By Andrew Beer, founder and managing member of Dynamic Beta Investments. 

Andrew Beer, founder and managing member of Dynamic Beta Investments.

The great hedge fund fee debate is arguably asset management’s Gordian Knot – on the surface an intractable problem, but one that may have a relatively simple solution for allocators and institutions.

A few years ago, hedge fund fees were a red-hot issue with various industry factions weighing in with potential solutions. Railing against the perceived heads-you-win-tails-I-lose 2/20 fee structure, a vestige from hedge funds’ small beginnings, institutional consultants proposed entirely new fee structures. Meanwhile, new funds offered discounted “founders” share classes to entice reluctant investors. In the world of quant strategies, such as alternative risk premia and managed futures, new entrants arrived to break the fee mould with sub-100 bps products.

Yet fast forward to 2021, and despite fee innovation, confusion reigns. Some of the most expensive funds have outperformed and even raised fees, with multi-strategy funds being a case in point. Others, such as structured credit, have performed poorly. Meanwhile, some of the least expensive products have underperformed badly, for example, alternative risk premia, while low-cost long-only products have trumped their higher cost, long/short brethren. And there are a hundred examples in between.  With such a level of complexity, questions for allocators today are: should they still care about fees and, if so, are there any viable solutions? 

The answers: yes and yes. To take a step back, there are two reasons to push for lower fees. The first, obvious reason is to improve performance.  Hedge funds have less of an alpha-generation problem than the fact that too much of it ends up in the wrong hands. We wrote in 2016 that 80% is paid away; in some recent years, the figure has been 100% or more. Even during 2020, a victory for the industry where hedge funds delivered nearly 300 bps of alpha, six out of every ten dollars of alpha was paid away.  Across the industry, clients take all the downside risk, but give away too much of the upside.

The other reasons are non-economic: regulatory pressure on “value for money” can make lower cost products safer for wealth managers, and pension funds can have optics issues when poorly performing billionaires are getting richer and richer off the backs of struggling pensioners.

The search for value 

The interesting question is why, after nearly a decade of debate, progress has been so uneven. It starts with the fact that there is little agreement on how to calculate “equitable” fees – in advance. Clearly, any rational allocator would be thrilled with a fund that generates 500 bps per annum like clockwork, even after the manager takes home 500 bps in fees.

The problem is that fund simply doesn’t exist.  Instead, allocators tend to pick funds that, due to luck or skill, delivered ample returns despite high fees; when performance, predictably, reverts to the mean, those fees become onerous. In one, unfortunately, not isolated, example, clients of a hedge fund that performed well early in the decade made roughly zero over seven years after paying $2 billion in fees. Railing about fees after the fact is like lamenting that you built an expensive house in a flood zone.

2020 won’t help this impulse. Extreme winners – funds up 50% or more – will bolster arguments that only net performance, not fees, should matter. The stars of 2020 will have allocators lined up around the block, which raises another issue:  negotiating leverage.  Funds on a hot streak still hold all the cards, so allocators are forced to decide whether to invest and hope the streak continues or look elsewhere. For many allocators, joining that club simply outweighs concerns about persistence.

By contrast, funds who suffered in 2020 might be willing to offer discounts, but few allocators will take the risk of catching a falling knife to save a few hundred basis points. Oddly, some allocators who do in fact have negotiating leverage, like global banks, often pocket the fee savings themselves – the economic equivalent of Walmart buying wholesale but charging the same as the old corner store – and hence gravitate to the most expensive funds. Because of this, the bifurcation of industry fees is likely to persist.

Hedge funds in UCITS structures could have been the solution, but weren’t. Those funds, on average, charge a third (sometimes half) less than hedge funds.  Plus, they offer something valuable, daily liquidity.  Unfortunately, lower fees have not translated into better returns.  Why?  Constraints within UCITS funds can dampen pre-fee performance:  imagine a long/short credit hedge fund whose highest yielding non-traded bonds are prohibited.

The simple calculus is this:  when performance drag exceeds fee savings, net returns are lower. This has reinforced the view among some allocators that if you want exposure to hedge funds, you should bite the bullet and invest only in high cost, illiquid offshore funds.  If not the real thing, then not at all.

Replication: the greatest form of flattery 

Which brings us to a potential solution.  Hedge fund factor replication copies how leading hedge funds are invested – cheaply and simply.  (Note: alternative risk premia is quite different and was never a true replication strategy.)  Unlike most UCITS hedge fund products, fee savings equal or exceed any lost performance. In our case, we take it one step further:  if we can replicate 90% or more of pre-fee returns and keep expenses low, we potentially can deliver alpha through “fee disintermediation.”

Despite strident criticism a decade ago from allocators who viewed the product as an existential threat, virtually every replication strategy from the pre-GFC period has materially outperformed UCITS hedge funds, outperformed funds of hedge funds, and performed in-line with hedge fund indices.  We view these strategies as “index-like” solutions because they behave more like diversified, and hence safer, portfolios of hedge funds than single manager allocations. Of course, every strategy has its limitations:  certain strategies – highly illiquid, market neutral — and single funds cannot be replicated.

For the allocator, this should be transformational. Costs clearly matter, but so too does predictability.  This was critical for the adoption of index products in the traditional space. Nearly twenty years after fund firms began to explore ways to create “index-like” hedge fund solutions, replication stands alone in its combination of performance, attractive fees, and high correlation.

Consequently, allocators now have a tool to combine high cost, illiquid hedge funds with a low cost, liquid complement to lower average fees and improve liquidity characteristics without sacrificing returns. Wealth managers who embrace these “index-like” products may be able to demonstrate better performance relative to fees – a cornerstone of “value for money” under MiFID and RDR.  Consultants can benchmark actual hedge funds to a lower cost, investable alternative – much the same way a long-only stock picker can be evaluated against the relevant equity index.

Given the difficult issues with bringing down hedge fund fees directly, the next best solution may simply be imitation as the greatest form of flattery.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)