25/01/2012 Author: Tony Griffiths

The future of 2 and 20

It’s a familiar story. Performance dips and investors re-evaluate their options. With the disappointments of 2011 still raw, the heat on fees has rarely been as intense.

Last week, Towers Watson’s European head of investment consulting, Chris Ford, was quoted in the press as saying his firm was “not prepared to go along with the traditional hedge fund fee structure of 2% and 20%.”

The hedge fund industry’s historic 2% and 20% fee structure has, of course, been under scrutiny for years. According to Hedge Fund Research, the average management fee for funds launched in 2011 declined to 1.58% from 1.61% the year previous, while performance fees declined over an entire percentage point to 17.04%.  

The head of one European hedge fund platform, who preferred not to be named, admitted that many of their fund managers were feeling pressure from investors on the subject of remuneration – particularly with regard to management fees.

Andrew Rubio, CEO of specialist accountancy and service provider Throgmorton, told HFMWeek that the consensus among his clients was that there was currently pressure on fees, but it was a bit of a “mixed bag”.

“It’s definitely a talking point,” he says. “Investors are looking to force down management fees rather than performance fees. It’s looking closer to 1.5% than 2%.

“We’re seeing a different class of investor now, pension funds, for example, and they’re more used to dealing with long-only funds where the cost base is less.”

There has been a historic criticism of larger managers who get to a certain size and then no longer need to perform to generate a healthy profit. “At times when industry performance has been good that argument falls on deaf ears,” says Damien Loveday, global head of hedge fund manager research at Towers Watson. “However, a year such as 2011 might bring that argument back.”

This all depends on the strategy, Loveday notes. Some strategies will argue that they have made a significant investment in systems and that increasing their size requires further investment and, consequently, a larger management fee.   

Shopping around is possible though – and investors know it. Winton Capital has maintained fees of 1% and 20% at its Futures Fund, a vehicle that magnetised the majority of the firm’s industry-leading $8bn in inflows for 2011. With about 240 staff globally and an investment approach renowned for sophistication, few could argue if its management fee was higher.  

According to Loveday, some managers have set up their management fee to be ratcheted down as assets go up, so that if assets are raised beyond a certain point, they generate no marginal management fee revenue. “They’re basically saying that they won’t raise assets unless they feel confident they can maintain performance and thereby generate performance fees – intellectually it’s a very powerful message,” he says. “We’ve seen a few manager groups globally doing that over the last 12-18 months.”

For Emanuel Arbib, CEO of fund of hedge funds Integrated Asset Management, the issue remains divided along asset size. “There are price-makers and price-takers,” he says. “Everyone that isn’t in the top league is a price-taker – for them there is always pressure.”

Arbib doesn’t believe that the problem is with pricing; it’s with flows. “There isn’t really a price competition, there’s a credibility competition and there’s a performance competition,” he asserts.

Qualifying Towers Watson’s stance on fees, Loveday says the salient point is that, particularly with regards to performance, it’s not enough for investors to look at the headline fee.

“It’s about understanding what returns are comprised of,” he explains. “Once you know how returns are divided into their constituent parts, you have a better basis on which to make forward-looking assumptions and from there can better work out the total fee and total alpha and consequently the proportion of alpha being paid away in fees.

“It’s less that people are necessarily trying to negotiate on fees and more that they are recognising that looking purely at the headline fee is not appropriate.” As a result, he says, it’s fair to say the standard 2% and 20% structure is rarely suitable.

According to Loveday, more and more institutional investors are digging down into fees – a fact likely to be linked with the growing number of institutions going direct.

Other options are also becoming more popular. KB Associate’s Phillip Chapple says that hurdle rates for performance, typically between 5% and 8%, are becoming more prevalent.

Investors haven’t lost their appetite for hedge funds. Their taste for hedge fund fees, however, is becoming more refined.