an expensive manager who shaved 20% off the top simply for getting up in the morning.
Of course, this begs the question: which index is the best measure of beta in these cases and why? Our earlier example, seems to have a somewhat exotic opinion (she uses the S&P Super Composite). Of course, the investor should be careful to watch the benchmark selected. Selecting an overly broad (and therefore less volatile) benchmark might have the effect of boosting the "alpha" component of returns for a manager by reducing the beta. Clearly, there has to be some rationale for the index selection. For example, that the manager will actively pick stocks only from the index components. (This might explain the selection of the S&P 1500, as smaller stocks are probably a more serious target than the mega-caps). A quick comparison shows that the Super Composite would have generally, but limitedly, reduced the alpha component of returns in this structure (probably because of the inclusion of so many mid and small cap stocks in the index).
The real answer here is probably "it depends." The strategy of a given fund, and in particular its degree of focus, will likely (should) drive the selection.
Some more interesting wrinkles rise to the surface if you extend the concept of fees calculated on "outperformance" of whichever broader index we have decided to index against. What is "outperformance" exactly? I suspect many would be tempted to define it much less broadly than logic would dictate.
What if, for example, our new hedge fund, Sub Rosa Long-Short, LP charges 2% of assets under management and 20% of returns in excess of the S&P 500 for the same time period? Let us then assume that for Period 3, the S&P 500 slips 9.00%. Suppose, further, that Sub Rosa Long-Short, LP shows returns of -4.00%. Should Sub Rosa Long-Short, LP charge 20% of 5.00%, the amount of capital preserved by the astute investment strategy of Sub Rosa and that which would have been lost had the client invested instead in the index? Is a milder loss relative to the index "alpha?" It seems that if one is being a purist about the concept of alpha indexed fees, Sub Rosa Long-Short, LP should be entitled to fees on those missing losses, just as that would be entitled to fees on positive abnormal returns. This is, after all, one of the key marketing points of hedge funds. They are, in theory, supposed to protect downside. Should they not be incentivised to do so?
In the next period, then, if the index held at 0.00% but Sub Rosa Long-Short, LP managed to capture 3.00% in gains, should Sub Rosa charge 20% of this 3.00%? Many traditional two and twenty fee structures don't start running the meter again until the prior "high water mark" is attained again. But if we are really compensating for "alpha" then the "double dip" of charging on a loss and charging fees again on the way back up over already covered ground actually makes sense. The client is, after all, now 8.00% above the rest of the market. Are avoided losses as good as gains when we are scoring alpha?
How do these sorts of fee structures shake out in practice during strong bull markets? Let's just see.
Credit Suisse publishes the Tremont Hedge Fund Index which shows the average for year to date hedge fund returns to be 9.55%. The S&P 500 sits at about 9.04% at the moment. Fees on the average hedge fund (assuming $1 billion under management which probably isn't really average) would look something like this:
Kiss $18 million and any bonuses goodbye. And for the best performers on the index, emerging markets funds with 13.58% returns year to date?
67% of their incentive fees go right out the window. Ouch.
