Festering Fee Pressures Continue to Hit Hedge Funds

Despite many getting some bang for their buck in the markets in 2016, investors still have issues with the fees.

First it was spotty performance, and now hedge funds are being hit by investors pushing for lower fees and more flexible fee structures tied to performance.

A recent study by Preqin, a supplier of data, analysis and intelligence services to the alternative assets industry of 276 hedge fund managers, found 75% say they are willing to take lower fees after a period of major redemptions by some large institutional investors.

What prompted the changes was a bad 2016. Last year, investors withdrew a net $110 billion in investor capital, including some big-name withdrawals from some of the nation’s largest institutional investors: New Jersey State Investment Council, NYCERS and Metlife Insurance Company. Many of the large investors cited degraded performance and high fees as the leading reasons for heading to the exits.

While performance was cited as an issue, it was important, but also relative. Preqin said 2016 saw hedge funds post a 7.34% return, their best annual return since 2013, when the funds rose 12.49%, more than triple the gains of 2015 (2.14%). But even with these gains, Preqin’s AllStrategies Hedge Fund benchmark still lagged the S&P 500 Index (+9.54%) by two percentage points. This means investors may have gotten some bang for their buck in the markets, but they had issues with the fees.

The change of heart from the $3 trillion hedge fund industry comes after the industry’s decades-long sacred model of “2 and 20,” meaning a 2% quarterly management fee and 20% of profits earned over a high-water mark, became a hurdle that too many hedge funds failed to meet on a consistent basis. At the same time, this market became more competitive institutionalized, volatile and unpredictable. “Reverting to the mean” became the most common excuse when trying to explain fund performance that often went from stellar to average or worse. 

But at the heart of the matter, the issue was whether investors were getting what they were paying for. “If you are paid for performance and the performance isn’t there, people won’t pay for it,” Richard D Steinberg, CFA and president of Steinberg Global Asset Management in Boca Raton, Florida, said.

Countering the Fee Pressure

Grumbling about hedge fund fees is not new. “Investor dissatisfaction shows no signs of abating in the early part of 2017, and it is clear that addressing investor pressure around performance and fees will be the key challenge for hedge fund managers in the year ahead,” Amy Bensted, Preqin’s head of hedge fund products, said. “Managers will be looking to build on the three-year high returns of 7.30% seen in 2016 to restore confidence in the asset class as a whole, revive investor sentiment, and begin reversing the trend of outflows from hedge funds. Although investors show high levels of concern about the short-term performance of the industry, hedge funds have proved their worth in the portfolio of institutional investors on a risk-adjusted basis over the long term.” 

A July 2016 Preqin study found that new hedge funds were adopting a 1½%-and-20% model rather than a 2%-and-20% model.

In this older study, Preqin found 52% of respondents reporting that investors have grown more negative about the industry over the past 12 months. Of the more than 270 fund managers who responded, 43% said clients are citing fee structure as the primary concern, an increase from 28% in December.

While it remains true today, larger investors—those with over $100 million to invest—have more leverage over managers to negotiate fees. Large clients report they are getting 50% discounts from the standard 2-and-20 structure. This leaves smaller investors—with only a few million to invest—with less leverage to negotiate fees. However, they have a choice from the expanding and innovative ETF market that continues to attract investor cash. ETFs are closely following new investor cash into hedge funds; ETFs pulled in about $118 billion in investments in 2016, slightly less than hedge funds.

This downward fee trend has been developing for a long time. Doug Steinbrugge of Agecroft Partners, Richmond, Virginia, wrote in January 2017, that “Hedge funds fees remain under extreme pressure by large institutional investors.”

While tier fees based on the size of an allocation have been around for decades, Steinbrugge said customized fees that include negotiations over performance hurdles, performance crystallization time frames, longer lock-ups, guaranteed capacity agreements, and potential revenue shares or ownership stakes in a management company in return for early stage investments are all in play. He also noted that “Many hedge funds are developing lower-fee strategies that can be used in a 1940 Act structure, institutional share class or separate account. These structures are growing in popularity with large public funds focused on reducing fees.”

On the downside, Steinbrugge realistically assessed the industry by saying it has overcapacity and that many funds will close in the years ahead. “The hedge fund industry is oversaturated with an estimated 15,000 funds,
he said. “We believe approximately 90% of all hedge funds do not justify their fees, which is evidenced by the mediocre returns of hedge fund indices.

“Fed up with poor performance, investors are increasingly more likely to redeem from underperforming managers, leading to an increase in fund closures. We anticipate greater capital markets volatility. Such an increase will magnify the divergence in overall returns between good and bad managers, and highlight these underperforming managers.”

As for the hedge funds, they announced they will be countering pressure on their fees by spending more on education and marketing to explain the asset class itself and a fund’s particular investing approach. 

By Chuck Epstein