Not all hedge funds are created equal. Certainly consultant groups such as Cambridge Associates have ways of assessing the bottom line value of strategies and managers. In a recent paper, Hedge Funds: Value Proposition, Fees and Future, Cambridge’s Jon Hansen, Gordon Barnes and Elizabeth Warren discuss what can be done to prevent buyers’ remorse.
Of the 9,000 or so entities self-titled as hedge funds, only a small percentage (think low single digits) offer compelling value propositions for institutional investors. According to Cambridge, manager selection is critical, but equally important is the need to identify the specific role each fund serves as part of an overall portfolio.
The past few years have led to increased scrutiny of hedge fund returns, and now more than ever managers must be able to show how their funds contribute to broader portfolios and explain why specific fee and liquidity structures exist. Cambridge clients have had exposure to hedge funds for close to four decades, and have benefited from the differentiated return streams, capital protection and reduced volatility offered through these partnerships.
For its part, Cambridge continues to view hedge funds as serving a vital role as part of strategic asset allocations. Its clients have $25 billion to $40 billion invested in hedge funds, but not all of the assets are directed by Cambridge.
As investors have revisited their hedge fund allocations over the past year or so, some common themes have emerged in the discussions that Cambridge has had with investors and managers, in particular: (1) the characteristics of successful hedge fund partnerships; (2) the importance of understanding each fund’s expected role; (3) fees and terms as part of the hedge fund value proposition; and (4) the future landscape for hedge funds.
Cambridge finds successful hedge funds exhibit three basic characteristics: consistent alpha-generative security selection, portfolio management expertise and business proficiency.
One sizeable win from a correct market call or one-time market event (such as the subprime trade) may generate a spectacular windfall and public acclaim, but does not on its own make a compelling case for long-term investment. The repeatability of a manager’s idea-sourcing process is critical. For evergreen funds, this process must apply for one or multiple strategies and be driven by a specific research skill, investment philosophy, or other competitive idea-sourcing edge. Exceptional managers blend their proprietary research with portfolio construction in a way that allows them to leverage their best ideas while maintaining sound risk management.
Position sizing, entry and exit timing, strategy rotation and internal prioritisation of investment ideas all contribute to performance. Skill in these aspects of portfolio management often separates true moneymakers from merely good storytellers. From a manager evaluation perspective, portfolio construction talent is often the most challenging attribute to identify.
Cambridge also finds that a surprisingly large number of managers still fail to step back and apply the same analytical lens they use for prospective investment opportunities to their own businesses. An inability to motivate employees, retain key personnel, share wealth, reinvest in the business, be entrepreneurial and provide sound customer service (including transparency beyond rote reporting of numbers) often doom managers that otherwise have the pedigree for investment success.
The role hedge funds play in a portfolio is also important to determine. Investors should require more from their hedge fund managers than a mirrored equity market return that could be implemented easily and cheaply through index funds and exchange-traded funds. Fund characteristics to consider include strategy exposure, expected volatility, equity or credit beta, upside/downside capture rate, and correlation to markets and other managers. Performance expectations are part of an effective manager evaluation where investors consider potential near-term returns, performance in times of stress and longer-term opportunities, while keeping in mind the carrying costs for maintaining the investment.
Prudent turnover across a hedge fund roster is necessary and healthy. It is rare (if indeed it has ever been the case) for an investor to comment on how manager proliferation has added value to a portfolio. Reasons for manager turnover include organisational changes, shifts in assets under management (increase or decrease), style drift or prolonged underperformance.
In manager evaluation, investors need to ask whether they are getting what they are paying for in terms of a more flexible, less liquid investment structure and higher fees: this question is especially important for hedge funds. The concern continues after funding a manager, as LPs should regularly evaluate each hedge fund in their portfolio regardless of any lock-up.
Basic costs of hedge funds are: advisory fees (including management and performance fees), fund expenses and indirect costs. Limited partnerships may wish to consider each component in isolation, but an effective evaluation looks at the investment’s full carrying costs. A hedge fund that offers a low management fee but then passes through a high percentage of fund expenses may represent no better value proposition than a manager with a higher fixed management fee but much lower discretionary expenses.
Managers should be able to explain why they have a certain fee structure in place and how the fees fit within the operations of the business. According to the white paper, investors should be wary of any manager who says he has set his fees at a certain level because that is what the capital introduction team told him he could get or because that is what everyone else does.
Management fees are usually net asset-based and charged on a quarterly basis. They are intended to allow the manager to run the business and should not be a primary source of profit.
Generally, incentive fees are charged annually and are meant to compensate a manager for generating positive investment results. The structure is intended to create alignment of interest between the GP and the LPs. Often the performance fee will be subject to a high-water mark. Some funds implement a modified high-water mark wherein LPs pay a reduced carry (typically half of the normal incentive fee) until the fund recoups an amount in excess of the drawdown (often 150% to 200% of the drawdown). This structure is intended to provide a manager with organisational stability after a down period.
