FundFire – Low-Cost Hedge Funds Gain Ground amid Alpha Pressure

By Romil Timbadia

Price compression is still a major challenge for hedge fund managers despite improved performance across the industry this year – and investors are showing appetite not only for discounted fees on existing and new strategies, but in some cases are sending flows into products designed as lower-fee options.

Managers already recognize that for a relatively larger allocation and commitment of capital, the 2% management fee and 20% performance fee is no longer the standard, says Darren Wolf, head of hedge funds for the Americas at Aberdeen Asset Management. “And this is for their flagship products – not a watered-down, cheaper version,” he states. Hedge funds, knowing it’s a buyers’ market, have shown they see the need to adapt. Recent data from Eurakahedge outlines how performance and management fees have steadily declined over the last ten years in fund launches. Performance fees in launch year 2007 were 18.8% while management fees were 1.7%, while in 2017 so far, performance fees averaged 17.9% and management fees were down at 1.3%. A newer strain of activity may also point to managers accepting a lower fee world through funds explicitly built as lower cost options. For example, Blackrock’s Style Advantage fund, which charges a 0.95% management fee and 0% performance fee, more than doubled its assets in the first half of 2017 to $1.6 billion, according to a Bloomberg News report. And Man Group in a recent earnings statement described how a significant contributor to its net inflows of $8.2 billion in the first half of 2017 came through winning several large, low-margin mandates. The group says it is now starting to see good traction in alternative beta strategies, given the growing client interest in cost-effective risk premia return streams. Lower-cost strategies have also been getting investor traction in the liquid alts hedge market, according to a new report from Goldman Sachs Asset Management. “Lower-cost, quantitative or ‘alternative beta’ investment strategies within the GSAM LAI Multistrategy Peer Group garnered the majority of inflows in the first half of the year,” the report states.

• Strong beta returns and inconsistent alpha in recent years have resulted in a phenomenon in which some allocators have become more focused on attaining the “right” beta than on reducing beta and seeking alpha, says David Frank, CEO of Stonehaven, a third-party marketer. That can reduce demand for alpha and push fees downward, he says.   That scenario of strong beta might not always be the case, however. “Where beta is more challenged, the desire among allocators to reduce beta and pursue alpha increases – and this has the potential to push fees upward,” Frank adds.

And while low-cost avenues are gaining ground, there seems to be no strong evidence of an industry-wide scramble towards these products. In fact, hedge funds that have strong performance and stable asset bases have not felt the same pressure to reduce fees as peers with weaker performance, leaving the cost question more dependent on a manager’s ability to produce alpha. As the universe of investable risk premia and alternative beta indices has expanded, it also has allowed investors to redefine what can actually be called ‘alpha,’ says Wolf, whose company creates funds of underlying managers. “That means we can better calibrate which managers warrant hedge fund fees and redefine what ‘full fees’ actually represents,” he says. When it comes to lower cost, hedge funds may find comfort in the fact that there is a little more cushion in offering discounted fees to investors who allocate more capital for longer periods of time. “New funds launching and looking to raise capital are being increasingly flexible on fees, especially in exchange for seed capital and/or a lock in for the first year or two of the fund’s life,” says Mohammad Hassan, head analyst for hedge fund research and indexation at Eurekahedge. In the end, investors are looking for net returns. That means fees concessions can be a reliable form of alpha, Wolf says. “Very often, the difference between top-decile returns and second-decile returns can be more than offset by the difference between the 2 and 20 model and the lower fees we are able to realize,” he adds.