Hedge Funds: Courageous Performance Fees “Rule”…Risk-Less Management Fees “Flounder” by GlobalSlant

Headline:

Hedge Fund Fee Structure Is Both Good [Performance Fee] and Bad [Management Fee].

Mutual Fund/ETF Fee Structure = ALL BAD = No Incentive To Excel.


As many hedge funds are getting “crushed” this year it has become fashionable to bash the industry’s entire fee structure…typically [but not always] 2% management fee & 20% of profits. Obviously, there won’t be too many 20% profit distributions to the portfolio management teams this year but the 2% management fee has been/will be applied. And that may “piss off” some people.

[drizzle]Specifically the Mutual Fund/ETF industries whom, it seems, continually criticize hedge fund fee structures. However, this is so hypocritical as many mutual funds still apply fairly egregious fees inversely related to gating periods while regularly under-performing the S&P 500. And ETF’s? Frankly they are a joke. Low fees? Sure…but the risky products they’ve developed for the mainstream retail investor [2x/3x daily sensitivities to various asset classes] are nothing to be particularly proud. Their primary incentives, it seems, are to promote increased trading activity for their particular products. Please ignore their protests of adding liquidity and hedging capabilities. It is mostly a smokescreen.

Plus, ETF’s are as close to black boxes as I’ve seen i.e. SPY. That’s why the fees are low. Basically, with rare exception, no real thinking behind them. Top heavy, market capitalization weighted indices mirroring the GIC weightings established by Standard & Poors. Their “Pitch” = Do not even try to defeat the market as it is a fruitless endeavor. Just invest in our generic products & when we do under-perform just blame The Market/ The Fed/ The Terrorists…anybody but us. The Untouchable, Un-criticizable “Passive” Asset Manager.

On the other hand you have discretionary hedge fund managers. Admitted or not their jobs are infinitely more difficult than the typically long only, fully invested mandates of most mutual fund portfolio managers and the mindless ETF product managers. Hedge fund portfolio managers must decide among asset class, then long or short, position sizing decisions, margin utilization…etc. It is a lot and it is not simple but it is, also, a chosen profession.

This is not to say that mutual fund mangers are collectively lacking in skill. Many are supremely talented but, unfortunately, many more are not. The ETF’s, as indicated, are essentially “soft” black boxes offering intellectual short cuts to index/sector participation. It makes some sense but is surely not a panacea i.e. August 24, 2015. And there is a business model “arb-ing” ETF’s as they offer a host of inefficiencies only articulated in the encyclopedic prospectus’.


Back to Fee Structures….

The ‘High Water Mark” feature of most hedge funds is simply AWESOME and, of course, is likely never even contemplated by the serial fee streaming strategies of the Mutual Fund and ETF industries. Basically, this feature disallows any profit participation by the portfolio managers, principal’s etc unless the limited partner’s capital account is greater than their initial capital basis [net of contributions & withdrawals].

The basic message = WE DON’T MAKE MONEY UNLESS YOUR CAPITAL ACCOUNT IS “IN THE MONEY”. Conversely, if your capital account is “OUT OF THE MONEY”, no performance fees [and in rare cases no management fees] are applied until your capital account is, at the very least, break-even. I’ve yet to meet any limited partner that objects to this feature…the feature NEVER articulated by the penny pinching “I don’t care if you make money as long as my firm makes money” Mutual Fund/ETF sectors.

Their two business models generally rely on dubious skills more tilted toward marketing and hand-holding rather than a strict pursuit of consistent capital building. Because despite their efforts to dissuade…a fair amount of performance is timing related. When the returns do not fit their marketing materials they’ll simply stretch the time frames in which returns are calculated…shaping the facts to fit their predetermined conclusions.

Some may argue that the “High Water Mark” is somewhat misleading as the 2% management fee, for example on a $500M fund, equals $10M. So somebody is making money. Surely salaries, rent and other fixed costs usually do not equivocate this number…especially considering the soft dollar expense paying feature many funds enjoy that is tied to their trading activity. That can free up a great deal of the management fee to boost incomes across the firm’s labor force…which is not entirely a bad thing but does seem moderately flawed…as it rewards short term trading activity that is not necessarily wise trading.


Therefore it is time for the Hedge Fund Management Fees [2%] to be COMPLETELY ELIMINATED.

INCOME TO PORTFOLIO MGR = STRICTLY LINKED TO THE PERFORMANCE FEE. Might as well term it the COMMANDO INCENTIVE FEE STRUCTURE. And there are some funds that adhere to this precept but not too many. Some that do actually charge greater than 20% of profits or may attach profit sharing to terraced, and agreed upon, performance criteria. Again…no problem with that. And perhaps the payouts are 2/x year rather than calendar based? No problem.

Controversial = Yes. There is bound to be a fair amount of push-back Some hedge fund mangers could argue that this will increase the stress level/decision making capabilities of an already hyper-stressed analysts/portfolio managers. Perhaps…but I say “TOO BAD”. I suggest they “LEAN INTO” the stress and contemplate that it could actually result in more distilled/cleaner decision making. And it is important to reiterate that a lot of a hedge fund’s expenses i.e rent, legal, accounting, etc are still soft dollar-ed with trading commissions. Yes…not all expenses but, recall, you are not supposed to get rich just by raising capital, “showing up” and trying. The real goal = returns on that capital. And still…just perform and large amounts of money will be EARNED.

The era of the wealthy hedge fund manger living the “HIGH LIFE” primarily due to the 2% management fee [while just not “Blowing Up”] are primed to change. Beyond this…liquidity and transparency are “on deck”…and, it seems, even a strong legacy of performance will not interrupt this dynamic. Nevertheless, it is a much fairer/better business for an investor than the Mutual Fund/ETF sectors.

The Optimal Size Of Hedge Funds

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