A fund typically incurs other costs and fees, though fund pass-through expense policies differ from firm to firm. Annual audit and tax costs, third-party administration costs, fund-related legal fees (set-up and offering), investment research and offshore fund director fees are examples of typical fund expenses. Others may include investment-related legal costs, research travel, technology costs, marketing costs and employee compensation. Indirect costs include trading commissions and prime brokerage-related costs.
Annual all-in carrying costs (fees and fund expenses exclusive of incentive fees) greater than 160 basis points to 180 basis points may be worthwhile in some circumstances, but LPs should be careful not to lose too much margin of safety (and also give up too much upside) when investing with a manager. Just because a manager generates strong returns does not mean LPs must pay excessive fees and forego an extra 25 basis points or 50 basis points annually.
The traditional hedge fund compensation model is skewed in favour of the GP as there is no upside cap on fees, and at least theoretically a hedge fund manager can generate a limitless return as a percentage of each investor’s initial contribution (i.e. the percent incentive fee charged remains constant but the dollar value of the actual carry earned increases as a percentage of the initial investment).
Investors have downside protection through the high-water-mark structure, which makes the fee distribution more symmetrical by reducing or eliminating certain fees following periods of negative returns, but the structure is still asymmetric since fees are never negative. In a worst-case scenario, a manager can lose most (or all) of his LPs’ capital, close the fund down, and then reinvent himself elsewhere (an unfortunate outcome that has occurred in the industry).
Liquidity also has value, though, and LPs should be sceptical of managers that artificially claim the need for a long-term lock-up for more liquid strategies and portfolios without any equitable trade-off on the incentive fee. From an organisational stability perspective, length of lock-up is no more important than how staggered exit points are across the LP capital base.
Having a more balanced capital base with varied exit points across the partnership was one of the most positive organisational changes to come from the liquidity issues experienced in 2008, as managers recognised the importance of avoiding a self-imposed run on the bank. Mandatory side-pocket exposure arrangements have largely disappeared and instead most hedge funds that still invest in private deals have leeway for investors to opt out.
In term and fee negotiations with managers, an anchoring effect clearly exists. In general, managers perceive change in a negative light; even firms with strong risk-adjusted track records, loyal capital bases and stable organisations have proceeded cautiously when considering term changes. No one wants to give off any scent of weakness and most managers have been quite comfortable with the legacy hedge fund structure.
Although the base compensation structure of management and incentive fees is likely to remain, the industry continues to evolve as investors seek and realise term and fee modifications. In some cases, managers have lowered their base fees – the market has shifted and although two and 20 still exists, the industry is moving away from it as the standard. Other adjustments include management fees that scale down as assets grow or over time to reward investor loyalty, a feature likely to become more common. A more creative approach may see managers implementing a hard dollar cap on management fees and rebating any excess fees at year-end.
Current best practice calls for managers to calculate the incentive fee net of all other expenses. Managers may go a step further and calculate incentive compensation off a base that represents a return net of two or three times all expenses. Not yet in use, this structure would provide an ongoing non-market-related hurdle and also maintain alignment of interest by serving as an incentive to keep costs low. The periods over which firms crystallise the incentive fee may also lengthen (i.e. from an annual calculation to over a two- or three-year period to match lock-ups), although such a structure may have a derivative impact on organisational stability and trigger potential tax-related complications.
As different investor types including pensions and sovereign wealth funds have embraced alternatives, the composition of the hedge fund investor base has shifted. Investors able to allocate large blocks of capital may impact not only fees but also portfolio construction. LPs should be alert to the possibility that when a manager accepts a large capital allocation from one entity, the manager may change the investment approach of the organisation to be a better fit for that particular sizeable investor.
A shift in mandate can also occur without a change in investor composition. For example, the risk appetite of a manager who has a majority of his wealth invested in his fund may evolve as that individual matures. As more managers run funds for longer periods, industry participants may question the traditional notion that alignment of interest must call for a manager to have most of his liquid net worth invested in his fund.
Manager selection remains critical. Cambridge says its clients’ longest-standing and best hedge fund relationships are with managers that care not only about their risk-adjusted track records, but also about their reputations. These managers couple a desire to be right with a willingness to learn and acknowledge mistakes, and have a natural and insatiable curiosity for finding and profiting from inefficiencies.
To a certain degree, the concept of alpha has been lost in a recent market environment composed of higher correlations across assets and narrower return dispersion across managers. Over the long term, investors that believe in active management understand that partnering with talented investment professionals adds value to diversified portfolios. The challenge remains constant: identifying the right partners and paying the right price for that alpha.