Proposal for New Hedge Fund Fee Structure: 1% + 33% of Alpha

One of my pet peeves is the way that insiders — whether corporate CEOs, hedge fund managers, or elected politicos — capture compensation (or credit) for normal cyclical gains they had little or nothing to do with.

This is the approach favored by the Crony Capitalists — those people pretending to be free market participants, and who merely pretend to be creating value. They are taking credit for structural successes that would have occurred with or without them. What they are actually doing is capturing value, not creating it — and then transferring it from its true owners (shareholders/investors) to themselves.

This is wrong; it is legalized theft.

If you want to see a good example of how CEOs transfer shareholder wealth to themselves, a good place to start is Roger Lowenstein’s 2004 book, Origins of the Crash: The Great Bubble and Its Undoing. The section on CEO compensation is astounding; these guys were essentially getting wildly overcompensated for being CEOs during a bull market. The prime example was the CEO of Heinz, who gave himself (with the tacit approval of his Board of Crony Directors) a $90 million bonus. And this was back in the early 1990s, when $90 million was real money.

Here is an idea for you corporate governance types: How about a compensation scheme based on genuine Alpha generation?

For corporate executives, this means their bonuses are based on something more than mere stock price irrespective of what the market and their sector is doing; I would suggest a combination of revenue gains (total sales) + total dollar profit growth (not a mere slashing of costs) + outperformance of stock relative to both the broad benchmark (S&P500/400/600 as appropriate) PLUS out-performance relative to their own sector.

In other words, stop paying excess bonuses for having the good fortune to be CEO during a bull market.

Which brings us to hedge funds. As we discussed over the weekend (A hedge fund for you and me? The best move is to take a pass), we discussed how much of the investing profits were captured by fund managers for themselves. It is a similar situation in that they are taking performance pay for Beta, not Alpha.

A better fee structure? Replace 2% + 20% current structure with a 1% + 33% of Alpha.

How would that work? Well, the 2% fee gets cut in half, for the simple reason that 2% fee on million dollars plus is excessive. But the real change is when it comes to the performance fee/bonus. That 20% of gains as of late has not been performance, its been only Beta. If their benchmark is up 20% and the manager is up 15%, there is precisely zero Alpha generated. So why should the manager get a bonus or a performance fee? They under-performed.

Instead, I propose a 33% of Alpha as a performance fee. The manager gets a bonus performance fee ONLY IF THEY CREATE EXCESS ALPHA OVER BETA — only on the percentage of gains over the benchmark.

Lets use a simple example: Two hedge fund managers run funds. Assume the market (their benchmark is the S&P500) is up 10%. Manager 1 (Fund ABC) is up 20%, while manager 2 (Fund XYZ) is up 10%. We will use a million dollar fund as a nice round number.

Fund ABC:  FUND +20%, SPX +10%

Fund ABC sees the manager handily out performing the market. The fee comparisons are below.

Example 1:

2 & 20:   $20,000 + $40,000
(Twenty thousand dollars is the two percent management fee; forty thousand is twenty percent of the two hundred thousand dollar gain. Half of which is Beta, half of which is truly Alpha.

1 & 33:  $10,000 + $33,000
(ten thousand dollars is the one percent management fee; thirty-three thousand is thirty percent of the one hundred thousand dollar Alpha gain.

In our example of the out-performing manager, 2&20 generates a 6% fee versus 4.3% fee for the 1&33 structure.

Example 2:
Fund XYZ: FUND +10%, SPX +20%

Fund XYZ sees the manager under perform the market. The fee comparison is:

2 & 20: $20,000 + $20,000
(Twenty thousand dollars is the two percent management fee; twenty thousand dollars is twenty percent of the hundred thousand dollar gain.

1 & 33: $10,000 + $0
(ten thousand dollars is the one percent management fee; zero dollars is thirty three percent of the gain above the markets.

In our example of the under-performing manager, 2&20 generates a 4% fee versus 1% fee for the 1&33 structure.

In both examples, managers are being wildly overpaid for Beta; in the other, they are receiving a bonus based in part on Alpha generation. Hence, their compensation is more aligned with the client’s.

Note that fund manager of ABC makes less under 1 +33 when they generate Alpha — $43k versus $60k. But look at the enormous savings that come from an underperforming manager: Instead of making $60k for partial Beta generation, he makes $10k — a quarter of the fee generation for partial Beta.

I don’t expect fund managers will rush out to embrace this model — unless the institutional players, trustees, and endowments demand it.