Hedge fund incentive fees are often called a “free option” since the fund manager can win, but can’t lose.  Since managers can influence the volatility of their funds, many assume that this asymmetry will always give the manager an incentive to “swing for the fences”.

But with so many hedge funds starting off 2009 well below where they were a year ago, we thought it might be useful to examine whether this axiom holds true in the existence of the ubiquitous high water mark.  Last year, two academic studies published before most hedge funds took a dive under water address the impact of high water marks on manager incentives and decision making.  Now is probably a good time to have a second look at them.

The first, by Stavros Panageas of the University of Chicago and Mark Westerfield of the University of Southern California, finds that high water marks mitigate the manager’s potential benefits from goosing their fund’s volatility.  The duo points out that the value of the manager’s “free option” is based on the extent to which the fund is below its high water mark (or, to use the option analogy, below its strike price).  So swinging for the fences and losing has a direct impact on the wealth of the manager.

In a real sense, the “free option” is actually an infinite series of future (annual) options, each with new strike prices in relation to the fund’s value.

In their words:

“A bolder portfolio today could help increase the probability of crossing the current high water mark, but it will also increase the probability that the assets in the fund will be substantially lower next period, while the high water mark will remain unchanged. In the latter case the value of future options will decline, as the assets in the fund will be lower for the same value of the high-water mark. Hence, future options will become more ‘out of the money’.”

So lower moneyness means less value in the option for the manager - an outcome than can make a manager think twice before pointing to center field and taking that Babe Ruth-sized swing for the fences.

While Panageas and Westerfield’s study assumes the hedge fund in question has an infinite life span, the second study, by Susan Christoffersen of McGill University and David Musto of Wharton, recognizes that as small businesses, hedge funds fold on a regular basis.  Thus, investors who are below the high water mark can be shut out of their well-earned performance fee holiday if the manager unilaterally calls it quits.  This can mitigate the negative effect of high water marks on the value of the managers’ “free option”.

Christoffersen and Musto also point out that high water marks can divide investors according to their  tenure in the fund.  As they write,

“…with a HWM, old investment invests on better terms after a loss, because it does not pay the incentive until the loss is made up, whereas new investment has no loss to make up, and therefore pays higher expected fees. So if expected profits after a loss are zero for new investment they must be positive for old investment.”

This is going to be a big issue in 2009.  Most investors are about to embark on a year-long performance fee holiday (which, as an aside, will likely drop the average cost of a hedge fund in 2009 to below that of many mutual funds).  But new investors - or even new assets from existing investors - will face a high water mark of the fund’s NAV on the day of their new investment.

With dramatically different pay-offs, it’s not a huge stretch to imagine potential infighting among hedge fund investors as new entrants pay markedly higher fees than old ones.  The problem is that these “new” investors might just be those who have redeemed from other funds and have reallocated back to the asset class in the form of a different fund.  Just as loyal investors face the frustration of watching their manager give up as a result of  being too far below the high water mark, many other investors will likely frustrate their own chances of success by switching horses - only to have their high water marks reset.

Last week, Peter Douglas wrote on this website that growing competition in the hedge fund industry would lead to what he called “fee differentiation”:

“Investors will be in control, given the new scarcity of investment capital. 2&20 may be the sticker price, tho’ some new funds may go for a more conciliatory 1 & 20, but the effective pricing of investment strategies is likely to disperse dramatically, through the use of separate accounts, co-investment rights, and advisory contracts, as well as through simple fee rebates.”

Douglas is suggesting that the industry will move beyond the one dimensional view of compensation (low to high) and begin to trade off certain aspects of fees with other factors such as co-investment rights.

