An influential group takes aim at a traditional and potentially conflicted fee model
An influential hedge fund investor group has criticized the traditional “2 and 20” fee model used by hedge funds, which they say drives managers to focus on raising assets rather than improving performance to get returns.
Under the model, hedge funds charge a 2% management fee and a 20% performance fee, according to the Financial Times. As returns at larger hedge funds waver, investors are becoming leery of managers’ efforts to get more management fees, which are viewed as risk-free revenue. Performance fees, which reward returns, are not as scrutinized by investors.
“Management fees should not function to generate profits,” the Alignment of Interests Association (AOI) — which represents US-based pension funds, endowments, foundations, and family offices — said in a new report. “This creates a conflict of interest for the parties because fund investors are vested in the performance of individual funds, while managers are vested in the health and growth of the business as a whole.”
The AOI clarified that hedge funds are still worth investing in, but changes must be made to the fee model. With cheaper index-based funds outperforming many hedge funds, investors have started to question the latter’s strategy and high fees.
“Alpha exists, and it should be rewarded handsomely,” said Robert Lee, deputy chief investment officer at Texas Tech University, told the Times. “Beta however, often masquerading as alpha, is today a commoditised exposure. Beta should be cheap.”
Several studies indicate that hedge funds are already bringing down their fees, with management fees averaging close to 1.5%. The AOI said it has no issue with management fees as long as they are used to cover legitimate costs of business.
The AOI has suggested that hedge funds introduce a tiered management fee model, under which the amount is reduced every time a certain level of AUM is reached.
Some managers have also been asked by investors to stop at a certain level of AUM to prevent dilution of returns, or to manage a customized mandate at an agreed-upon cost. A founders’ share class, where early investors are essentially given a discount, is another common approach.
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Under the model, hedge funds charge a 2% management fee and a 20% performance fee, according to the Financial Times. As returns at larger hedge funds waver, investors are becoming leery of managers’ efforts to get more management fees, which are viewed as risk-free revenue. Performance fees, which reward returns, are not as scrutinized by investors.
“Management fees should not function to generate profits,” the Alignment of Interests Association (AOI) — which represents US-based pension funds, endowments, foundations, and family offices — said in a new report. “This creates a conflict of interest for the parties because fund investors are vested in the performance of individual funds, while managers are vested in the health and growth of the business as a whole.”
The AOI clarified that hedge funds are still worth investing in, but changes must be made to the fee model. With cheaper index-based funds outperforming many hedge funds, investors have started to question the latter’s strategy and high fees.
“Alpha exists, and it should be rewarded handsomely,” said Robert Lee, deputy chief investment officer at Texas Tech University, told the Times. “Beta however, often masquerading as alpha, is today a commoditised exposure. Beta should be cheap.”
Several studies indicate that hedge funds are already bringing down their fees, with management fees averaging close to 1.5%. The AOI said it has no issue with management fees as long as they are used to cover legitimate costs of business.
The AOI has suggested that hedge funds introduce a tiered management fee model, under which the amount is reduced every time a certain level of AUM is reached.
Some managers have also been asked by investors to stop at a certain level of AUM to prevent dilution of returns, or to manage a customized mandate at an agreed-upon cost. A founders’ share class, where early investors are essentially given a discount, is another common approach.
For more of Wealth Professional's latest industry news, click here.
Related stories:
Why a ban on embedded commissions would hurt smaller portfolios
Investors demanding lower-cost funds
