Hedge-fund fees fall to an all-time low. Source: HFR

Hedge Fund Fees in Free Fall Is the New Reality For a Humbled Industry

By Nishant Kumar, Demetrios Pogkas and Hema Parmar

Published: July 27, 2020, 3:00 AM EDT | Updated: July 27, 2020, 8:45 AM EDT

Hedge-fund fees had already been shrinking before the pandemic ripped through global markets. Now, they’re in terminal decline.

One of London’s fastest-growing hedge funds is enticing new investors by agreeing to forgo performance fees until returns hit a key threshold. In Hong Kong, a fund boss is offering to cover all losses, a concession that’s almost unheard of in this rarefied world. And famed investor Kyle Bass has told clients he’ll charge his usual 20% cut of profits only if he earns triple-digit returns in a new fund he has started.

Long notorious for charging high fees, the $3 trillion industry runs portfolios that are generally open only to institutions and affluent individuals. It’s going to extraordinary lengths to attract new money as the coronavirus pandemic triggers losses and accelerates an investor exodus that has plagued the industry for years. Many of the world’s most prominent managers have come to the stark realization that they need to upend the “two-and-twenty” fee model that’s been a fixture for decades if they want to expand. For some smaller firms, the goal isn’t growth. It’s survival.

Note: Data for 2020 through end of June.

Source: Eurekahedge

“The hedge fund industry is littered with the carcasses of small funds that never reached scale,” says Andrew Beer, founder of New York-based Dynamic Beta Investments, whose firm seeks to outperform hedge funds with lower costs. “Fees in the industry are still twice what they should be.”

Standout returns in the 1990s—fueled by celebrity managers such as George Soros and Seth Klarman—helped hedge funds command exorbitant prices. A 2% annual management fee and a 20% cut of profits (variously known as the performance or incentive fee) became the norm for most firms, even for startup managers with little pedigree. One selling point was that hedge funds had the flexibility to pursue strategies other money managers couldn’t. They might make big bets on assets declining in value as well as rising or even make money on the market’s volatility.

But mediocre performance since the 2008 financial crisis has sparked an investor mutiny. Now even the best-known managers are coming around to the notion that they need to make some concessions to stay competitive: industry titans such as Alan Howard, David Harding and Paul Tudor Jones have all cut their fees in recent years.

There are notable exceptions. Billionaire Jeff Talpins’s Element Capital Management hiked its incentive fees to 40% last year and even a discount on management fees only brought them down to the industry norm of 2%. D.E. Shaw & Co. has upped the charges in its biggest hedge fund to a 30% share of gains and a 3% annual levy. But they’re now the minority.

Exclusive Club 👆

Even for the biggest hedge funds, high management fees are no longer the norm

Note: Selected funds with fee data available are shown. For funds charging a range of fees, the lower or upper figure is used depending on data available. Chart excludes Bridgewater Associates which offers client-selected fee structures. Read full methodology note

Sources: Preqin; Bloomberg reporting; investor documents

In the chaos of the pandemic-induced market rout, some hedge funds were able to capitalize on a long-awaited surge in volatility to boost returns. But many had their worst months on record in March, including firms run by Ray Dalio and Michael Hintze.

As shell-shocked investors assess the damage from the coronavirus pandemic, the grim statistics are piling up. Clients pulled more than $55 billion from hedge funds in the first half of 2020, the most in at least a decade, according to data tracker EVestment. Hundreds of firms shuttered in the first quarter, the fastest pace in more than four years. And the number of new launches slumped to near record lows.

Against this backdrop, some managers are signaling that they’re ready to waive fixed fees altogether while also offering other perks. Giving clients access to their prized research, co-investment deals allowing clients to put money into exclusive deals alongside hedge funds, and even risking all their money before clients bear the loss of a single penny are suddenly on the menu.

Selwood Asset Management, the $3.5 billion London-based hedge fund run by Sofiane Gharred, invited some new clients to invest without paying performance fees until the fund hits a threshold known as the high-water mark (or the previous peak level in value). Selwood typically charges performance fees ranging from 13.5% to 30% for its main fund.

Zachary Squire, who started his New York-based hedge fund Tekmerion Capital Management with backing from Alan Howard and Mike Novogratz, offers its research to clients. Squire said the research that his firm offers “to institutional investors in our capacity as a CTA” (a type of investment advisor), is a “real differentiator” and helps clients who may not have inhouse capabilities.

Meanwhile, Hayman Capital Management’s Bass has proposed charging the traditional 20% incentive fee for his new fund only if the net return exceeds 100%. He’s also offering to forgo annual management fees after an upfront 2% fee to cover initial costs. The catch is that investors need to stick with his bet on the collapse of the Hong Kong dollar for two years.