Last weekend, the FT quoted a hedge fund administrator who seemed to share Douglas’ view.  John McCann of Trinity Fund Administrators told the paper:

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Cynics often describe the hedge funds not as a unique asset class or investment strategy, but as a unique “fee structure“.  To some extent, they are correct.  After all, mutual funds now use hedge fund strategies (long/short, 130/30 etc.) and yet we still call them mutual funds.  Conversely, many hedge funds pursue high-beta long bias (a.k.a. mutual fund) strategies, yet we still refer to them as hedge funds.  And indeed, one of the main regulatory differences between the two types of funds is the ability to charge a performance fee.

Hedge fund fees are generally viewed by the media with a jaundiced eye.  Many people have expressed frustration that hedge fund fees don’t seem to budge - even as hedge funds have been producing lackluster absolute returns.

Take 2008 for example.   A recent study by Eurekahedge recently found that 90% of hedge funds are currently below their hurdle rates or high water marks and are therefore at risk of earning no performance fee this year.  And that was only as of July 31.

As Financial News reports:

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McKinsey & Co. released their annual state of the asset management industry survey earlier today - and it contains what the company refers to as some “surprising” findings.  The annual report (see related posts on the last two editions) is conducted in partnership with Institutional Investor’s “US Institute” and is based on the results of surveys of 90 US money managers.  This year’s edition (available here) covers the year 2007.

At the top of the list of surprises was that while 2007 looked like a banner year overall for US asset managers, asset growth was flat in Q3 and turned negative in Q4.  Making matters worse, costs continue to drift upward - mitigating the effect of higher assets on overall margins.  Part of the problem, says McKinsey, is that headcount continues to rise, and is now up 23% over the past 2 year.

The survey also finds that “outperformers” - those managers with the highest net margins - cut compensation per employee by 1%, while “underperformers” continued to hand out juicy bonuses, leading to a 6% increase in average compensation.  Compensation is generally considered the biggest expense for any investment manager.

Barbells

The report contains evidence of the so-called “barbell” in asset management (see yesterday’s post).  But the chart below from the report also shows a modest reversal of the recent flight to “higher alpha” and “cheap beta” products.

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Although the Olympics is an “amateur” athletic event, many athletes get one time bonuses from their government or corporate sponsors if they do well.  In part, such incentives are designed to ensure the athlete doesn’t just go the games to have a good time.  While the Olympic festivities are an experience in their own right, many other athletes with such incentives often forgo competitions if winning seems out of reach or a pyrrhic victory is likely (take, for example, tennis players who skip tournaments to rest a nagging injury or recuperate after weeks of competition).

The incentive to win - whether financial or purely psychological - is arguable what separates athletes from entertainers or performers.  But are incentive fees also valuable in asset management?

A hedge fund incentive fee is often referred to as a “free option”.  In a 2001 article for the Journal of Alternative Investments, Mark Anson described it this way:

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Pop Quiz: Which are more expensive, hedge funds or mutual funds?

Sounds like a pretty dumb question, right?  Well as regular readers will know, this question is actually central to our views here at AAA.  Over two years ago, we told you about an academic study called “Measuring the True Cost of Active Management by Mutual Funds” by Ross Miller of the State University of New York.  Miller argued that since mutual funds could be largely replicated by low-cost index funds or ETFs, the implicit fee for their active management was significantly higher than the posted expense ratios.  For good reason, the paper was subsequently included in the Q1 2007 edition of the Journal of Investment Management.

The latest to make this argument is Mark Kritzman of Windham Capital.  In his article “Who Charges More: Hedge Funds or Mutual Funds?” (Winter 2008 Journal of Applied Corporate Finance) Kritzman says:

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Back in January, consultancy Watson Wyatt released the high-level results of a study it co-authored with The Financial Times called “2020 Vision: Research on the Future Pension Landscape”. The study queried nearly 500 institutional investors from Europe and Asia on various issues.

According to the report (available here with free registration), respondents “expected the appetite for alpha to rise” and that “interest in extra-financial financial factors (such as sustainability)” were seen as increasing.  We covered some of the other data in this AllAboutAlpha posting.

