Two and twenty is long dead. Hedge fund fees fall further below onetime industry standard

Justin Chin | Bloomberg | Getty Images

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A previously unknown hedge fund called White Square hit the headlines last week after the Financial Times reported it was the first known victim among those who sold GameStop short.

But betting against GameStop wasn’t the death knell for White Square. In fact, his performance had recently recovered.

As White Square said in the letter announcing the company’s closure, “We have seen firsthand the shift away from hedge fund investments to cheaper alternatives.” The company found that two investors repaid this capital and redirected it to cheaper passive funds or private equity.

White Square isn’t the first, and it certainly won’t be the last hedge fund, failing to convince investors to pay for its wealth management. But fees are as inseparable as short selling and leverage in the hedge fund industry. The earliest known hedge fund, developed by AW Jones more than 70 years ago, charged investors a 20% fee on realized profits, which was a novelty at the time. A management fee of 2% of total assets was later added, popularizing the 2-and-20 structure.

Average fees have shrunk in recent years. According to HFR, hedge funds averaged a management fee of 1.4% and a performance fee of 16.4% in the fourth quarter of 2020. That’s less than the 1.6% management fee and 19% performance fee that were common a decade ago.

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A recent study by Ohio State University, however, examines the so-called “effective incentive fee”, which, according to the researchers, is closer to 50%, not the nominal 20%, as is often advertised.

When considering variables such as exit decisions and losers in the fund cross-section, the researchers found that limited partners in hedge funds actually spend much more fees as a percentage of profit. If, for example, capital is repaid from a fund with losses, but which has previously generated returns and collected incentive fees, the payment to the general partners as a percentage of gross profit would be lower, the study shows.

After deducting management fees, the study concluded that limited partners take home only 36 cents for every dollar they make with their invested capital.

Christopher Ailman, chief investment officer of CalSTRS, the second largest public pension fund in the United States, said he thinks the fee structure is “broken”. Instead of paying the traditional price for access to hedge funds, he chooses to replicate hedge funds through cheaper, passive strategies.

“For us as long-term institutional investors, it’s all about structure and net return,” said Ailman. “And if I can get the beta of each of these underlying asset classes at very little cost, that’s my core foundation.”

Despite all of the hedge fund fee complaints – a notorious complaint that goes back decades – there are still plenty of investors willing to buy in. Assets under management are close to an estimated record high of $ 3.8 trillion, according to HFR.

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“Hedge funds are not for everyone,” said Bryan Corbett, president and CEO of the Managed Futures Association, the trading group promoting the alternative investment industry in Washington and elsewhere. “But obviously there is a significant part of the allocators who see it as an important part of the mix.”

Corbett said the way most agreements are structured allows for reconciliation between the allocator and the hedge fund (i.e., incentive fees). The MFA launched an “education campaign” last week promoting the “important role hedge funds” play for Americans. She argues that pension funds, colleges, and nonprofits invest in hedge funds to grow and protect wealth.

The public perception of hedge funds is worse than ever after the GameStop short squeeze, when the industry faced countless individual investors trying to force significant losses among those who were bearish.

“I’m not surprised to see that all the young people in the hedge fund industry want some meat,” said Ailman. “I don’t think it’ll get rid of hedge funds. But I think this is actually a really interesting change that we’re seeing.”

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