Why High Hedge Fund Fees Are Justified

November 1, 2003 Leola Ross

Paying the price for truly active management.

The relatively high fees charged for hedge funds may cause some of your clients to have second thoughts about investing in them.

Who can blame them? Accustomed to paying an average 0.7% for long-term investment products, they can perhaps be excused for initially balking at fees that typically run from 1% to 2% of asset value plus 10% to as much as 25% of gains. In addition, fees for fund-of-funds hedge fund products add another layer of fees for doing the considerable job of sorting through all the hedge funds to create portfolios of hedge funds.

The relatively high fees as a portion of committed capital clearly do not alienate all investors. Indeed, the popularity of these investments is growing strongly, particularly now that some are offered to investors with as little as $25,000 to put in such a fund. Estimates are that the number of hedge funds is now reaching 6,000 with nearly $600 billion in assets, an increase of some 25% in the number of funds and 50% in the assets invested in them over just the last year.

If your clients are considering joining the ranks of those investors, you will, of course, need to examine carefully such aspects as the fund’s investment management process, the amount of risk your clients can take and what proportion hedge funds should occupy in the portfolio. But if you have done that and fees are the only aspect keeping your clients from joining those investors, you may advise them to think again.

A study Russell Investment Group recently conducted shows that, for the most part, the higher fees charged by hedge fund managers are indeed justified. In it, Russell concludes that investors are receiving the active management for which they are paying.

The study did not attempt to assess the quality of the active management involved in hedge funds, nor did it look at the safety of hedge funds or such aspects as volatility, expectations of return and excess return, or investment style. It only attempted to assess the fee structure.

As a basis for our study, we compared hedge fund fees with those charged for long-only funds. We did so because, for the most part, investors accept that the fees charged on long-only fees are justified. By comparing them with hedge-fund fees we would obtain an indication of the degree to which they could be said to be acceptable.

In order to make the comparison, we determined the degree of active management that hedge fund managers devote to their products compared with that practiced by managers of long-only funds. We reasoned that once we knew how much active management was involved, we could assess the fee structure. In other words, the higher exposure to active management may justify a higher fee.

A way to assess the degree to which long-only funds are actively managed is to compare them with their benchmarks, which, of course, are unmanaged. To construct the active portion, we compared the degree of weight assigned each holding in the portfolio with that of the holding in the benchmark.

Clearly if the weights are all the same, the portfolio would essentially be an index fund and would not be actively managed. It follows, too, that the greater the number of stocks in the fund that are weighted differently than the benchmark, the greater the degree of active management that has been exercised when compiling the fund.

Let’s say a portfolio has 22.5% more in larger bets than the benchmark, whereas another has small bets adding up to only 3%. The first portfolio, therefore, is clearly more actively managed than the other. Indeed, the second portfolio comes close to being an index fund. It follows, too, that the first portfolio has a greater potential to perform better than the benchmark-and also, of course, a greater potential to fare worse than the benchmark.

An investor with $100 could simulate the exposure of the first portfolio by investing $22.50 in a dollar-neutral fund and $77.50 in futures. Indeed, investors can make a portfolio as passive or as active as they wish. A completely passive portfolio would have 100% invested in the dollar-neutral fund, whereas the completely active portfolio would have 100% invested in futures.

By defining a long-only portfolio in this way, we can view fees as payment for active management-active management that can be measured and compared. In a sense, we can move from comparing onions and potatoes to comparing like with like. We’ve identified a common denominator.

To assess whether we are receiving what we pay for, we need to accept that we hire managers only to manage our assets actively. Beyond basic administrative fees, we would not expect to pay for the portion of a portfolio that is not actively managed. If an investor pays 0.5%, for example, for the management of the first portfolio outlined above, the fee reflects only the 22.5% of the portfolio that is actively managed. To compare the fee for that portfolio with a portfolio that would be entirely actively managed, we would divide 0.5% by 22.5, which equals 2.22%.

Similarly, if an investor pays the same amount of 0.5% for the second portfolio, then the equivalent fee, if that portfolio were entirely actively managed, would be 16.67%. This fee seems expensive compared with that of a typical hedge fund because the long-only fee would be charged regardless of the fund’s profitability.