Dog days for hedge funds forced to cut fees

April 28, 2013 5:50 pm

Dog days for hedge funds forced to cut fees

By Sam Jones

The definition of a hedge fund, people used to joke, was a fee structure in search of an investor to fleece. However, four years on from the financial crisis, and with so far little to show for it, hedge funds’ notoriously high fees are looking less and less definable, let alone defensible. Some investors now hope that the industry’s totemic “two and 20” fee structure – 2 per cent of assets and 20 per cent of returns annually; a formula that has made many managers fantastically wealthy – may finally be beginning to crack. Challenging fees is no easy task for investors, however. Thanks to the crisis, they may well have more clout than ever before when it comes to negotiating with managers, but they are also themselves more desperate. In a time of ultra-low bond yields and high equity volatility, hedge funds are proving an irresistible draw. And as such, investing in hedge funds still seems to be a game rigged in the managers’ – and not the investors’ – favour.“With any industry in its development, margins start out high. Then, as an industry starts to mature, firms start to compete on price,” says Jeff Holland, managing director of Liongate Capital, which has $2bn invested in hedge funds. “The hedge fund industry, for whatever reasons, has so far been very good at avoiding that path. Managers have been very good at defending their margin.”

According to data from Hedge Fund Research this month, industry assets rose by $122bn in the first three months of 2012 – the largest quarterly inflow in more than two years – to stand at $2.375tn. Hedge funds now manage more money than ever before.

With those large inflows, however, a shift has taken place.

Institutions – pension funds, insurance companies and endowments – are now the single largest group of hedge fund investors, accounting for close to three-quarters of the industry’s assets.

By comparison, the wealthy individuals and private banks that once dominated hedge fund investing and brought with them a more handshake-oriented, take-my-money-and-shoot-the-lights-out attitude are becoming bit-part operators.

Glitzy penthouse offices with Tracey Emin paintings and Jeff Koons sculptures are out, and institution-friendly sobriety is in.

“There are increasing numbers of sophisticated institutional investors who are questioning managers on fees as a result of both regulatory and investment pressure,” says Eric Schlaikjer, co-founder of $5bn quant fund Cantab Capital Partners, which recently launched a new, low-fee fund.

“Australian superannuation funds, as an example, are unable to pay the industry standard fees of two and 20. Investors are also used to paying less for scalable strategies; for example those investing in large-cap equities,” he says.

There is every indication the trend is set to continue. According to a recent comprehensive survey of hedge fund investors by Deutsche Bank, 66 per cent of pension funds increased their hedge fund allocations in 2012, compared with just 19 per cent of private banks. Furthermore, 94 per cent of pension funds said they would increase or maintain their hedge fund allocations in 2013.

“There is now a lot of flexibility on the manager side,” says Anita Nemes, global head of capital introduction at Deutsche. “It is really the institutional investors that are driving fee changes – they are the ones that are negotiating.”

The Deutsche survey also showed that, while on average, wealthy individuals targeted returns of 10 per cent from their hedge funds annually, institutional investors target just 8 per cent.

Institutions do not just look for managers promising the big gains on investments, but those with returns that are uncorrelated to broader markets, or else are consistent, with as little volatility as possible.

And if the expected returns are lower, they believe, then the fees should be too.

“The reality is that while we say we don’t negotiate on fees, if a North American pension plan comes to us looking to invest $200m, then we’re going to sit down and have a talk,” says the head of marketing for one of Europe’s biggest hedge funds, who declined to be named because discussing fees publicly is too sensitive an issue. “Anyone who says otherwise is lying to you.”

In particular, it is hedge funds’ management fees – the “two” – that are coming under pressure.

And with good reason: the average hedge fund has returned just 9 per cent in the past five years, meaning investors have paid more in management fees alone to their managers since the crisis than they have received in profits.

Janchor Partners, one of Asia’s most successful recent hedge fund launches, has a management fee which decreases as firmwide assets under management rise: incentivising the manager to concentrate on performance as a source of income, rather than asset gathering.

Even big, established blue-chip funds have not been averse to pressure.

In October, Caxton Associates, one of the world’s biggest macro hedge funds, cut its management and performance fee in a concession to the “tough investment backdrop” and changed investing “reality”. Caxton’s fees, though, started at three and 30. The company now charges 2.6 and 27.5.

“In a way, whether you are a hedge fund manager or in any other industry, the lesson is the same – quality commands a premium,” says Deutsche’s Ms Nemes.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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