This month, Watson Wyatt completed the full report promised in the summary data above.  It can also be downloaded here with free registration.  This more lengthy narrative covers a lot of good issues, but a couple of observations really popped out at us.

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Angelo Calvello has been around the alpha-centric investing world longer than almost anyone.  In fact according to our research, he actually coined the term “alpha-centric” investing.  In a guest posting today, he applies this thinking to hedge fund fees.  And what he concludes will surely surprise many.  

Special to AllAboutAlpha.com by: Angelo A. Calvello, Ph.D. 

I recently attended a conference on 130/30 strategies.  The discussion eventually and inevitably drifted to the well worn but poorly understood topic of hedge fund fees and more specifically the inevitable compression of those charges. 

It is a debate founded on the belief that hedge fund fees are simply too high, although it is not clear what yardstick is being used to support this conclusions. Hedge fund fees could be compared to those charged by traditional long-only managers, but this would assume that fees charged for ‘active’ long only management fairly represent the value added by these strategies.  This, of course, is questionable. 

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Last week, we told you about a paper that suggested price competition in the mutual fund industry was somewhat less than robust.  Rather than lopping all mutual funds into one pot and comparing their fees, the authors of that report examined the fees of individual funds relative to their Morningstar category average.  While not as ideal as examining the active management delivered by each fund, this approach loosely categorizes funds by their level of active management (e.g. the small cap growth category has a higher level of active management than the large cap value category).

Although not directly examined by that particular paper, one category that makes no denials about its lack of active management is the S&P Index Mutual Fund category.  These (almost) purely passive funds are the subject of another paper by the same authors available here.

In “Institutional S&P 500 Index Mutual Funds as Financial Commodities: Fact or Fiction?” John Haslem, Kent Baker and David Smith examine whether index funds are really are all the same and whether they are truly “commodities”.

They find a wide variation in the fees (and therefore the performance) of S&P index funds.  This is counter-intuitive given their common Investment strategy, but even more counterintuitive when one considers that institutional investors should be less likely than retail investors to pay unwarranted fees.

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Industries dominated by fixed costs tend to experience a lot of price competition.  You don’t have to look any further than the airline industry to find evidence of this economic axiom.  In fact, price competition is often even more fierce in growth industries where price cuts are enabled by economies of scale.  For example, the Model T Ford had a price tag of $850 when it was launched - blowing away most rivals priced in the $2000-$3000 range.  Within a few years, the Model T MSRP was around $300 - illustrating to the world the new economics of scale.

But price competition seems to have bypassed one particular fixed-cost business - the money management business.  This, according to an article in the Journal of Investing that was made available for free recently.  The paper by John Haslem of the University of Maryland, Kent Baker of the American University and David Smith of SUNY at Albany has the benign-sounding title “Identification and Performance of Equity Mutual Funds with High Management Fees and Expense Ratios”.  But don’t be fooled.  The authors rail against what they see as a lack of price competition in the US (and by extension the global-) mutual fund industry before examining the relationship between fees and performance.  They even name names - highlighting the US mutual funds with the highest relative fees in the land.

In their words:

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After the release of Alpha Magazine’s rankings of the highest-paid hedge fund managers (e.g. John Paulson of Paulson & Co.), we questioned the uproar over the compensation of some managers.  Although astronomical, their compensation fell short of gains logged by entrepreneurs in other sectors (e.g. by Gates, Buffett, Bloomberg, and several lesser-known rich guys).

We proposed a number of hypotheses to explain this apparent double-standard.  One was that traditional entrepreneurs created a product or service of tangible value.  However, the value created by hedge fund managers (provision of liquidity etc.) is intangible at best.  As a result, hedge fund managers are often accused of simply “re-arranging the chairs”, not building them.

But a letter in last Thuraday’s New York Times by John Berlau of the Competitive Enterprise Institute reminded us how traditional entrepreneurs shouldn’t be given a free ride since they create something tangible.

Berlau was responding to a June 10 Times Op-Ed (IHT reprint here) that said:

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