Investors need a new fee calculation method that more fairly rewards alpha-generation by hedge funds, a recent paper published by the CFA Institute argues.
According to the study authored by Tanuj Khosla, investors have generally failed to rein in hedge fund fees despite devising a raft of quantitative and bespoke qualitative techniques.
“… a vast majority of institutional investors have been overpaying for beta that has been masked as alpha by the hedge fund manager or worse, paying for non-performance,” the paper says.
The ‘How much of your alpha do you pay away to your hedge fund manager?’ analysis says traditional fee restraints such as high water marks and hurdle rates have not proved adequate in protecting investor interests.
Khosla says in the study that even more sophisticated attempts to define alpha (and hence the applicable performance fee) such as the ‘variable beta hurdle rate’ – usually a “mutually agreed upon and publicly available index” – could still see investors short-changed.
“… the calculation of alpha largely depends on the choice of base used i.e. hurdle or high-water market,” the paper says. “In case of the former, it can be further sub-divided into the type of hurdle to use – fixed, floating, Variable Beta Hurdle Rate (VBHR) or Beta adjusted Variable Beta Hurdle Rate (VBHR).”
Defining alpha will depend on both the fund structure and investor preferences, the study says, with no “right or wrong here”.
“… just like the construction of hedge fund portfolios, this is a combination of art and science and different institutional investors might make different choices while computing alpha,” the paper says.
Regardless, Khosla says investors need to measure outperformance (as per the agreed alpha definition) as a proportion of the total hedge fund fees charges.
He says the eponymous trade-marked metric, the TK Fee-to-Alpha ratio, provides investors with a better indicator of “how much alpha they are giving away”.
“Many institutional investors have got a raw deal from the hedge funds as (a) alpha has been shrinking (b) they have been paying alpha fees for beta,” the paper says. “It is then nothing short of a cardinal sin if they have to pay a disproportionate share of the real alpha generated to the manager as fees.”
Under current market conditions, the study says any TK Fee-to-Alpha ratio above 0.3, indicating investors are losing more than 30 per cent of outperformance, “is excessive and calls for attention and maybe even corrective action”. The analysis found a TK Fee-to-Alpha ratio of 0.32 in a sample portfolio of 10 hedge funds.
The paper says the ‘1 or 30’ hedge fund fee structure recently implemented by Teacher Retirement System of Texas fund could prove influential.
Under the ‘1 or 30’ approach hedge funds accept a 1 per cent fixed management fee in exchange for 30 per cent of alpha “when the latter is greater”, ensuring investors retain 70 per cent of any outperformance.
“This fee structure is rapidly gaining the attention of both managers and investors and might very well become the industry standard in the years to come,” the study says.