Ever typed “Hedge Fund” into Wikipedia? Here’s an excerpt of what you get:
“A hedge fund is a private investment fund charging a performance fee and typically open to only a limited number of investors…
Funds may also specify a ‘hurdle’, which signifies that the fund will not charge a performance fee until its annualized performance exceeds a benchmark rate, such as USD 90-day T-bills or a fixed percentage. Rules as to what period should be considered for the hurdle vary from fund to fund, but it most commonly covers the current fiscal year.
Sometimes the performance fees are levied only after a performance “Hurdle” has been met. A common practice is to use a hurdle rate linked to short term interest rates, for example 3 month LIBOR in the fund currency. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money in a bank account.
Though logically appealing, this practice has diminished as demand for hedge funds has outstripped supply and hurdles are now rare.
Note a few salient elements of this definition. Firstly, “performance fees” are mentioned in the first sentence – suggesting that such fees are an important part of what it means to be a “hedge fund”. Second, note that the default hurdle rate is a risk-free rate. And third, note that it says “hurdles are now rare”. We’ll revisit these facts in a moment.
For the last three days, some of the hedge fund industry’s finest have met in London to discuss the mysterious sources of hedge fund returns. They have concluded that a significant portion of hedge fund returns can actually be explained by “alternative beta”, rather than pure alpha. In addition, several of them have highlighted what they consider to be the “high fees” charged by hedge fund managers. Yet little time was spent discussing the implications of alternative beta on fees (particularly on performance fees).
Performance fees are by their very nature alpha-centric. Ostensibly, the aim of performance fees is to incentivize the manager to try as hard as possible to generate returns – to “align the interests” of the hedge fund manager and his investors. But while it is not defined as such, this “performance” is really just a proxy for alpha. After all, why pay performance fees for beta?
Usually, a performance fee is assessed on returns above a “hurdle rate”. And quite often this hurdle rate is set at LIBOR or some other risk-free rate (and much of the time it’s 0%, which lacks any rationale - other than simplicity - in our minds). The implicit assumption here is that LIBOR is what a dart-throwing monkey would earn if he managed, say, a market-neutral equity fund ($100 of equity…$100 short, generating $100 cash…which is invested $100 long…leaving $100 cash in the bank to earn LIBOR). Any return over and above LIBOR would be considered value-add (“alpha”) and split 80/20 with the manager in the form of a performance fee.
But it now seems that many hedge funds generate returns that are partly “alternative beta”. For example, a convertible arbitrage manager might generate returns that are partly driven by a strategy-wide tailwind represented by, for example, the HFRI convertible arbitrage index.
So what is the appropriate hurdle rate for a hedge fund in an alternative beta world? One might argue such a manager should have been given the HFRI convertible arbitrage index as his hurdle. Perhaps he should have only earned a performance fee if he added value by exceeded this strategy-wide tailwind.
It makes sense to us that a discussion of hurdle rates should follow closely on the heels of any discussion regarding alternative betas. We don’t believe you can have one discussion without the other. You can’t explain a portion of hedge fund returns as alternative beta on the one hand, then turn around and continue to pay managers as if those alternative betas had never existed on the other. A LIBOR or 0% hurdle rate is a throwback to a time when we all believed hedge fund returns were 100% alpha. The emergence of “Alternative Beta” clearly illustrates this is not longer the case.