Hedge Fund Fees: Should 1 or 30 be the new 2 & 20

For as long as anyone can remember, the classic hedge fund fee structure has been two and twenty. Or more formally, a 2% annual management fee and a 20% performance fee. The management fee is to allow for the manager to operate their business, invest in technology, and pay their quants. The performance fee is to incent them to make the investor a lot of money, as the more money they make the investor, the more money the fund manager makes.

This was long thought of as a nice alignment of interests, until you could own the entire S&P 500 for 9bps in an ETF. The proliferation of passive index tracking ETFs at expense ratios next to nothing has certainly put pressure on hedge fund fees. Why, exactly, is the state of Rhode Island, for example, paying hedge fund managers more in fees than they earn on the assets those managers are investing for them:

In the last three years, Rhode Island has paid more in fees to its hedge funds than they have produced in investment returns, according to the treasury.

“There is something that is broken here in the fee structure,” Magaziner said.

This is just one of the chorus of voices saying hedge fund fees are too high, with some even saying the classic 2&20 structure results in the manager retaining more of the profits than the investor putting up the assets.

But it shouldn’t really be front page news that at least 20% of the gains are eaten up by fees. That is the model, and that is what you sign up for. And let’s talk about time frame here for a second, and the skewed perception that can come from looking at the percentage of fees earned by the manager during periods of poor performance versus times with good performance. A simple excel exercise will show you that a net return of about 3% (gross of 6%) is the break-even point between more money going to the manager or client under a “2&20” fee structure. At a 1% net return, it’s 70% of the return to the manager, and only 30% to the customer. At a 15% net, those numbers are flipped – with 70% going to the customer.

But regardless of how many excel exercises you run, there’s still an air of distrust/dislike when it comes to hedge fund fees, especially when you have firms like AQR offering hedge fund strategies in a mutual fund wrapper for just 1.25% a year (with no performance fee!)

Investors have called for change, and we’re seeing not just fees coming down, but also the evolution of the very concept of management AND incentive fees:

“…with managers exploring new and nontraditional fee arrangements [some] fees are falling, with the average hedge fund management fee dropping to 1.3 percent, according to AIMA’s findings.”

“2&20 is no longer the only game in town,” said Michelle Noyes, head of Americas for AIMA, in an interview. “It used to be a joke that a hedge fund is a fee structure. But now there is a tremendous amount of nuance in fee structures. There are a lot more levers that can be pulled to fine tune the fee equation.”

Take a look at the differences in hedge fund fees over the past 12 years.

The 1-or-30 fee structure:
A new structure reportedly created and implemented by Albourne Partners and the Teacher Retirement System of Texas, is the 1 OR 30 model:

This structure has been referred to as “1-or-30” because it will always pay a 1% management fee, which the manager trades in for a 30% (of alpha) performance fee when the latter is greater. The only exception to this is when an investor is catching up to its 70% share of alpha, following periods when the 1% management fee exceeded its 30% share of alpha. (Fiduciary Investors).

The ‘or’ component is the main differentiator here. The investors are meeting managers half way, saying – ‘hey, we understand you need to run your business, and we’ll compensate you 1% a year to do so’. But you also don’t need that 1% when have had a great year and are earning a big incentive fee check.’

The 1 or 30 aligns incentives just as the 2&20 model does, but also protects the investor in the case of there being small single digit returns where the manager’s share of the profit when combined with the management fee would be 50% to 75%. Here’s Albourne doing their own excel work showing the investor percentage of profits retained in the different fee scenarios.

(Pension Pulse)

 

Higher Alpha = Higher Fees

Of course, if you’re able to churn out profits year after year at a pace much better than your peers; none of this matters all that much. The best performers and niche, capacity constrained strategies are still able to command higher fees, as witnessed this year by DE Shaw increasing its fees to 3 and 30 and Element Capital moving from an already high 2.5 & 25 to 2 & 40!!

 

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

logo0