When Seward & Kissel, the law firm that claims the longest track record servicing the hedge fund industry since the industry’s founding with A.W. Jones in 1949, released the sixth edition of its New Hedge Fund Study, it did so at an interesting moment in hedge fund history. With fund managers generally underperforming stock market benchmarks yet earning tidy sums for their efforts, the study provides insight into how fund managers are coping.
Hedge funds adjust strategies amid growing beta benchmark tied to performance
The most meaningful finding, according to study author Steve Nadel, was the increased percentage of fund managers using non-equity-based strategies. Hedge funds using non-equity strategies jumped nearly 75%. In 2016, 35% of hedge funds were using non-equity strategies, compared to 20% in 2015. At the same time, 65% of funds were using equity or equity-related strategies, down from 80% in 2015.
The adjustment of strategy mix comes as hedge fund allocators, led by the Teacher Retirement System of Texas, rolls out a system that only pays for alpha above a beta-related benchmark such as the S&P 500. While some managers are adjusting strategy to get more noncorrelated, there are other issues with the new proposed fee structure. In fact, the topic of changing fee structures was significantly evident in the study.
Seward & Kissel has issues with 1% or 30% fee structure
Seward & Kissel has not yet seen the proposed Teacher Retirement System of Texas “1% or 30%” fee proposal in practice, and Nadel has questions about how it is intended to be implemented.
The study noted that fee structures are changing on several levels, with equity hedge funds commanding an average of a 1.5% management fee against nearly a 20% incentive fee.
Early stage hedge funds are increasingly turning to “founders classes” of investors who receive special benefits, including discounted fee structures with additional amounts invested. Fully 75% of the equity funds and just 36% of the non-equity funds offered some sort of founder’s class benefit.
When considering the TRS fee structure, Nadel noted various issues.
In an interview with ValueWalk, he pointed out that the 1% management fee is actually supposed to be a “draw” against future earnings and not an unencumbered payment against assets under management. If a fund manager underperforms their beta benchmark and is overpaid in year one, the overpayment is carried over in year two. “It makes it a multi-year compensation structure,” something Nadel is not accustomed to seeing in funds engaged in trading as opposed to long-term buy and hold, where multi-year compensation agreements are not as uncommon.
There could also be tax issues with the new TRS system if the intent is to treat the management fee as a profit allocation, as he understands.
Statements made by the IRS in late 2015 and early 2016 indicate there is a degree of concern regarding the tax treatment of a management fee that is tied to a profit incentive. “Tax consequences need to be factored into the 1% or 30% TRS hedge fund structure,” Nadel noted, saying there is tax risk to making management fees more analogous to fund profit generation.
Fund liquidity has been a consistent issue in hedge fund allocations, and here the Seward & Kissel study notes that the vast majority – 94% — offer quarterly or better liquidity while just 6% have annual liquidity. Withdrawal notice periods favored 60-day liquidity, with the average notice period coming in at 52.73 days.