Earlier this week, The Telegraph reported that pension funds were fed up with “high fees” and planned to “tell hedge funds to drop fees.”

Fees are never far from the top of the list of institutional investors’ concerns about asset managers (of all stripes).  The Telegraph’s claim was backed up by an interesting duo of surveys conducted by consultancy bfinance.  Our reading of the results suggests that last year’s frustration over fees may actually be subsiding.  Can we be on the verge of a detente between pensions and asset managers when it comes to fees?  You decide… More…

The fable of The Wind and Sun tells the story of how the Wind and Sun argued over who was more powerful.  Seeing a passerby wearing a coat, the Wind blew as hard as he could to blow it off the man – to no avail.  The Sun, on the other hand, shone on the man, lifted his spirits (and his body temperature) – and basically cajoled him to remove his own coat.

As they develop ways to keep investors in their funds during times of lacklustre performance, a new study suggests that hedge fund managers might find this fable to be somewhat instructional.

One of the great ironies of 2009 was that so many investors were “locked-up” in gated hedge funds at a time when the fee levels they faced – the very fee levels that raised the ire of so many in the recent past – were at an all-time low.  In September 2008, we noted that hedge fund investors the world over were about to go on a lengthy performance fee holiday since so many of their funds were well below their high water marks.

Still, many wanted out and managers began to halt redemptions.  As the gates began to come down, many commentators decried the callousness and alleged self-interest of those hedge fund managers.

But according to a new academic paper, many of the “gated” investors actually have wanted to stick around (at least, assuming a stampede to the exits by co-investors could be averted).   George Aragon of Arizona State University and Jun Qian of Boston College describe the ubiquitous high water mark as a sort of self-imposed gate for investors.  By comparing the asset inflows and outflows of funds with and without high water mark provisions, they say that,

“Our model also predicts that HWMs provide a lock-in mechanism that serves to reduce fund outflows following poor performance…compared to funds without a HWM, investors are less likely to remove capital from HWM-funds following poor performance, as they perceive this as a better opportunity going forward.”

Further, the researchers found that actual outflows cannot be explained solely by the use or avoidance of redemption gates.  In other words, many un-gated investors actually opt to stick around in the tough times.  Writes the duo:

“Overall, our findings cannot be explained by a greater use of share redemption restrictions by HWM funds, and are consistent with the lock-in mechanism that retains investors after poor performance in HWM-funds.”

Like redemption gates themselves, HWM provisions can benefit investors by reducing the traffic heading for the exits (i.e. reducing the likelihood of what Aragon and Qian call an “inefficient liquidation” of the fund).

In fact, not only do investors seem less inclined to run from underperforming funds with HWMs, but they seem to strongly prefer well performing funds with a HWM over strongly performing funds without one.  The authors chalk this up to investors’ beliefs that the manager essentially has “asymmetric information” about their own true skill level – and their assumption that a great manager is more likely to offer a possible fee holiday since he/she probably believes they will never actually have to provide it to investors.

Overall, the study finds that funds with a HWM tend also to have a higher performance fee (to make up for the downside of the HWM we conjecture), come from younger firms, have longer redemption notices and are more likely to have a lock-up (ironically).  (See table below constructed with data from the paper).

So while commentators cry foul over redemption restrictions, we wonder how many gated investors are secretly glad that their fellow movie goers have been forced to sit in their seats, rather than run for the exits. (After all, the movie is now provided at a discount).

While funds will likely always have to use brute force to stave off investor panic, they should apparently also take a page from Aesop and consider the power of a little cajoling.

If you could simply backspace and delete all the red racked up in 2008, 2009 would be seen as one of the best years ever for the hedge fund industry.

Yet despite the great returns, most hedge fund managers are still “substantially” below their high water marks, with little likelihood of rising above them this year, according to the latest Bank of America / Merrill Lynch Hedge Fund Monitor.   In others words, they’re building up quite an appetite for performance fees.

“Based on a very optimistic scenario (greater of the rate at the 90th percentile of monthly historical returns or their 2Q09-3Q09 monthly pace) we estimate most strategies will take four to eight months to get back to their high water marks,” noted report authors Mary Ann Bartels and Shan Hasnat. More…

Like Democrat versus Republican, Communism versus Capitalism or Yankees versus Phillies, discussion and debate over fees, their justification and their pending demise is perennial and never-ending. With each market downturn and never-again wave of investor revolt, the banter over whether alternatives managers can and should be exorbitantly charging for their services inevitably heats up.

