With downward pressure on hedge fund fees, time is right for expansion

In response to the uncertainties of a politically charged environment, investors are diluting risk by choosing diversification. Heavy in the mix are hedge funds, doubled from just five years ago. But while volume is up, fees are down and showing every sign of staying there. Why, and what to do? There are any number of causes and numerous responsive strategies — perhaps the strongest being expansion.

Fee aggregates dropped between 2015 and 2017 Top fee pressures: Returns, competition and margins As far as fees go, tradition is gone. Until recently, conventional wisdom had management fees at 2% and performance or incentive fees at 20%. No more. Between 2015 and 2016, according to a March 2017 Hedge Fund Journal report, management fees dropped from 1.60% to 1.33%, and average incentive fees fell by four basis points to 17.71%. And in a Credit Suisse survey released in early 2017, 57% of investors reported that their management fees had been lowered over the previous 12 months.  

Three primary factors in driving fee pressures are:
  • Lower returns. Performance has not been generally stellar over the past five years. In the aggregate, according to Hedge Fund Research’s June 2017 performance notes, hedge funds have returned an annual average of only 4.3%. This does not compare well to the S&P 500’s average of 14%, as reported in a June 2017 Investopedia article. Disappointed investors expect that fees will come down to reflect the level of returns.
  • Stiffer competition. Passive management entities are surging. In 2016, states a May 2017 Economist article, more than half of asset management funds flowed into one passive manager — Vanguard, whose S&P tracker expense ratio was just 0.04% of assets. In early 2017, according to Moody’s Investors Services February announcement, 28.5% of assets under management (AUM) were in passive investments. Their share is expected to rise to more than 50% by 2024.
  • Trade-off of decreased liquidity. Large investors like pension plans and endowments appear willing to trade liquidity for lower fees and more stable returns. Some hedge funds are feeling compelled to respond by stretching 90-day liquidity norms with offers of discounted fees for more permanent capital.
Businesses are reshaping themselves It is apparent that the way forward for hedge funds will not be through fees. Leaders will find that a thriving future can be found via many other routes, including transition to a hybrid model that combines the best of traditional and alternative investment management.

To take control, leaders will recreate their business strategies to explore new fees and structures, revise operations, refocus on compliance and — most visionary of all — turn their attention to expansion.

Explore new fees and structures
  • Link fees to performance metrics; investors expect fees to be reduced when performance drops to a specified minimum number
  • Offer discounted fees for more permanent capital; challenge the 90-day liquidity norm
  • Diversify:
  • Expand class offerings, and explore hybrid models
  • Create offerings for “near wealthy” investors, e.g., 1-and-10 fee for those below $100,000 net worth

Revise operations
  • Scrutinize back office processes for time and cost savings, and tighten internal controls for efficiency and responses to SEC and Department of Labor inquiries
  • Embrace technology, especially for new distribution avenues; determine how automation, robo-advising, blockchain and artificial intelligence could fit into your business model

Refocus on compliance
  • Build cybersecurity into business strategy, risk management policies and diligence processes
  • Ensure compliance of outsourced technology providers
  • Verify use of SSAE 18 rather than any previous standard
  • Require SOC 1 & 2 reports

Consider expansion
  • Recognize the global nature of the hedge fund industry, including investors and investments
  • Define business size in the marketplace and among the competition
  • Grow by acquiring or being acquired to realize accrued value

In regards to size, larger funds are achieving scale through acquisitions, much of them global. Per the Hedge Fund Journal report, during 2016, the average gain of the top 10% of managers went from 20.3% to 32.7%; averages for the bottom tier declined 15.5%. Facing the challenge of beating an eight-year bull market and a squeeze on funds, businesses that are midsized — too small to dominate and too large to fill a unique niche — will need to decide if it’s time to grow larger by acquiring another fund, or sell to a larger fund to take advantage of higher valuations.

Drivers of fee reductionExpansions short of M&A can also broaden the business and investor base. Alliances and joint ventures could prove valuable. For example, if a real estate, pure-play hedge fund and private equity group offered those asset classes under one asset management umbrella, pensions and endowments of large institutions could approve that advisor at a high level, almost as another institution, and deploy capital within the advisor. Alternatives of various stripes should be considered — including opening up the liquid book for the business to segue into more of a mutual fund; and outsourcing office, risk management and other services. Consideration could be given to stepping up use of exchange-traded funds, such as the emerging ETFs offered by Vanguard and iShares. Hedge funds already own 13% of the combined total of these two products, which are up more than 20% in the past year, according to Credit Suisse.

Ceasing dependency on fees will require moving the business in a new direction. It will mean a broader organization with revamped strategies and structures. Businesses that succeed will be reshaped to offer the products that appeal to a growing investor base.

Learn more
  • Register to replay the webcast The Future of Growth and the Asset Management Industry, and download the presentation deck.
  • Visit “Reignite Growth in Asset Management” to download the report and read more about adapting to fee compression and succeeding with new strategies.
  • Find more about the near-term regulatory — U.S. and global — and technological landscapes could provide your business with both stress and relief; read Hedge Funds Look to Boost Performance amid Changing Political and Economic Trends.

  • Contacts
    Michael Patanella
    Leader, National Asset Management Sector
    Partner, Audit Services
    T +1 212 624 5258

    David Sites
    Partner, International Tax Services
    Washington National Tax Office
    T +1 202 861 4104