Hedge Fund Incentive (Mis)Alignment

Christopher SchellingThe best options trader I personally know learned his craft prop trading for a large shop in Chicago. (Well, that’s partly true: He also learned it while schooling us in Texas Hold ’em into the wee hours of the morning at the University of Illinois, but I digress.)

After watching his success, first at the larger firm, and then later as he launched his own smaller prop shop and put up 100%-plus returns, I encouraged him to consider productizing his strategy. His return stream was extraordinarily compelling, almost completely uncorrelated, and thus highly attractive to investors. 

His response surprised me. 

“Why would I take 2% and 20%, when I can take 50% and 50%?”

I explained he could probably raise much more capital, but he countered by detailing capacity constraints, and how they’d dilute performance. Even pulling management fees on the larger pool, he’d likely take home less than his current 50% cut on 100% gains. 

Besides a deeper understanding of my friend’s impressive net worth, I realized that in an efficient market, if a manager is truly capable of generating substantial alpha, the fees will reflect that. You get what you pay for.

Perhaps the hedge fund industry’s explosive growth—and disappointing recent returns—relate to this. 

Let’s assume a young trading phenom can make 25% per year on $10 million, sharing 50% of profits with his backer. That’s $2.5 million a year in trading gains, $1.25 million he takes home, before taxes. Importantly, no returns means no take home. 

Now let’s look at an ‘average’ hedge fund arrangement: $640 million in capital (Preqin), 1.75% management fee, and 18% profit share (Cambridge Associates’ 2016 data). Over the five years ending May 31, 2016, the HFRI Fund Weighted Composite and Dow Jones Credit Suisse Hedge Fund Index averaged an annual return of 4.5%.

If net return = (gross return – management fee) x (1 – incentive), then the gross return has been around 7.24%. The average hedge fund manager generated $17.5 million a year in topline revenue, with $11.2 million from management fees and just $6.3 million from incentives. Two-thirds of their income is sticky, asset-based revenue and only one-third is performance based. 

In short, they’re asset gatherers now.

Of course, managers will argue they need to support significant overhead, but that’s part of the problem. That same fixed overhead incentivizes them even more to focus on recurring, predictable revenue, and frankly creates little benefit to the end investor. It may be a sound business model, but not necessarily one that incents the best investment results.   

If the revenue stream for an average hedge fund manager moved to a 50% management fee, 50% incentive split (theoretically making the manager indifferent to asset gathering vs. performance generation, operational leverage aside), gross returns need to get back to 11.5% (I’m not holding my breath). Or, management fees need to come down to 1.1%.

Otherwise, we’ll get what we pay for.

Christopher Schelling is the director of private equity at Texas Municipal Retirement System.