Alternative Investment Management Association Representing alternative asset managers globally
The traditional “2 & 20” fee model for alternative funds has come under intense scrutiny. There may be no single answer as to what the right fee level should be. But the price an investor is willing to pay reflects a set of factors that all hopefully lead to the right outcome: a fair alignment of interest between buyer (investor) and seller (fund manager).
One of the key attractions of hedge funds and other alternatives products has always been the close alignment that managers seek to offer to investors. Concepts like “skin in the game”, the almost universal practice whereby managers invest a significant portion of their own money alongside external investors, and the high watermark, a peak fund value only above which performance fees are paid, are almost unique to alternatives and have underpinned the industry’s growth for decades. Mutual funds and other forms of traditional investments are simply not designed the same way.
A holy grail of investing is a perfect alignment of interest between fund manager and investor. Perfection in this context may not exist but hedge funds and other alternatives come closer than other forms of investing. Its impact on investor loyalty and manager behaviour is frequently underestimated by commentators.
For managers, it is essential to strike the right balance - investing too much of your own capital could lead to extreme risk-aversion, while setting performance fees too high might incentivise excessive risk-taking. For institutional investors, what matters most is finding a method of incentivising managers to meet their investment objectives – whether beating a particular benchmark, reducing volatility, improving risk-adjusted performance, extending diversification and so on – at a fair price.
We have recently undertaken an extensive survey into the design of manager remuneration, investment terms, lock-ups and other methods of interest-alignment. What the survey shows is that “skin-in-the-game” and the high watermark are as popular as ever. But many fund managers are clearly going much further today.
A menu of options for both the management and performance fee is now commonplace. Often these (and other) incentives are agreed in return for investors agreeing to lock up their capital for longer.
Discounts and rebates on the management fee are more popular, particularly for early stage investors. About three-quarters of fund managers told us they offer or are considering a sliding fee scale, whereby management fees are reduced as assets rise above particular thresholds.
On the performance fee side, one in three managers now charge such fees above a hurdle rate, such as a fixed percentage or an index-based benchmark, as well as a high watermark. About 70% of managers now agree to calculate and charge performance fees annually, rather than throughout the year, such as when profitable positions are closed out, as was more the norm for some strategies. And although not yet widespread, a growing group of fund managers are offering claw backs, whereby a share of past performance fees are returned to investors during loss-making periods.
Could the increasing breadth and prevalence of methods of aligning interests be one more reason why investors still allocate to hedge funds and other alternatives and why the industry’s assets remain at or near their all-time high of about $3tr? We tend to think so. It was only two years ago that commentators were predicting a rapid decline in new investor interest in hedge funds. We were led to believe that a watershed was reached with the announcement in September 2014 by the California Public Employees' Retirement System (CALPERS), a public pension fund, that it would be closing its $4bn hedge fund allocation. Yet while a small proportion of the industry’s assets has been withdrawn, mostly from underperforming funds and strategies, recent investor surveys suggest much of this will be rotated back into funds and strategies thought to offer better potential.
The number of investors that allocate $1bn or more to hedge funds has in fact grown. Some 238 institutional investors worldwide now allocate over $1bn to hedge funds, up from 203 at the time of CALPERS’ announcement, according to Preqin. Among billion-dollar investors, the average allocation is now 16.8% of total assets, up from 15.9% last year, while for investors with smaller portfolios, it has risen from 14.3% to 14.8%.
Since 2009, the industry’s compound annual growth rate, comprising inflows and performance gains, has been around 10%. Growth this year may be lower, but the partnerships that alternative investment managers are building with their investors is providing sustainability for the industry and fairness for both buyer and seller.
This article first appeared in Absolute Return (AR) magazine in October 2016
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