Paul Singer’s Elliott Management Corp., which has been in business for 43 years, is also offering lower fees in exchange for locking up capital for longer. New York-based Elliott is asking some clients to switch to a share class that will lower their fees to 1.5%, from 2%. In exchange, it will take investors 18 months to take all their money out. Hong Kong-based Infini Capital Management’s chief executive officer, Tony Chin, is offering to cover 100% of any losses, or what is called full-loss insurance. In exchange, it will charge half of the profits generated.

Investing Superstars

Hedge funds trace their roots back to the early 20th century but only became mainstream in the past two decades. Some consider famed economist John Maynard Keynes as the modern world’s first hedge-fund manager, with his bets on currencies, commodities and stocks in the 1920s and ‘30s. Others say that honor belongs to Alfred Winslow Jones, who opened his fund in 1949 and coined the word “hedged fund.” More recently, firms run by Soros, who famously broke the Bank of England in 1992 by forcing a devaluation of the pound, and Dalio, founder of the world’s largest hedge fund Bridgewater Associates, became superstars.

Hundreds of billions of dollars in assets flowed into the industry as returns flourished. The riches filled the coffers of hedge fund managers and created larger-than-life characters who splashed their fortunes on luxurious lifestyles, bought expensive artwork and sports teams and funded political campaigns. The abundance of wealth also inspired books, movies and TV series.

Note: Data for 2020 through March.

Source: HFR

The gilded era came to an end after the 2008 financial crisis. Returns slumped as central banks flooded the market with cheap money, upending traditional relationships between asset classes and economic data. Volatility fizzled and many managers struggled to profit from betting against stocks as markets entered their longest bull run in history. Over the past decade, hedge funds have produced less than one-third of the annual returns of stocks.

In the first half of 2020, hedge funds lost 3.4%, slightly more than the decline in the S&P 500 with dividends included, another underwhelming performance for an industry that traditionally promised to protect, or hedge, against losses in bad times.

Lagging Behind

Hedge fund returns have trailed behind S&P500’s rebound since the financial crisis

Note: HFRI Fund Weighted Composite Index against S&P 500 Total Return Index normalized using a factor of 100. Data through June 30.

Source: Bloomberg data

Until the financial crisis, the idea of the two-and-twenty was so entrenched that few really kept track of hedge fund fees. Even as returns started tapering off, hedge funds were able to earn plenty of money from the management fees generated by their huge pile of assets. But that undercut their main premise: That the high cost for clients was justified by outperformance over other investments.

In 2014, the largest U.S. pension fund decided to exit hedge funds altogether, a decision that was highly symbolic of the industry’s decline. California Public Employees’ Retirement System dumped $4 billion of such investments, citing complexity and costs. Even Warren Buffett has since waded into the fray, calling out high-fee money managers for reaping profits at the expense of clients.

“Some hedge funds have become like very large oil tankers cruising down the Suez Canal at snail’s pace,” says Saleem Siddiqi, founder of Musst Investments, which provides capital to hedge funds. “Lower asset levels will cut reliance on management fees and potentially refocus managers on performance.”

How Fees Work

Change the figures to calculate fee income

Assets under management

× Management fee

Fund return

Profit/loss from trading

× Performance fee

Total earnings

$80,000

Note: This calculator is for illustrative purposes and excludes variables such as high-water mark and performance hurdles.

One of the industry’s most influential consultants, Albourne Partners, has proposed a radical overhaul of the hedge fund compensation structure to align the interests of managers more closely with their investors. Under what Albourne dubs the “1-or-30” model, in a good year, fund managers would take 30% of returns and no annual fees. In a bad year, they would still be able to charge a 1% management fee that would be deducted from the following year’s performance payout. That model is gradually gaining wider acceptance since Albourne first proposed it in 2016.

Albourne, which advises more than 280 clients who have allocated over $550 billion to alternative assets—an umbrella term for complex investments such as hedge funds— says 77 funds have adopted this fee structure. That figure excludes the large number of such arrangements that have been privately negotiated and implemented through what’s known as “side letters,” says Jonathan Koerner, a partner at Albourne. In a recent survey of 391 funds, 63% of managers either already offer or are willing to implement such an arrangement, he says.

Minting Billionaires

The industry continues to point to the enormous gains it has made for investors over the years. Hedge funds overall have churned out almost $1.3 trillion in profits, according to LCH Investments. But here’s a revealing detail: In an industry with more than 8,000 funds, the top 20 managers accounted for almost half of those profits.

