Over the past 15 years, hedge funds have struggled to remain competitive amid lackluster or even tumbling returns, which caused many to drop the traditional 2/20% model for management and performance fees. In fact, hedge fund fees have been declining steadily over the last decade and a half.
Unfortunately, while a recent study suggests those fee declines may have stabilized, the industry’s most important clients are dumping their hedge fund allocations. Meanwhile, the cream of the crop of hedge funds is charging significantly higher fees — even higher than the traditional 2/20% model.
A complex topic
Citing data from HFR in its recent whitepaper, Peltz International reported that management fees appear to have settled at around 1.36% since the second quarter of 2022. Meanwhile, performance fees have been relatively stable at around 16.05% since the fourth quarter of 2021.
Of course, fees can be a complicated topic due to the wide variety of strategies employed by hedge funds, especially with the rise of hybrid funds potentially utilizing more than one fee structure for the different parts. More hedge fund managers are adding hybrid funds, which is causing problems with management and performance fees.
The firm also noted that conflicts of interest develop if some investments outperform while others don’t. The lack of a standard approach is making the fees issue even more problematic. Additionally, some hedge funds are at either extreme with their fee structures, with some charging no management fees, others charging extremely high fees, and some charging pass-through expenses instead of management fees.
A key problem facing many hedge fund managers is the growing costs associated with the increasing regulations, which are making it challenging for those who don’t charge management fees. Kevin Neubauer of Seward & Kissel told Peltz he doesn’t believe hedge fund fees can go any lower for most managers due to the heavy regulatory environment, forcing managers to do more with less.
Institutions are dumping hedge funds
Institutions are the hedge fund industry’s most important client group, but demand from them continues to weaken as scrutiny of fees has increased. The California Public Employees Retirement System (CalPERS) closed out its $4 billion exposure to hedge funds in 2014, as fees were a significant issue.
According to HFR data, the average management fee was 1.5%, while performance fees averaged 18% at that time. CalPERS CEO Marcie Frost said hedge fund fees are still a problem but has approved boosting the pension fund’s private equity allocation as part of their new four-year plan.
CalPERS is boosting its PE allocation from 8% to 13% and adding a new 5% allocation to private debt. However, most private equity firms utilize the traditional 2/20 fee structure that the pension fund found to be so problematic years ago.
CalPERS isn’t the only institution dumping its hedge fund allocations. Institutions hired about $900 million net worth of hedge funds in the first 10 months of this year, a decline of 85% from $5.7 billion a year ago. Total hedge fund hirings have totaled $2.5 billion year to date, while terminations stand at $1.6 billion.
Most hedge funds are lacking in returns
All investor types want to see that they’re benefiting from their investments. James McElroy of investment consulting firm LCG Associates told Peltz that the marketing pitch for long/ short equity funds a decade ago was that they could generate higher net returns than traditional long-only equities with lower beta.
Since then, most long/ short equity managers have managed the risk side of that promise, but their net returns have been severely lacking, causing many investors to question why they’re holding those hedge funds. McElroy warned that fund managers that can’t demonstrate a compelling risk/ return story will likely face challenges when trying to raise capital.
Inconsistent returns are the key reason hedge fund fees have been falling steadily over the last 10 to 15 years. Other critical reasons include many hedge funds providing long-only or beta-type returns, competition from other investment products with lower fees, and investors becoming more sophisticated and demanding.
Although 2/20 is considered the traditional fee structure, the average management fee was already at 1.54% in the second quarter of 2008, while the average performance fee stood at 19.15%. Management fees were somewhat stable until 2016 when they reached 1.5% and continued to decline from there. Performance fees have fallen steadily year after year since 2008.
Of course, emerging fund managers typically charge lower fees at launch to attract investors. The average management fee for new funds launched in the second quarter of this year was 1.32%, while the average performance fee was 17.9%, a decline of eight basis points from the first quarter.
As with any study, there are always outliers. Several funds that have been able to increase their fees due to their consistency, performance or limited capacity. These managers include Caxton Associates, DE Shaw, Point72 and Brevan Howard.
For example, Caxton raised its management fee from 2% to 2.5% and performance fee from 22.25% to 25% in February. The fund also changed its liquidity terms to limit the amount of capital that investors could redeem each quarter. Caxton’s Global Fund returned 7.9% in 2021 and 42% in 2020, while its Macro Fund returned 7.5% in 2021 and 60% in 2020.
Some of the outlier funds are multi-strategy platforms that charge high fees with little or no liquidity. Many large multi-strategy funds have instituted pass-through fees instead of standard management fees.
This strategy allows expenses like rent, trading fees, technology, server costs, salaries, performance bonuses and client entertainment expenses to be passed onto the investor. These expenses frequently run as high as 10% of assets per year with no cap and are in addition to the 20% to 30% of the profits these funds take. Generally, such high fees enable these funds to hire and retain top talent.
DE Shaw is hiking its performance fees by 5% for its Oculus, Composite and Valence funds to 30%, 35% and 40%, respectively, using the increase to pay for technology, data infrastructure and compensation.
These funds have generated robust returns, with the largest Composite fund returning an impressive 20.5% for the first eight months of 2022. DE Shaw also raised its fees for the Composite fund from 2.5/25% to 3/30% in 2019 following its robust performance.
Point72 Asset Management charges a management fee of 2.85% and a performance fee of up to 30%, depending on its returns. Brevan Howard plans to start a share class in its flagship fund with pass-through fees.
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