Looking at the hedge fund panoply, Barclays Prime Services Capital Solutions Group has a unique perspective. Speaking with investors on a daily basis they get a discretionary sense of trends occurring in the field. But it is not until they take a statistical survey of the action that they can connect logical dots. It is here where the bank’s hedge fund experts note subtle trend changes taking place among institutional investor needs, in both hedge fund fee demands as well as selection criteria, that speaks to larger issues.

hedge fund fee
hedge fund fee

Hedge fund managers under fire

The February Hedge Fund Pulse report titled “Turning the Tide” observes numerous trends. In part, the study notes increased interest in smaller hedge funds and a focus on risk premia topping the minds of pension funds, foundations and family offices.

As fees and a recent drought of hedge fund returns dog the industry – Vanguard founder Jack Bogle, a passive investing advocate, was quoted as saying today that hedge funds were not worth paying zero in fees – smaller hedge funds with the ability to target idiosyncratic opportunities in niche markets are coming into focus. From 2014 to 2016, 38% of hedge funds under $500 million in assets received institutional allocations, up from 11% from 2010 to 2013. In part the logic for such a move is that in smaller markets, larger funds can’t move the performance needle to the same degree as smaller hedge funds.

In part the logic for such a move is that in smaller markets, larger funds can’t move the performance needle to the same degree as smaller hedge funds.

The move to identify repeatable opportunity in generally lesser known markets with at times complex strategies is justified, in part, based on the desire for noncorrelated investment returns or the potential to provide returns above a beta market benchmark.

Hedge Fund Fee – Investing in smaller hedge funds requires different due diligence

Investing in smaller hedge funds is not a panacea and involves different considerations, including an increased focus on different due diligence considerations.

Institutional investors, particularly larger ones, want institutional grade risk management and technical structure, which smaller hedge funds sometimes cannot logically afford given their revenue streams. Larger hedge funds often employ top risk management talent in house and use the latest technology. Smaller hedge funds sometimes compete by outsourcing tasks and employing an increasing number of financial services technology that levels the playing field to various degrees.

Investing in smaller hedge funds often requires an understanding of the business operations, not just based on their strategy. Hedge fund consultants often focus interviews on not just the chief investment officer, but also the chief financial officer or head of operations to ensure a sustainable business model.

hedge fund fees
hedge fund fee
Hedge Fund Fee
Hedge Fund Fee

As hedge funds fee structure under pressure, institutions seek to align interests

When it comes to aligning interests, the fee model is increasingly coming under pressure. This can be publicly evidenced on several levels, including Winton Capital Management and Paul Tudor Jones lowering hedge fund fees in a bid to attract and retain investors.

The business model for smaller hedge funds is for the management fee to cover operational expenses while the incentive fee, sharing profits, is designed to reward performance. As a smaller fund gains traction, gathering assets under management, increasingly the management fee is a source of profit, eliminating incentive from the system, as can be seen in the trending Teacher Retirement System of Texas plan, implemented over the past month as reported in ValueWalk.

Another area where negotiation between investor and fund manager takes place takes place with the performance benchmark upon which the fund is compared. Fund managers tend to prefer benchmarks which might be naturally hit or beaten, but increasingly allocators are selecting the benchmark to which they compare the fund’s performance.

An increasingly important area where allocators are focusing is in portfolio risk management. The Barclays study noted an increase in demand for Risk Premia hedge funds, which offers opportunities for allocators to find noncorrelated alpha. The issue is understanding the business operations and how the strategy models through various mechanical market environments.

hedge fund fees
hedge fund fee