Certainly AllAboutAlpha.com is just as guilty when it comes to focusing on and feeding the fee frenzy. Only a few weeks ago we published this post about the yet-again demise of 2 and 20 in light of the new era of reduced returns – and reduced interest – in hedge funds.

So it caught our attention when Tabb Group published a report last week noting that while they too expect management and performance fees to steadily decline over the next couple of years, that according to their poll of hedge fund managers 1.75 and 21.93 are actually the new 2 and 20.

“Many wouldn’t be surprised to know that ‘2 and 20’ is still alive and well,” Matt Simon, TABB research analyst and author of the new study, “US Hedge Funds 2009: Fees, Redemptions and Managed Accounts,” noted in a statement accompanying the release of his report. “When weighted by assets under management, the reality is ‘1.75% and 21.93%’.” More…

Another day, another complaint about “arrogant” hedge funds charging unfair fees.  This one was from a UK pension fund head to a conference in London.  According to Reuters, Philip Read, the chairman of the British Coal Staff Superannuation Scheme told the audience “If they want money from us they will have to offer … alignment of interests. If hedge funds remain arrogant and not humble, I think money will go elsewhere…”

Read went on to say that he and other pension funds will “gang up” on hedge funds if they don’t eat some humble pie – and quick.

His comments were representative of the love/hate relationship institutional investors have with hedge funds.  They threaten to “go elsewhere,” yet make great efforts to stick around and force changes.

But hedge funds aren’t the only ones being attacked for allegedly exorbitant fees.   It looks like the mutual fund industry is about to undergo another series of attacks.  As Investment News reports, one mutual fund company is being dragged all the way to the U.S. Supreme Court to defend its fee structure.

A couple of individual investors are suing Harris Associates for excessive advisory fees charged to the Oakmark Series of mutual funds.  Rather than complaining about the cost of the funds themselves (a pretty reasonable 1.1% according to Oakmark’s website), they are taking issue with the fees paid by the Oakmark funds (which were created by Harris) to the fund Advisor (Harris itself).

As the Cornell University Law School’s Legal Information Institute (LII)  reports, the advisory fees paid by Oakmark to Harris would range from 1% per annum to 0.75% per annum depending on the eventual size of the fund.   Oddly, Harris was only able to charge 0.75% to 0.35% to arm’s length clients (funds it did not create) such as pension funds or other mutual funds.  (By comparison, eVestment Alliance’s annual fee survey says the average fee for large cap mandates ranges from 60bps to 50bps.)

As the Cornell LII warns: More…

Beyond being recognized as one of the founding fathers of hedge funds, Alfred Winslow Jones (see AllAboutAlpha’s tribute here), who would have hit the lofty age of 109 last month, in 1949 also introduced a concept not seen before: an incentive fee structured as a function of realized profits, with a set management fee to offset operating costs.

Sixty years on, the concept of “2 and 20” (bumped up from “1 and 20” about a decade ago, presumably due either to inflation, greed or both), has held as the hedge fund industry benchmark. While variations have emerged over the years, ranging from “1 and 10” for funds of hedge funds to “5 and 30” for highly sought after, pedigreed enterprises, most managers have stuck with it, for the main reason that most investors have been willing to pay it.

One of the reasons for this is that hedge fund fees (unlike mutual fund fees) respond immediately and proportionately to performance.  Critics who cry foul that hedge fund fees seem to stay the same in the face of lackluster returns often ignore the fact that last year’s poor returns mean that many hedge funds are charging “2 and nothing” this year.  Indeed, this recent article shows that some funds have gone beyond this and actually provided investors with a performance fee holiday – regardless of how 2009 turns out. More…

By: Konstantin Danilov, AllAboutAlpha.com Editorial Board.

Private equity funds can bring many valuable qualities to a portfolio.  But critics of the asset class  sometimes charge that its defining characteristic is its high fees and relatively low performance.   Yet investors continue to invest in new funds. Is it possible that some investors are “fooled” into investing in buyout funds?  This is the question posed by Ludovic Phalippou of the University of Amsterdam in a new paper called “Beware of Venturing into Private Equity”.  Phalippou focuses his critique on buy-out funds.

