Study Finds Few Hedge Funds Pocket Mythical '2 and 20'

The Wall Street Journal reports that the head of the Utah Retirement System is taking a stand on what he says are unfair hedge fund fees. As the Journal reports, Utah’s Larry Powell has extracted “better fees” from 10 of the 40 hedge funds in which Utah has a direct investment. In doing so, he has won fans in the institutional investing community, such as the head of the Illinois State Board of Investment, who told the Journal that:

It’s a laudable effort and it’s the right time to do it…The current fee structure does not work going forward, at least not for the client.

There is no question that this is a buyers market for (most) hedge funds. That’s why it’s somewhat surprising that Powell is demanding so little.

The chart below from the Journal shows that Powell is asking for hedge fund fees to be charged on a sliding scale depending on the assets managed (as is quite common in the long-only space).

He’s okay with “2 and 20″ for smaller allocations, but wants to see fees slide to “1.5 and 15″ for larger allocations. Plus, he wants to see a LIBOR hurdle be reached before performance fees kick-in.

Many hedge funds already have a hurdle rate. And there has actually been an ongoing debate in Hedgistan regarding whether LIBOR was actually too low a hurdle for many managers who might rely on passive investment in “alternative betas” to deliver their returns (see related posts).

But hurdles aside, many hedge funds already charge less than what Powell is demanding. Barclayhedge produced a really interesting report in January on the average fees charged by hedge funds over time. (The report is free with quick registration). It’s worth a look, and while you’re there, check out some of the other nifty monthly observations made by this hedge fund database company.

According to Barclayhedge’s January report, a minority of hedge funds actually charge 2% or more. As the chart below from the report illustrates, the percentage of funds charging 2% or more in management fees is around 30%.

But it’s true that fees have been drifting upward over the past decade. As you can see, the portion of funds charging 1% or less has dropped from 40% to as low as 20% recently. It appears that some funds charging 1% or less at the turn of the century jumped into the “1-2%” category over the ensuing 8 years.

But holy smoke, check out the blips at the end of the chart - a complete reversal of fortune. In the course of a few months, 5% of hedge funds dropped their fees from over 1% to under 1%. Interestingly, the “2 and 20 crowd” (to borrow Warren Buffett’s term) held the line on management fees over this period.

A flight to quality? Perhaps. As the WSJ reports:

That sentiment mightn’t apply across the board. Top-tier funds, at least, still have the upper hand in negotiating terms such as fees, say big investors, lawyers and bank executives that work with hedge-fund clients. The really top talent will be able to retain standard fees of 2% for management and 20% for performance, says Howard Altman, head of the financial-services group of audit and tax firm Rothstein Kass, which has many hedge-fund clients.

Utah’s Powell isn’t just trying to save a buck or administer social justice here. As he wrote in the February issue of The Hedge Fund Journal, his demands are based on an underlying philosophy about what fees are meant to cover:

Management fees should be used to cover operating expenses only, and are not appropriate funding sources for staff bonuses, business reinvestment, strategy expansion, or wealth accumulation by partners.

Far from being anti-rich-guy, he goes on to endorse performance fees as an important “alignment of interest”, but also writes that their payout should be constrained during a lock-up (e.g. 50% during the lock-up, 50% at the end).

He also proposes what he calls a “liquidity risk subsidy” that should reward pensions for providing liquidity to other shorter-term co-investors in a fund (for example, when they run for the hills, kicking off a round of forced selling by the manager). Writes Powell:

When heterogeneous investment horizons are pooled in the same fund structure, long horizon investors effectively subsidize the availability of liquidity to short-horizon investors. The costs of this subsidy have been largely dismissed until recently.

We sometimes bristle at knee-jerk demands for lower fees, particularly when market forces seem to support current levels. But Powell has presented a cogent argument for changes to the current hedge fund fee model without gutting them.

For more on hedge fund fees, click here.

Comments

[kotika98:]

> Management fees should be used to cover operating expenses only...

Indeed this would is a prudent mode of operation, if only because managers would be able to ride out a drop below watermark. As it is now, many are forced to close shop when they lose performance fees for a couple of years - the management fee is often not enough to keep going.

Mar 13 01:20 PM

[Between The...:]

In my view, using management fees for *anything* other than operating expenses may be fraud or at least questionable. Hedge funds should itemize and track expenses, just like regular funds, and unused fees for management should be returned to the investors (or not collected in the first place).

Also, the Utah Retirement System is right on as well, as management fees should factor in to any high-watermark calculation. If hedge funds purport to deliver risk-adjusted returns greater than a 10bp treasury portfolio, then this is the bare minimum return over which they should be considered to have any "performance" at all.

Also, a rolling multi-year return window is likely a better way to align investor goals with hedge fund compensation. Some have even speculated a partial claw-back provision that returns some (not all) performance fees paid in previous years when the fund has significant down performance soon after (as to dissuade short-term gain over long term risk).

Mar 13 07:31 PM

[Mike in the...:]

"He’s okay with “2 and 20″ for smaller allocations, but wants to see fees slide to “1.5 and 15″ for larger allocations."

Has this guy ever read a PPM? 99% of funds can waive or reduce management & performance fees for strategic (read: large) investors. The problem was that during the HF boom it was a "seller's market" and funds could take a hard line on fees. Nowadays, If a large institutional investor plays hard ball on the fee structure there is a good chance the fund will make some concessions.

While the chart is informative, I'd really like to see the data broken out by fund size.

Mar 13 07:58 PM

[Moon Kil Woong:]

Considering when a hedge fund looses money it isn't doing its primary job, preventing you from losing money, the fee should be 0%. Only after insuring this outcome should it then maximize your gains given this constraint.

If it can't do this without making the return rate appealing it should not be in existence.

You might say, well that is a tall order to meet. That would mean most hedge funds would have to close their doors. Yes it is a tall order. That's why they get paid the big bucks when they are successful. And yes, most hedge funds are a crock and should close their doors.

Most are just there to collect money off of people who are lured by the highly successful hedge funds but get shunted by their brokers into a financial company's money making churn machine designed to maximize their wealth not their clients.

Mar 16 12:24 AM