Hedge-fund fees are coming down, but it will take time before they are reasonable. The archetypal 2-and-20 structure isn’t actually the norm. Even slightly lower charges, though, look way too high against the feeble returns of late.
New data suggests investors are gradually paying less. Funds opened this year on average charge about 1.5 percent a year for management, down from nearly 1.7 percent in 2007, according to research outfit Preqin. The slice of investment gains kept by hedge-fund bosses also has dipped on average to 19.1 percent, from 19.5 percent.
In theory, an investor ought to care only about his or her net return and whether it stacks up against the alternatives, after fees. When fees are high, though – compared with big Vanguard stock index mutual fund levies of 0.2 percent or less, for example – they stand out.
The big problem is the recent performance drought. Hedge Fund Research pegs year-to-date net gains for the typical fund at 3.5 percent. Last year the figure was negative, and the year before just 3 percent.
Ross Margolies, founder of Stelliam Investment Management, suggested at CNBC’s Delivering Alpha conference last week that it may be reasonable for fees to absorb a quarter of the outperformance a manager can generate. For a 2-and-20 structure to fit that rule even simply as a proportion of gross return, the gain before fees would need to be 30 percent. The net return would be about 22 percent. The last time the average fund managed that, according to HFR, was in the 1990s.
Today, fees on average are probably eroding closer to half the gross return. Yet few funds are average. Investors don’t pressure top performers to cut fees, while weaker firms often just close. In addition, investors don’t know until later that an appealing hedge-fund strategy didn’t work out. Fees are set more on the promise than the result.
Moreover, fees are logically calculated over a typical market cycle. Given the fairly crowded field, automated systems that erode arbitrage opportunities and other factors, hedge-fund returns may prove lower over the long term than in the past – but still higher than at present. That suggests a new fee reality will set in only slowly.
This view is a Breakingviews prediction for 2017. Click here to see more predictions.