Today, with returns in excess of benchmarks becoming more and more elusive, the managers who still make money are mostly the old guard sitting on billions of dollars in assets and adding hundreds of millions to their net worth every year. Even as Bridgewater Associates lost money in its flagship fund last year, Dalio, its founder, added $480 million to his net worth. He’s estimated to be worth $15.4 billion, according to the Bloomberg Billionaires Index.

The hedge fund industry’s fees have helped spawn dozens of billionaires. Sebastian Mallaby, the author of More Money Than God, noted that in 2016 Goldman Sachs Group Inc.’s then-CEO Lloyd Blankfein was awarded $54 million. That same year the top three hedge fund earners took home more than $1 billion each. Five hedge fund managers made more than $1 billion for themselves last year, according to data compiled by Bloomberg.

Note: Graphic includes a selection of managers that have generated the most cumulative net gains (after fees) since fund inception as of 2019. Net gains data for George Soros is as of end of 2017. Net worth data as of July 24. George Soros net worth figure excludes assets transferred to his foundations.

Sources: LCH Investment NV; Bloomberg Billionaires Index

But outside that exclusive circle, hedge fund managers are facing a new reality.

It’s especially difficult for smaller money managers and new hedge funds, who can no longer count on gathering enough assets to break even. Some are joining so-called platforms—firms that provide back-office support such as trading and compliance infrastructure—to reduce costs. One such provider, Mirabella Group, has seen its client base more than double, to 67, and assets almost triple, to about $17 billion, since mid-2017. Others are abandoning plans for their own firms all together. Chris Wheeler, a money manager at Citadel, for example, had planned to start his own hedge fund. But he abandoned the idea after a key investor backed out and rejoined Citadel last year.

Note: Data for 2020 through March. Moore Capital’s founder Louis Bacon returned outside investors’ money in three main funds and stepped back from trading; Maniyar Capital Advisors spun out of Tudor Investment Corp.

Source: HFR

And then you have veterans such as Martin Taylor, who came out of retirement last year to start London-based Crake Asset Management. The manager, who generated a 6,400% cumulative return for investors from 1995 to 2015, didn’t just count on his past performance to lure investors. He charged a fraction of the traditional fees: 0.5% in management fees and 10% in performance fees on the first half of the funds raised. The rest had to pay 1% for management and 12.5% for performance. After raising $1.6 billion in 2019 for Europe’s biggest hedge fund startup, more than he aimed for, Taylor lowered the fees even further. Then he closed the fund to new capital for two years.

“Martin recognizes that the industry has changed,” says Caron Bastianpillai, who allocates money to hedge funds at Notz Stucki & Cie and invested in Taylor’s new firm. “He has changed the norm.”

At an annual hedge fund meet-up in Monaco last year, most of the 450 delegates arriving in the nearby French city of Nice eschewed the €140 ($163) chopper ride to the sunny principality. The cost of a seven-minute flight over the breathtaking French Riviera to Monaco was hardly prohibitive—even taxis charge more than €100—but the attendees were too concerned about the optics.

Stuart MacDonald, one of the attendees who helps funds raise money as managing partner at Bride Valley Partners, says groups of managers at the event could be seen furtively planning return journeys by bus, a stark contrast to the glory days of yore. “Time was,” MacDonald says, “you could barely see the sky in Monaco at hedge fund conference time, as chopper after whirling-bladed chopper brought the hedge fund glitterati in from Nice.”

Updates to add additional comments from Tekmerion’s Squire in fifth paragraph below the “Exclusive Club” chart

With additional reporting from: Bei Hu

Edited by: Sree Vidya Bhaktavatsalam, Shelley Robinson, Jeremy Scott Diamond and Christian Baumgaertel

Photos: Takaaki Iwabu, Simon Dawson, Jeenah Moon, David Paul Morris, Patrick T. Fallon and Adrian Moser/Bloomberg

Note on funds’ fee structures: Bridgewater Associates’s $140 billion in assets is evenly split between its Pure Alpha and All Weather strategies. The firm offers fees that are based on the targeted risk and returns of its clients. Element returned a fifth of its assets, cut management charges from 2.5% to 2% but hiked incentive fees to 40% from 25% last year. Fees for The Children’s Investment Fund Management are for its 3-year share class. ExodusPoint, Millennium and Citadel do not appear in the management fee chart because they follow a fee structure known as cost-pass through, where costs are passed along to investors. Return to the graphic

Hedge Fund Fees in Free Fall Is the New Reality For a Humbled Industry

Seismic Shift

Exclusive Club 👆

Explosive Growth

Lagging Behind

How Fees Work

Money-Makers

The Big Shakeout