Man vs. Machine: Performance Of Discretionary And Systematic Hedge Funds by Preqin
Drivers of Change Series: Hedge Fund Fees
Hedge fund fees are the focus of our second article in our series on the issues facing the hedge fund industry. Using data from Preqin’s Hedge Fund Online and the Preqin Investor Outlook: Alternative Assets, H2 2016, Joe McGee examines how increasing investor attention to this issue is driving major debate within the industry.
Hedge fund fees have come under increased scrutiny recently as some investors, disappointed with the recent performance of their portfolios, have begun to pay closer attention to the costs of their investments.
A number of institutional investors withdrawing from the asset class have cited hedge fund fees as a factor in their decision. Although California Public Employees’ Retirement System (CalPERS)’s widely discussed decision to withdraw from the asset class in 2014 was motivated by a variety of factors including costs, more recently other investors such as Railways Pension Trustee Company (Railpen) and New York City Employees’ Retirement System (NYCERS) have also attributed their decision to reduce or liquidate their hedge fund portfolios to avoid the fees associated with these investments.
Even though many institutional investors remain committed to hedge funds, with over 5,000 institutional investors active in the asset class tracked by Preqin’s Hedge Fund Online, a growing proportion are questioning whether current fee arrangements are acceptable and whether these appropriately align fund manager incentives with those of their investors. Forty-nine percent of investors surveyed for the Preqin Investor Outlook: Alternative Assets, H2 2016 identified fees as one of the key issues facing the hedge fund industry in the second half of the year, making this the joint most cited
concern alongside performance (Fig. 1). With fees set to be a key discussion point between fund managers and investors over the coming months, we take a look at how investors are approaching the issue and how the debate has been affecting the fees charged by the industry.
Investor Scrutiny of Hedge Fund Fees
Disappointment with recent returns has increased concern among investors that the way hedge fund fees are charged at present does not properly align fund managers’ interests with their own. As discussed in last month’s Hedge Fund Spotlight, 79% of investors surveyed by Preqin reported that their portfolios had fallen short of expectations over the past 12 months. At a time of lower returns for the industry generally, management fees represent a larger proportion of overall gains and hedge funds have become a target of institutional investors looking to reduce fixed costs to their portfolios. Similarly, although performance fees have long been part of the industry’s fee structure, some investors have questioned whether current levels are appropriate and whether the way that these fees are charged rewards genuine long-term outperformance.
As a result of these concerns, over half (58%) of institutional investors surveyed by Preqin believe that fund manager and investor interests are not properly aligned at present, up from 49% in June 2015. However, investors did report that fund terms are beginning to improve. Fifty-eight percent of investors surveyed felt that fund terms and conditions had changed in favor of investors over the past 12 months, compared with only 8% stating that these had changed in favor of fund managers (Fig. 2). Sixty-three percent have noted an improvement in management fees and 32% have observed improvements in the level of performance fees and how these are charged (Fig. 3).
Despite these changes, the investors surveyed felt that there was room for further improvement in several areas, particularly hurdle rates, where only 15% had noticed improvements over the past year but 57% wanted to see further change. Similarly, fund-level transparency was another area in which there was a significant difference between the proportion of investors that had observed improvements and those that felt further changes needed to be made (56% and 27% respectively).
The Decline of “2 and 20”
Increased investor scrutiny and the possibility of investor withdrawals have encouraged some prominent fund managers to lower their fees in recent months. Examples of fund managers tracked by Hedge Fund Online that have recently lowered their fees include Tudor Investment Corporation – which reduced the fees for one of the share classes for Tudor BVI Global Portfolio LP to a 2.25% management fee and a 25% performance fee, from 2.75% and 27% previously – and Och-Ziff Capital Management, which announced in August that it was reducing the management fees for three of its funds by 25 basis points.
The pressure to offer lower fees, however, goes beyond these individual fund managers and has been felt across the industry. Although “2 and 20”, a 2% management fee and a 20% performance fee, is still sometimes referred to as the standard hedge fund fee structure, at present only 35% of single-manager hedge funds tracked by Preqin charge this standard; average fees are currently a 1.57% management fee and a 19.29% performance fee (Fig. 4). The “20” part of the fee structure is more common than the “2”: only 37% of active funds have a 2% management fee, while 82% have a 20% performance fee.
In fact, although hedge fund fees have attracted particular attention recently, the level of these fees has fallen over recent years. Hedge funds launched in 2016 so far have a mean management fee of 1.53%, compared with approximately 1.66% for funds launched in 2007 (Fig. 5). This reflects the smaller proportion of these funds that charge a 2% management fee: 32% of 2016 launches, down from 47% in 2007 (Fig. 6).
The mean performance fee has also fallen, with funds launched in 2016 so far having a mean performance fee of 19.13%, compared with 19.48% for funds launched in 2007 (Fig. 7). The proportion of funds charging a 20% performance fee has dropped over the same period, from 87% in 2007 to 77% in 2016 (Fig. 8).
Factors Influencing Hedge Fund Fees
The number of hedge funds has increased significantly in recent years, to over 13,500 active single-manager hedge funds tracked by Preqin’s Hedge Fund Online. Investors have been finding it increasingly challenging to find and select funds that meet their investment criteria from within this wide group: 46% of those surveyed for the Preqin Investor Outlook: Alternative Assets H2 2016 reported that it is currently harder to find attractive investment opportunities compared with 12 months ago. The same characteristics which serve to make certain funds attractive to investors and allow them to attract large capital commitments – such as a strong track record, differentiated strategy and an institutional quality infrastructure – also give these funds bargaining power with investors when setting their fee terms.
This can be seen noticeably in the case of funds with strong performance track records: funds with a stronger three-year and five-year track record charge higher performance fees on average than funds which have performed worse (Figs. 9 and 10). This is particularly the case for funds with a five-year track record: funds with top quartile performance on a five-year annualized basis charge a mean performance fee of 19.67%, compared with 18.75% for bottom quartile