The “No Arbitrage” Rule Applied to Hedge & Mutual Fund Fees
Nov 9th, 2006 | Filed under: Investment Management FeesIf a mutual fund is essentially a marketing package that delivers beta and alpha in a specific proportion (as we have argued here), then what should be the relationship between the (effective) fee for the alpha portion of a mutual fund and the fee for a real hedge fund with similar risk/return characteristics?
We propose the following line of thinking to link hedge fund and mutual fund fees…
The No Arbitrage Rule (applied to active management fees):
The appropriate fee for active management is the fee at which a physical market neutral hedge fund and the comparable market neutral overlay embedded within a mutual fund are equally priced (ceteris paribus).
Sure, friction and lack of liquidity means you can’t really arb funds like you can stocks. But the implications of this notion are profound nonetheless. For example, fees for index-hugging equity funds must fall until their embedded market neutral overlay is priced to equal a real market neutral hedge fund. Similarly, a market neutral hedge fund fee must rise until it reaches the fee that the market has already determined for the embedded market neutral overlay in index-hugging mutual funds.
To continue reading this article please login (at the right) or click here to learn more about accessing our archives.
[…] All About Alpha proposes a “no arbitrage” rule for hedge fund and mutual fund fees. […]
[…] We have touched on the optionality of a performance fee a little on this blog. But this paper actually puts a value on that call option. Naturally, the value of the fee to the manager is based on the particular level of performance fee. But it’s also based on the portion of the fund owned (or more appropriately not owned) by the manager. In other words, if a manager owns most of the fund, then charging herself a meaty performance fee is not that useful. […]