Fee-for-all

He cites two studies to show that after fees, the average buyout fund underperforms the S&P 500 Index; however, gross-of-fees, the average fund is able to outperform.   So how much does it really cost to invest in a buyout fund?

Using a proprietary collection of fund-raising prospectuses, Phalippou dissects the key compensation terms for a typical fund:

• Management Fee – annual fee, typically 2 percent of the capital committed until the end of the five year investment period, at which point it is applied invested capital only.
• Carried Interest – annual incentive fee that is based on the returns earned by the fund, given that a hurdle rate of 8% is met.
• Portfolio Company Fees – fees taken directly from portfolio companies that include: transaction fees; termination fees; legal and accounting fees; monitoring fees; and director fees.  Contracts typically do not specify the level or timing of fees, despite the fact that these fees can account for as much as one-third of all fees charged by the fund. A portion of these fees are rebated to LPs, although actual amounts differ vastly between funds.

Using figures that are representative of fund performance, Phalippou calculates the fee amount charged as an annual percentage of the invested amount – or, the equivalent amount an equity mutual fund would have to charge to collect the same amount of fees. That amount comes out to a staggering 7% per year, which appears excessive – especially for an investment that underperforms the S&P 500.

A Small Misunderstanding…

Despite less-than-stellar performance and apparently egregious fees, buyout funds appear to have no problem attracting investors.  The two potential reasons behind this phenomenon appear to be 1) minor differences in opaque fee contracts that lead to disproportionally larger fees and 2) exaggerated performance figures.

Effective management fees, for example, can be significantly higher than the nominal 2% fee stated in the contract. Because funds typically levy the fee on the amount of capital committed – but not actually invested – the effective fee (i.e. the amount charged relative to the amount actually invested) can vary substantially across funds; it depends on how much of the committed capital is actually invested.

Carried interest calculations create even greater levels of variance in paid fees, despite the fact that most funds do not deviate from the 20% of profits with an 8% hurdle rate structure. Portfolio company fees are not specified in advance, despite the fact that it appears that these levels vary greatly across funds. Further, some firms even deny investor requests for records of previously charged fees that can be used to estimate future fees. Because of the hidden complexity of the fee contracts, investors will often have great difficulty comparing contracts and anticipating future fee payments.

On the other hand, inflated performance figures often result from various reporting problems; lack of reporting of negative IRRs for low multiples (see chart below), overvaluing poorly performing investments, using IRR flaws to improve performance, and sample bias often lead to inflated performance. Lack of detail in fundraising prospectuses further compounds the problem; for example, omission of the relevant time periods and leverage levels make the reported multiples difficult to gauge.

Not Smart Enough for Their Own Good?

Phalippou reaches the conclusion that investors continue to invest in buyout funds because of a combination of a) the high level of complexity of the information regarding fees and performance and b) a lack of expertise on the part of some investors. The fact that funds often refuse to provide additional information to smaller investors further compounds the problem, making learning from past experience or comparing fee structures between funds extremely difficult. It seems that some investors are indeed “fooled” into investing in new funds.

Even if the flaws Phalippou discusses are eventually corrected, other factors may allow the “low-performance-high-fees” phenomenon to persist. Overconfidence and herding biases are surely as rampant in private equity investing as they are in traditional equity markets. And because no passive investment alternative for private equity exists means that investors have little choice but to continue writing hefty fee checks to fund managers. Lastly, because funds don’t compete on the basis of cost – performance is the main product differentiator – there is little hope that, at some point, increased competition will drive down fees.

The asymmetry of a performance-based fee is often seen as a “free option” for hedge fund managers.  After all, say critics, managers can win but they can’t lose.

Throughout the brief history of hedge funds, academics and researchers have attempted to measure the value of this option.  And quite often regulators implicitly acknowledge the existence of this transfer of value from investor to manager by banning performance fees or by requiring them to be symmetrical (the SEC’s regulation of mutual funds jumps to mind).

But when a hedge fund is under its high water mark, no performance fees are charged and the value of the option is minimal (at least until the fund gets close to the high water mark).   Put another way, investors in under water hedge funds have earned a performance fee holiday.  But when they redeem their investment during this holiday, the holiday ends.  If/when they buy another hedge fund, the high water mark is reset at the subscription NAV and the performance fees begin anew.

