How the Compensation Model Affects Hedge Funds

How Funds Are Normally Compensated

In the normal model of fund compensation, funds make their money through charging fixed fees to their investors. Fixed here means independent of results, so if a fund has a fantastic year or a terrible one, the fees do not change.

No one is going to manage your money for free, nor can you manage your own portfolio for free either, and there are always costs involved. If you trade on your own, you will have to pay commissions and spreads, in addition to things like exchange fees, and other costs of doing business such as computer hardware and software, training materials, and the like.

How the Compensation Model Affects Hedge FundsWith funds, if it’s a mutual fund, you will pay management fees at a minimum, a fixed percentage of your portfolio which is charged as your share of managing the fund overall. Management fees do differ somewhat between funds and some investors do use this as a criterion for selecting among them.

Index funds have the lowest management fees, also called management expense ratio or MER, because these funds do not require active management and also have lower trading costs due to trading less than an actively managed fund on average. They also don’t need as big of a staff or talented managers to select their positions because all of this becomes just a matter of proportioning the fund to the index it tracks.

Funds also may charge a number of other fees, and there may be a fee for purchasing shares in the fund, called a load, fees when you close a position, as well as other fees that may apply. Funds over the last while have gotten away from these other fees for the most part and while some do charge them, no load funds have become more in vogue, where investors just pay the management fee and perhaps some administrative fees here and there but that’s it.

Exchange traded funds have even lower management fees, but they also involve paying commissions as one buys and sells them on the stock market, where brokers of course charge for this service. When you buy a no-load fund from the fund itself this avoids these additional costs, but there are advantages with exchange traded funds that may still make them preferable, and which is best will depend on the situation.

What This Compensation Model Lacks

There are limitations on how much a fund can charge their clients of course, relative to their performance. If a fund averages 6% a year in returns, they obviously can’t charge 6% in management fees, because no one would want to invest in it without an expectation of profit. Management fees come off the top of returns, and in this case if it returns 6% in a given year, the net return to investors would be zero.

There has to be enough room between the expected return and management fees, the costs of owning the fund, or it won’t make sense for people to be in the fund. The greater the spread between average return and average management fees, the bigger the net return to investors.

Even though we never really know how a fund will perform in the future, we look at the average of past years to get an idea of what we may expect, and this is nowhere near an exact calculation but can give us at least an idea of what the return to expense ratio may be.

This limits management fees and also limits the resources a fund can put into its management, especially when it comes to attracting talented fund managers. Lately, the competition from passively managed index funds, with their significantly lower management fees, as well as that from exchange traded funds or ETFs, have made this all the more challenging for these funds to grow their investor base, as other funds may offer a better spread overall between return and fees.

What a fund may spend on trading resources therefore become even more limited and this makes it even more difficult to beat the market and keep up with index tracking funds. These challenges are in addition to the ones that are imposed by regulators, that funds be limited to holding only certain assets and they may not take short positions or use leverage. Under these constraints, and with dealing with massively sized portfolios, it can be challenging enough and is in most cases to just beat the market by even a bit, and most of these funds fail to do even that.

ETFs don’t have quite the same constraints, as they can use at least a little leverage and can also track markets inversely, gaining in value when the market goes down, and investors can also short regular ETFs as well if they desire and if their broker has inventory to lend them, similar to shorting individual stocks.

ETFs don’t involve any active management at all though, they are essentially index funds, and while individuals can use their own resources to manage a portfolio of them, few investors have the ability to do this very well.

Those of significant means can hire people of higher talent, or hopefully higher talent, to manage their portfolios in a way that no fund can, but this is limited to a small percentage of investors who have enough wealth to justify and attract this individual attention.

What is really missing from funds is the ability to manage them better, through more latitude in their management, as well as having people who really do have elite skills here interested in doing this.

How Hedge Funds Approach This

There really is a big skill gap between truly talented managers and more run of the mill ones, ones that can really set your portfolio moving and those who may be well satisfied just by beating the market by a small amount.

