FEBRUARY 1, 2016
While hedge fund fees have declined during the past several years, they are still remarkable for the fact that they have only come down marginally over a 30-year time period and that they are higher than almost any other fees charged for money management. How can we explain this phenomena? Taking a look at hedge funds as an industry and applying some of the principals of microeconomics may shed some light. According to the theory of the firm, in a competitive industry competition among participants will drive prices down, especially where new entrants can enter relatively easily.
The hedge fund world has over 10,000 hedge funds and hundreds of new ones start every year. This seems to be the model of a competitive industry, where one would expect continual downward pressure on fees. The explanation for this stickiness in fees are different for large, established hedge funds and for relatively new and smaller hedge funds. Larger more established hedge funds are very much in demand in the present economic milieu. As in other industries, well established brand names attract buyers (hedge fund investors). Although hedge funds are not allowed to overtly advertise, there are effective and long established distribution channels by which hedge funds become known to potential investors, including third party marketing, hedge fund databases, capital introduction sessions, industry publications, industry conferences, wealth management groups, brokers, banks, investment advisors and investment consultants. Adding to the upward pressure on fees
among larger hedge funds is the inflow of money into hedge funds, notably by pension plans. Plans now account for the largest single investment group for hedge funds and the fastest growing group. They have only tipped their toes into hedge funds and could continue to fund the industry for the indefinite future. Along with increasing demand, we have shrinking supply.
The larger and more established hedge funds have a tendency to close their gates to new investors after reaching a certain level where they find that additional funds cannot be fruitfully invested or where they earn enough from management fees so that they prefer not to threated their franchise by taking on market risks. Additionally, we have recently witnessed a growing phenomenon of hedge funds returning client money and managing the principals’ and employees’ funds, either as partnerships or family offices. George Soros is a prime example of this type of move. The story is different with newer and smaller hedge funds. In a typical, competitive, industry we would expect these funds to be willing to undercut the established firms by offering their service at a reduced fee. This seems not to be the case.
Hundreds of hedge funds choose to close up shop rather than engage in competitive price reduction. How can this be? The economics of new hedge funds and the psychology of their managers offer an explanation. Hedge fund managers tend to be successful, highly paid professionals working for hedge funds, banks, mutual funds and other financial institutions. The reason they move into the hedge fund field is to make more money than they have in their present position. A new hedge funds needs to reach a level of assets under management to meet the high expectations of the funds’ principals. Their goal is not to show a profit, but to show a very large profit.
So let’s take a hedge fund with $100 million under management (a healthy amount) and three principals. The management fee earned off these assets is 2%, yielding about $2 million. Before turning to incentive fees, we need to take away expenses, including salaries, office space, information systems, computers, etc. These can easily add up to $1 million a year. This leaves $333,000 for each principal. While this is a healthy compensation for most people, it is likely to be much less that they earned at their previous employment. Incentive compensation is the real goal of new hedge fund managers. An annual return of 10% would mean that the fund earns another $2 million (10% of 100 million is $10 million. The hedge fund would receive $2 million if it receives the traditional 20% of returns). This would translate into an additional $666,000 for each principal, bringing their total compensation to $1 million per years. At this level, the hedge fund starts to make economic sense. However, 10% return is extremely difficult in this market environment. If the hedge fund returns 5% from investment or even less, the principals can easily earn well below their expectations for years. It is no wonder that many give up and return to more remunerative lines of work. One solution here is to raise additional assets. However, here they face the reality that new money is tending more and more to be invested with larger, well established funds. The combined microeconomic situation of larger and smaller funds goes a long way to explaining why hedge fund fees have been able to stay as high as they have.