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The problem with hedge fund fees

The current fee structure arrangements used by many hedge funds benefit the manager more than the investor and dont necessarily incentivise performance, writes Harvest Lane Asset Management’s Luke Cummings.


There is a common misconception held by retail investors that the larger the managed fund, the greater the return on investment will be. This is simply not the case.

Even the biggest and the most well-known names go through bad times. No one is totally immune to posting losses.

Rarely do we hear anyone in the finance industry openly announce their poor results as, unsurprisingly, an unattractive performance record doesn’t do much to convince potential investors to hand over their money.

Unfortunately for the massive funds, their profiles make it more difficult for them to avoid the spotlight and hide their less than desirable results.

Luckily for investors, the media is more than happy to report on these negative results.

When big names report subpar performance, the matter of their fee structures is often raised.

However, despite a sudden flurry of analysing fees and some grumbling about the big guys having their cake and eating it too, things invariably continue as they were.

If it ain’t broke, why fix it?

Historically, hedge funds have been renowned for a fairly common fee structure otherwise known as ‘2 and 20’.

This means that they charge a management fee of 2 per cent of the value of assets invested, and a performance fee equal to 20 per cent for any outperformance they generate against their chosen benchmark.

In most cases, the management fee is charged regardless of the performance of the fund.

The fund could have had an appalling year, posting a before fees return of -25 per cent, and although investors wouldn’t have to pay a performance fee, the management fee of 2 per cent is still applied, taking the overall loss for investors to -27 per cent.

Hedge fund managers however, are not the only fund managers who benefit from this arrangement.

Even your everyday ‘vanilla’ managed fund manager is typically levying a management fee of at least 1 per cent on their investors.

Due to this handy 1 or 2 per cent management fee, most fund managers prioritise getting bigger in order to generate greater levels of fees.

This is a great deal for the fund manager, but not as great for the investor, whose returns often suffer as a result.

The issue is that fund managers are being incentivised by this management fee, with the result being that they may accumulate more funds than they can reasonably manage in some cases.

While the performance of the fund is arguably more important to smaller funds, it becomes less so for the large ones.

Warren Buffet recently put it beautifully, stating that, “When you have US$20 billion in assets, you’re getting US$400 million just from management fees. That 20 per cent becomes less important.”

If you were making $400 million a year regardless of your performance, would you be as focused on maximising the returns of your fund?

Or would you be more interested in getting as much money under management as possible so that you can maximise your returns with the least amount of effort?

This in itself is a big problem within the finance industry, but what’s worse is that after a few bad years, some hedge funds simply close up shop, wipe the slate clean and open a new fund under a different name.

Throughout this time of underperformance and prior to the establishment of their new fund, the fund’s managers have been able to charge management fees and pull in massive amounts of money for themselves, at the direct expense of their investors.

Time for change

The industry is ripe for change. It’s time for funds to prove that their interests are truly aligned with that of their investors by ditching the ‘2 and 20’ model. One way funds can do this is by choosing to be remunerated based solely on our performance, meaning the fund doesn’t make money unless its investors do.

If more funds start to operate this way, then more investors will demand it, hopefully stamping out the trend of accumulating investor funds solely for the associated management fees in the process.

It may take a little while to get there, and it’ll likely upset a few fund managers along the way, but we’re confident that it’s the right way forward.

Luke Cummings is the managing director of Harvest Lane Asset Management.

 

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