Hurdle Rates: Institutions Need To Take the First Step
| Feb 15th, 2007 | Filed under: Investment Management Fees | By: Alpha Male |
UK-based hedge fund magazine Hedge Funds Review responded to yesterday’s posting on hurdle rates with a posting that suggests institutional investors should take the lead on factoring alternative beta into hedge fund pricing.
Hedge Fund Review’s Solomon Teague agrees that the performance fee debate isn’t going away any time soon.
“In a world of alternative betas, you would expect a management fee, ideally a reduced one, but the real debate must be over the performance fee.”
But he also acknowledges the obvious barriers to change. Says Teague:
“Having said all that, it is ridiculous to expect hedge fund managers to volunteer to cede fees, especially when most believe there is a greater level of skill in what they are doing than in long only investing.”
“A fund manager once told me he believed hedge funds would never compete on fees, no matter how much institutions complain about high fees, because a reduction in your fees would be tantamount to admitting you are not the best, or in the top bracket of your strategy.”
He’s probably right about that. Premium pricing is a time-honoured tradition in the hedge fund marketing (as is the “soft close”).
In his conclusion, Teague puts the ball in institutional investors’ court, suggesting they take the lead by purchasing alternative beta and alpha separately.
“…if institutions buy into the concept of alternative beta it opens the door for competition.”
“Investors, especially institutions, need to take the first step. While institutions continue to demand alpha, investing exclusively in hedge funds strategies they believe do this, and at the going rate, no manager in his right mind will claim to be anything less.”
So we seem to have two opposing forces now. A flood of cost-conscious institutional investors entering the industry over the next 5 years and the existing stock of hedge fund managers who would rather have root canals than drop their premium fees. Perhaps, as Teague suggests, the solution lays with new alternative beta managers who will “appear to fulfill the demand.”
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Why do hedge funds seem to think that it is their God-given right to get 2% + 20% of performance over a small hurdle such as LIBOR?
An investment in an S&P 500 ETF will outperform LIBOR’s 5.36% return about 63% of the time. And it will do that at minimal cost.
If I were an institutional investor, I would think that a reasonable fee is 1%, plus performance fees above the equivalent risk-adjusted benchmark (with credit towards the 1% fee). I would also be comfortable with higher performance fees as well. For example, if a hedge fund expects to have risk comparable to the S&P 500, then I would consider providing a 40% performance fee for performance above the S&P 500.
True rock stars with long histories of success (Renassiance) can charge more, but for the vast majority that haven’t provided stunning returns for the past couple of years, I don’t see how the 2/20 fees are justified.