Hedge funds attract the best out there, and the difference between hedge funds and regular funds can be well expressed by the difference between what the two charge. While a mutual fund may charge a 2% management fee, a hedge fund typically charges this plus 20% of the money it made you.

For this to work, the hedge fund would have to beat mutual funds by a good amount, 20% in fact just to make them comparable. Hedge funds do make this work though, and a lot of people are quite eager indeed to put their money into hedge funds as well as pay the much higher management fees.

There is about $3 trillion managed by hedge funds these days, in spite of the fact that most investors do not qualify and therefore aren’t allowed to invest in them. It takes a certain amount of wealth or industry expertise to qualify, but those who do, including institutional investors, will very often tend to select a hedge fund over all other types, because hedge funds deliver better returns with less risk generally, net of these extra costs.

The amount of compensation that hedge funds pay their fund managers is way beyond what any other type of fund can afford, and they will take this further by competing with each other for the best talent. This is comparable to mutual funds being populated with minor league baseball players with top hedge fund managers being like highly sought free agents in the big leagues, demanding and being paid many times more.

Potential Issues With this Compensation Model

If a fund were looking to do everything it could to enhance performance, this is the model to do it with. Top investors can already make fabulous amounts of money on their own, trading their own accounts, and if you want to attract these people you are going to have to pay them, even if this means spending hundreds of millions of dollars a year.

While the staff managing mutual funds tends to be pretty sparse, often with one person doing most of the work, this is far from the case with large hedge funds as they will have hundreds of employees and devote a lot of resources to managing their fund.

Some investors have a problem with the larger fees that hedge funds charge, but this is a case of you get what you pay for. You pay for a lot with a hedge fund, and provided that they are earning their money, which many do, you get a lot as well.

The bottom line here is how much money a fund makes you over time, and if you make quite a bit more with a certain hedge fund, it does not matter how much money they made as well, or even what percentage of the returns that you earned that they retained as their share of the bargain.

There is a potential issue though with this model that has concerned many investors and that’s the possibility of this driving fund management toward taking on excessive risk to make more profit.

The problem with paying a percentage of returns to a fund is that they are invested in the upside but not invested in the downside. Normally, risk management is driven by a concern to manage potential drawdowns, but without having to bear this risk directly, this may not have the same restraining effect.

This concern is similar to what we saw with a lot of people working for companies that invested heavily in what turned out to be risky derivatives, credit swaps and the like, but not really being concerned about these risks and instead being motivated by the fabulous bonuses they could earn if they ignored this.

Lots of money was made, and everyone at the institution was kept happy, and shareholders were generally none the wiser because of the esoteric nature of these investments. Once the party ended, a lot of money was made and the worst that could happen was that you could lose your job, but only after the spoils were enjoyed.

Hedge funds aren’t quite in the same situation, and one of the big differences is that the people who run them tend to have their own money invested as well, and if the fund crashes they have a lot to lose as well. Having a hedge fund manager invest their own money in the fund is actually pretty important if you are worried about these things and even if you are not, because this has them invested in the same way that their clients are and usually a lot more so.

Aside from this, these funds are such a real cash cow to hedge fund firms that their future value is tremendous, and they would be foolish indeed to risk that for the sake of shooting for some extra money in the short term.

Overall, this should not really be much of a concern to those who are looking to invest in hedge funds, although this does vary and we are wise to take a close look at the company and its management before we put a lot of money under their guidance.

Clients, many of whom are institutional investors, who represent the majority of funds under management by hedge funds, have been complaining lately about these higher fees. As a result, we’re now moving away from the 2 and 20 scheme that has been around for a long time and some funds are offering more reasonable rates.

This all needs to be put in perspective though, and we don’t want to rule out a fund that may charge more but put more money in our pockets over a cheaper one that we end up with less with on average. It is all about value, what we get back, and not so much what they get.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

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