Several Ways for Wily Investors to Get a Break on Hedge Fund Fees

Several ways for wily investors to get a break on hedge fund fees

Stephen Foley

Last year was another dismal one for hedge funds, as returns failed once again to live up to expectations and big institutional investors led by Calpers, the California pension fund, reconsidered whether managers were worth their high fees.

Given the climate, it is startling to find that the headline fees charged by the industry actually rose in 2014. The traditional “2 and 20”fee structure may no longer be the standard, but things never drifted far below that. The average fund charged a 1.69 per cent annual management fee and took 19.13 per cent of performance gains in 2014, according to a recent JPMorgan survey, up from 1.64 per cent and 18.99 per cent the year before.

The higher advertised fee rates mask — in fact, are specifically designed to mask — downward pressure below the surface, where the largest investors are getting all manner of discounts. Not everyone has a Calpers-size cheque book, of course, but there are numerous ways for smart investors to get a break on hedge fund fees.

The first way is, get in early. The use of so-called “founders’ shares” is growing in popularity as a way of attracting investors to new hedge fund launches. Even successful portfolio managers spinning out of existing hedge funds often need to offer incentives to get their first investors through the door to make sure their fund gets going at a viable size. Investors can find early bird specials of as little as “1 and 10” on the first $100m or so, according to bankers involved in fundraisings.

Founders’ share terms might be even more creative: the fees may be a full “2 and 20” for the first few years but then fall to zero after the hedge fund has reached a certain scale, a freebie “thank you” from a manager to his early backers.

Founders’ shares reflect the perception that new managers are riskier than those with established records — and they are, although a strong past performance is no guaranteeof future success, either. Box-checking institutional investors are often unable to back promising start-up managers because they lack a record, leaving the field to smart individual investors willing to take a risk in return for a bargain.

A second way to get a breakon fees is to accept a longer lock-up. Hedge fund managers want to guarantee investors will not be able to bolt at the slightest wobble in performance, and they are willing to pay up for that guarantee. Credit funds, which build complex trades out of esoteric and illiquid debt instruments, are among those most often seeking to lock in their investors for long periods so that they do not have to unbundle those trades before they come to fruition. Activist equity investors, too, like to have long lock-ups because it typically takes them several years to storm the boardroom and clean up the performance of the companies they target.

A third way to keep fees down is to pick a multi-strategy hedge fund, a class of vehicle that typically has the industry’s lowest fees — 1.56 per cent annually and an 18.83 per cent performance fee, according to JPMorgan. This could end up much cheaper than investing across a whole suite of different hedge funds, although investors would need to be comfortable with the concentration risk.

A final, particularly appealing option is to find a fund that has a “hurdle rate” built into its calculation of performance fees. About one in seven hedge funds have a hurdle. They only charge a performance fee on returns above a certain level, most often a number based on interest rates or a fixed figure somewhere between 4 and 8 per cent, according to a Barclays survey.

It is easy to see why hurdle rates are still unpopular among hedge fund managers. Given the average return of the industry was just 3.6 per cent last year, hurdles could have meant many funds did not make any money at all in performance fees. They represent a very big discount on fees in years of meagre returns, and a decent size discount even in years of stellar performance. Investors looking for a deal will probably find them being offered by the bolder hedge fund managers who are especially confident in their ability to generate outsize absolute returns.

As the industry faces greater pressure, it is likely that more funds will eventually cave in to demands for hurdles. Headline fees may never stray far from the totemic “2 and 20”; the number of funds that cave in to pressure to introduce hurdles may be a more telling number.