Hedge Fund Herding, and How to End It

Too much focus on outperforming peers is causing misalignment between hedge funds and investors, argues Novus Partners.

Decreasing management fees and increasing lockup periods will help hedge funds and investors become better aligned, according to analytics firm Novus Partners.

In a recent blog post, Novus Vice President Faryan Amir-Ghassemi argued that most funds are not in a position to behave as true permanent capital investors, especially once they begin to attract institutional investors.

According to Amir-Ghassemi, institutional investors are highly attracted to “promising young funds” that have generated $200 million in assets and demonstrated several years of alpha generation. The assets under management of these hedge funds often “climb to $1 billion in a matter of months,” he continued, as big investors commit capital.

“Once you cross this Rubicon, you become beholden to consistent outperformance, irrespective of your investment style or the opportunity set,” Amir-Ghassemi wrote.

Given that institutional investors are often invested in dozens of hedge funds, having them as limited partners (LPs) puts pressure “not only on the general partner’s (GP) absolute performance but on that relative to its peers,” Amir-Ghassemi argued. Funds that underperform peers are left vulnerable to capital flight, with the result that they become “more worried about their peers and the herd, rather than the intrinsic fundamentals of the very investment.”

“This may frustrate the portfolio manager whose time horizon on a security’s intrinsic value may be misaligned with the pressure felt,” Amir-Ghassemi wrote. “This misalignment can divert the fund from its core investment style.”

To improve alignment, Amir-Ghassemi said hedge funds should progressively decrease management fees as assets rise beyond certain thresholds, and place more emphasis on performance fees.

According to Amir-Ghassemi, this fee compression should be accompanied by longer lockups from the LP to ensure alignment issues are addressed.

“This gives GPs more degrees of freedom to express their ideas without fear of reprisal for short-term underperformance,” he wrote. “This change will ultimately solidify the alignment between GP and LP, so hedge fund managers can… focus solely on generating alpha.”

Related: Happy LP, Happy Life