In aggregate, this amounts to self-destructive behavior on the part of investors and is tantamount to a transfer of wealth from investors to managers.  As we pointed out in June: More…

As this article from Pensions & Investments points out, the long-awaited drop in hedge fund fees may finally have arrived.  Although performance fees – a significant portion of overall fees – have recently dropped to zero percent across a wide swath of funds, P&I observes this week that:

“Some hedge fund managers — including Renaissance, Citadel and Diamondback — are heeding the call from institutional investors, setting up new funds, share classes or better-priced offerings.”

While fee pressure may appear to be a relatively new phenomenon, research in the past has shown that in aggregate, investors have been forcing down the fees charged by higher risk hedge funds.  A study written in October 2008 by Gavin Cassar at Wharton and Joseph Gerakos of the University of Chicago found…

“…a positive association between the quality of internal controls and the performance fees rewarded to managers, consistent with investors protecting against potential financial misstatements by placing less emphasis on the reported performance when internal controls are less likely to detect or prevent managers from manipulating reported performance.”

In other words, investors have always put pressure on riskier funds by forcing them to charge lower performance fees.  However, unlike the current flavor of hedge fund investor activism, this pressure seems to have resulted from investors simply voting with their wallets and avoiding riskier, unproven funds – thus forcing them to lower their  fees to attract capital.

These charts from the paper confirms data we presented in this post a few months ago, showing that less than half of all funds actually charge a 2% management fee… More…

A couple of weeks ago, we examined the “rational irrationality” in the way that closed-end hedge funds are traded.  While you’d expect a flood of new hedge funds listings during periods when secondary market discounts were low; that was not always the case.  In fact, a lot of hedge funds IPO’d closed end funds during recent rough spots for the industry.

Our friends at Opalesque report last week from Monaco where Tarun Ramadorai of Oxford University was discussing his research into the field of closed end hedge funds.  Regular readers may remember Ramadorai from a post we published last spring on secondary market pricing data from HedgeBay.

At the time, we only discussed the endogenous factors that went into determining hedge fund discounts – recent performance, historical volatility, portfolio liquidity etc.  But there was one important exogenous factor that helps explain both closed end hedge fund and closed end mutual fund pricing: interest rates.

As this chart from Ramadorai’s 2008 paper clearly illustrates, discounts fall (premiums rise) when interest rates are down.  (black and green = closed end HF premium, blue = 3 month T-Bill rate, both on a scaled vertical axis) More…

Long-only equity strategies may have recouped most of their 2009 YTD losses, but there is little question the past year has left them with a volatility only their mothers could love.  The FT reports this week that UK pensions are “paying the price for an equity bias”.  Reports the paper:

“…UK company pension schemes are among the most heavily invested in equities when compared with employers based elsewhere. The average allocation to equities was 48 per cent at the end of 2008 – a figure that reflects the collapse in stock markets – and is higher than that in any other country where the private sector accounts for a significant proportion of pension schemes.”

At the same time, Hedge Funds Review points to a survey showing that pensions continue to allocate to equities.  Reports the magazine:

“On the issue of active management, 27% said their allocations to active management would be reduced.  A further 37% said they would increase their allocations but only if fee terms rewarded actual, not expected, out performance.”

Meanwhile, Pensions & Investments reports that European pensions are actually giving a “cold shoulder” to equities… More…

When I was in business school, I recall asking my accounting professor why stock prices change in the absence of any new information.  If stock prices really did represent the present value of future cash flows (an allegedly idiosyncratic number), then how could all stock prices crash in tandem – with little or no fundamental rationale?  It’s as if stocks weren’t simply a representation of a company’s economic prospects, but instead had demand and supply characteristics all their own.

This is essentially the question raised in an interesting article by Oliver Dietiker of the University of Basel called “Investor Irrationality and Closed-End Hedge Funds.”

Dietiker jumps right to the point in the opening stanza:

“The purpose of my study is to question the rationality of people investing in hedge funds (HFs). My investigation is based on the following simple proposition: it is irrational to have similar expectations about the future performance of different HFs.”

“How can he question the rationality of investing in hedge funds?” I hear you say (with tongue firmly planted in cheek).   He asks why the discounts or premia attached to new closed-end hedge funds seem to apply to apply across the board to supposedly idiosyncratic investment funds.  After all, if the whole hedge fund value proposition is to deliver uncorrelated returns, then how you apply beliefs about one group of funds to your forecasts for another? More…