A Hedge-Fund Fee Plan That Only Charges for Alpha
The industry had been paid a fortune for underperformance. That’s changing.
Bloomberg, May 9, 2018
One of my biggest criticisms of the hedge-fund industry has been the mismatch between fund performance and management fees. A traditional fee structure of “2 and 20” (a 2 percent management fee plus 20 percent of any gains) is both expensive and, truth be told, unnecessary. Expensive, because one can capture market-average returns, or beta, for a few basis points in fees in a low-cost mutual fund or exchange-traded fund; and unnecessary because investors end up paying a 20 percent surcharge for beta rather than outperformance, or alpha. (To be fair, a good number of hedge funds have lowered their fees to about 1.5 percent of assets and 15 percent of investment gains.)
What’s so puzzling is that hedge-fund investors typically believe they are paying a premium for a manager’s superior investing skills. Few seem to realize that often, fund managers are really being paid for their ability to both deliver market-based returns and pull in assets. The bottom line: This business model is an expensive wealth transfer mechanism from those who desire alpha to those who promise it but typically fail to deliver.
And yet the financial-services industry is filled with innovators who recognize how problematic this misalignment of interests is.
Enter the fulcrum fee.
Ignore for a second that terrible name and think of this kind of fee as a system that rewards managers for delivering above-average performance and does not not overpay them when they don’t. That 20 percent performance fee is only paid for outperformance above market returns. And there are often penalties for underperformance. A fee structure that rewards alpha, and not beta, represents a sea change from how hedge funds (and private equity and venture capital) have been rewarded in the past.
More than a year ago, the Wall Street Journal’s Jason Zweig discussed Orbis Investment Management, which now manages about $39 billion. It charges institutional clients a fee of 0.45 percent of assets under management, plus a quarter of any outperformance relative to benchmarks (though that money is set aside in reserve for refunds in the event of future underperformance). These fees clearly are much less than those traditionally charged by hedge funds. The discussion that follows was inspired by a chat I had with Andrew Wellington, chief investment officer at Lyrical Asset Management, a value equity boutique in New York with $8.8 billion in assets under management.
There are various types of fulcrum fees, but they all have a one thing in common: They don’t charge an additional performance fee for beta, making the total cost structure appreciably lower.
Consider a hypothetical traditional hedge firm that has $1 billion of assets under management and another that charges a fulcrum fee of 0.75 percent, plus a quarter of the profits. If the markets rise 10 percent and the fund outperforms by 200 basis points, or 2 percent, a traditional hedge fund would charge $20 million (2 percent of $1 billion), plus a performance fee of $24 million (20 percent of the $120 million in gains) for a total of $44 million. Our hypothetical fulcrum fund would charge $12.5 million — a management fee of $7.5 million (0.75 percent of $1 billion), and a performance fee of $5 million (25 percent of the 2 percent above-market gain). The breakdown of the $24 million performance fee portion of the traditional hedge fund works out to $20 million for plain old beta and $4 million for alpha. That total is five times more than what the fulcrum shop charges for investment gains. 1
Now imagine a scenario where the market is up by 10 percent and a fund is up only 8 percent, or has 2 percent underperformance. The traditional hedge fund would have charged $20 million (2 percent of the $1 billion in assets under management) plus a performance fee of $16 million (20 percent of the $80 million in gains) for a total of $36 million dollars. Meanwhile, the fulcrum fund would charge $7.5 million (the 0.75 percent management fee), but it also would give a refund of $5 million (25 percent of the 2 percent, or $20 million, in underperformance). The net charge to clients would be $2.5 million. This is a small fraction of the amount charged by a standard hedged fund. 2
A quick survey shows more firms are embracing the sort of fee structure that better aligns the interests of investors and managers. But data on exactly how many funds or managers are using fulcrum fees isn’t easy to find.
I contacted several money managers who employ a variation of this type of fee. Joel Greenblatt of Gotham Funds, and a recent Masters in Business guest, offers institutional investors the choice of paying 30 percent on outperformance or a flat 1 percent management fee in one of its hedge funds. The math suggests most investors would be better off with the flat 1 percent fee.
As noted above, some hedge funds have been forced to accept “1.5 and 15” — that is a 1.5 percent management fee plus 15 percent of and gains, even if they lag behind the market. Although this is less than the traditional fee structure, it still suffers from the same problem of paying a performance fee for beta or worse. As I’ve said before of hedge funds, Come for the high fees, stay for the underperformance. Fulcrum fees are turning the hedge-fund model on its head. In an era of low-cost indexing, the rest of the active-management world should take notice.
1. It is even more stark when the fund only matches its benchmark. Consider the same scenario as above, only the fund matched the market’s 10 percent gain. The traditional hedge fund would charge $40 million for beta, while the fulcrum fee fund charged $7.5 million. That additional $32.5 million in fees adds insult to injury.
2. Underperformance fees vary widely. Detailed information is found in the funds’ offering documents and the prospectus.