Hedge funds remain an appealing investment vehicle with the capacity to improve diversification and risk-adjusted returns for their investors. Suboptimal performance and unappealing historical comparisons of Fund of Funds have led investors to revisit the expensive prices they are paying for results that have been less than lukewarm.
Many aspects of Fund of Funds are on the forefront of change. With the investment structure in a state of reform, economics are evolving as well. We may see these structures touting a smaller price tag in the future as competitive products have now entered the fray. One possible contender that we have seen becoming increasingly popular are customised Fund of Funds baskets which are individually designed to each specific investor.
Reform on the Horizon
If the typical fee has been 1% on assets under management and 10% incentive fee, it is reasonable to imagine two possible scenarios for fee reform.
Advisory Fee Model
This model is analogous to how a consultant or investment advisor would be compensated. The Fund of Funds manager earns a certain percentage, let’s say 100 basis points, or 1%, charged on the amount of assets in the vehicle. Here the investor and the manager’s interests are aligned. The manager is not incentivized to take excess risks that are not suitable for the investor, which will result in lower assets in the long run, reducing the assets and thereby manager’s fees.
We feel that this model serves investors well because it encourages the manager to grow the fund at a palatable pace which will incorporate risk controls.
Performance Fee Model
In this scenario, the manager only gets paid an incentive fee if the fund reaches a value above a threshold value called a “high water mark.” This setup may provoke perverse incentives. The manager will therefore feel motivated to take higher risk in order to achieve higher returns. There also may occur a result called “moral hazard.”
This is best described through example. Let’s say that a $1MM portfolio passes January to June with a loss of -6%. The hedge fund manager has made no money or salary so far. Let’s say that the hedge fund manager aims to make $200k for herself this year. Remembering that losses compound, she will need to achieve more than 20% return by the end of the year, or she goes home empty handed.
We feel this model does not serve investors well as inordinate pressure to get paid may encourage hazardous risk taking.
It is pertinent to imagine what would have happened if fees had been charged on an “Advisory Fee Model” basis. Subsequent pieces will be a historical simulation which will examine in depth the comparison between these two fee methodologies.