Even as the average hedge fund has been lowering its fees, the cost to invest with a small subset of great performing managers is expected to rise, according to research from BRI Partners that will be published in the coming months.
Hedge fund managers that are able to deliver meaningful excess returns will be able to command a premium fee, as will funds that stand out in a down market and are able to protect investors from part of the carnage, says Stephen Scott, a partner with BRI Partners, which creates investable indexes for institutional investors.
“If volatility returns, as we saw last week, then hedge funds that can meaningfully outperform in a down market will be able to justify higher fees,” says Scott.
Scott adds that hedge fund fees have been falling for several reasons, including weak performance and an inability to shine in markets that have been rising steadily since 2009. But fees have also been under pressure because of the rise of systematic, factor-based strategies. These investments have been able to deliver some of the so-called alpha that was once only available through an actively managed hedge fund and at a lower cost.
“A lot of the tool kit that hedge fund managers have used is now being delivered systematically. The beta bar is being raised,” says Scott. “And if fewer managers can get over that bar, the ones that do will be compensated well.”
According to BRI, the fee for hedge fund beta, often called alternative beta, can range from 35 basis points to 2 percent.
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Scott expects that hedge fund managers that operate in niche areas that can’t handle a huge amount of new capital — strategies the industry called capacity constrained — will be among the most likely to be able to outperform and raise fees. But he cautions that few hedge funds actually cut off the flow of new money to protect the possibility of outperforming in the future.
“It’s the Peter Principle of hedge funds: Your assets under management will rise to the level of your inability to generate any excess returns,” he says.
Renaud Fages, a partner specializing in alternative investments at Boston Consulting Group, agrees that the best-performing hedge funds will likely be able to raise fees, but only for new clients, he says.
“Hedge funds used to be transactional, in that clients left when they didn’t get the returns they wanted,” says Fages. “Now it’s evolving to a relationship culture, and the best hedge funds won’t really raise their fees for their existing customers.”
He adds that attitudes about fees also vary widely among institutional investors. In the U.S., for instance, public pension funds won’t be able to pay premium fees because of the public’s negative perception of hedge funds. Canadian pension funds and sovereign wealth funds — less sensitive to the public’s perception of hedge funds —are more likely to pay higher fees if the funds are truly delivering excess returns.
Scott says fees ultimately come down to supply and demand. Hedge fund fees rose to 2 and 20, meaning a 2 percent management fee and a 20 percent performance fee, after the technology bubble burst in 2000. At that point, pensions and endowments scrambled to invest in hedge funds after witnessing how alternative investments had protected high-profile institutions such as Yale University’s endowment, and managers raised their fees. Before the onslaught of capital that began in 2000, hedge funds generally charged a 1-and-20 fee structure, he says.
