Opinion: Are asset owners losing patience with hedge fund fee structures?

A coalition of powerful pension funds led by the Teacher Retirement System of Texas, and including global giants like Korea Investment Corporation (KIC), Singapore’s GIC and Canada's CDPQ, took aim at the hedge fund industry, demanding the adoption of cash hurdles on incentive fees.

In other words, hedge funds need to outperform cash or its equivalent, 3-month Treasuries, before they get incentive fees.

The open letter, signed by the institutions representing over $200 billion in hedge fund investments, pulls no punches.

It argues that the current fee structure creates a "misalignment of interests" between hedge fund managers (GPs) and investors (LPs). 

With 3-month Treasury yields exceeding 5%, simply holding cash generates fairly reasonable income, for which some hedge funds, charging a typical 20% incentive fee, are handsomely rewarded without demonstrating any real investment acumen.

SKILL-LESS RETURNS

These "skill-less returns", as the letter terms it, form the bedrock of the investors' demands.

"In 2023, a $1 billion market neutral hedge fund could have earned ~$52 million (5.25%) returns just by holding cash, and if that fund charged a 20% incentive fee on absolute returns, would have taken home $10.5 million in compensation for taking zero risk," the letter reads.  

This, the institutional investors argue, is "not sustainable" and "not what LPs are asking GPs to do."

This frustration might be further amplified when considering the recent performance of hedge funds.

While the first quarter saw a resurgence in performance with an average 6.4% return, that was largely driven by equity-correlated strategies, essentially riding the wave of a bullish market, according to Preqin data.  

The sustainability of these returns, heavily reliant on broader market trends, rather than unique strategies, could lead investors to further question the justification for hefty fees.

The historical context of hedge fund fees also adds fuel to the fire.

The traditional "2-and-20" structure, while seeing some decline, remains a significant burden on investors.

The fact that multi-strategy funds, known for their high pass-through fees, are gaining popularity despite delivering a smaller portion of returns to investors raises further questions about the value proposition of the current fee structure.

NUANCED PERSPECTIVE

One senior executive at an asset management firm that AsianInvestor spoke to noted that while the concerns of the open letter are valid, implementing a blanket cash hurdle across the industry might be an oversimplification.

“Not all hedge fund strategies are created equal,” the executive said.   

Lumping together equity-focused funds, which benefited from the recent market upswing, with low-correlation strategies like global macro or alternative investment strategies, which typically shine during downturns, presents an incomplete picture.

“Imposing a cash hurdle might also discourage or disincentivise managers employing complex, non-correlated strategies that could potentially outperform in volatile markets -- precisely when investors need them the most,” this executive said.

In addition, the current high-interest rate environment, a key driver under the "skill-less returns" argument, might well be temporary. 

NEW ERA?

Still, the assertive stance, exemplified by the recent open letter from major pension funds, shows institutional investors are unhappy at how some hedge funds may be charging for returns in which they had little or no part in generating.

No longer content with the status quo, these investors are using their collective weight to push for change. 

The open letter, coupled with increased regulatory scrutiny in the US, Singapore, and China, could signal a global shift towards greater accountability.

It will be interesting to see how hedge funds adapt to this push from large investors - and regulators.

Embracing greater transparency, both in terms of fee structures and investment strategies, may no longer be optional if they want to stay in favour with giant asset owners.