Hedge Funds, Investors and Fees

Data released by Preqin(1) indicates that hedge fund returns have rallied strongly in 2013 and continue to improve. Event driven funds represented the most successful hedge fund strategy over Q1, returning 3.8%. Whilst even macro-funds, which underperformed in early 2013, have recently benefited dramatically as a result of “Abeconomics”(2) (e.g. London-based Sloane Robinson’s Japan fund has risen 44.6% in 2013).

According to Hedge Fund Research(3), Q1 also saw industry assets rise by $122bn, that is the largest quarterly inflow for over two years. This leaves industry assets at $2.375trn, i.e. the greatest value ever managed by the industry.

However, these inflows and returns come after four years where the average macro fund returned just over 7 per cent. That is, four years where hedge funds, which traditionally employed the two and 20 fee model, have cumulatively returned less than would have been achieved by a passive index fund tracking the S&P 500.(4)

In addition to the above, institutional investors are now the single dominant class of hedge fund investor, accounting for just under 75% of industry assets and almost half of pension funds expect to increase allocations to hedge funds by $100 million or more in 2013. The risk/return profile sought by these investors differs from that sought by the High Net-Worth Individuals that historically formed the hedge fund investor base.(5)

Whilst the hedge fund industry has been remarkably resilient to amendments being made to fee structures(6). The relative under-performance of Hedge Funds has combined with this change of investor base is leading to an increasing pressure on the hedge Fund industry to offer alternative fee structures. That is, a) the industry has not delivered the absolute returns that would justify the fees demanded and b) investors believe that fees should be reduced to reflect these lower return expectations.

Accordingly, recent fund launches, have incorporated alternative fee structures to address these concerns. That is, these structures utilise a management fee whereby a 20% profit share is maintained but management fees diminish in proportion to any increase of firmwide assets under management, thereby incentivising the manager to concentrate on performance, rather than marketing and “asset gathering,” as a source of income.

(1) http://www.preqin.com/blog/101/6605/event-driven-hf-performance
(2) Where increased quantitative easing from the Bank of Japan has led to a rise in the Nikkei 225 of 32% and a 11.4% fall in the yen/dollar exchange rate.
(3) https://www.hedgefundresearch.com/hfrx_reg/index.php
(4) Which produced a 22% gain over the last four years.
(5) Deutsche Bank Alternative Investment Survey (the “DB Survey”) suggests that wealthy individuals targeted 10% annual returns but have a relatively high tolerance for return volatility, whilst institutional investors target a 8% return but place a premium on returns having a low correlation to broader markets.
(6) The DB Survey suggests that only 29% of investors who negotiate fees are successful more than half of the time.

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