Comment and Analysis: Fees and Expense Ratios
The historic DNA of a hedge fund has been that out-performance through the generation of absolute alpha justifies the 2/20 fee model and for the most part, the traditional fee model prevailed. But look a little closer and it becomes clear that the industry has evolved considerably from this single dimensional moniker, and hedge fund managers are creating new products and fee structures as the competition for investors intensifies.
In the meantime, investors are seeking to gain a better understanding of the fees and expenses they are paying, hence the demand for greater transparency at the General Ledger (GL) level, coupled with portfolio transparency and risk parameters.
So what exactly does this mean and will it result in a seismic change in what and how much a fund can charge its investors?
It begins with management and performance fees. The 2/20 rate has typically varied according to the complexity and nature of the strategy; suffice to say that managers have always articulated their philosophy about the fees they charge very effectively, and strong performance has always been an eloquent advocate. Nevertheless, we live in an era when nothing can be taken for granted; take the consultant Albourne’s ‘FeeMometer’ tool that analyses the effect of fee levels on returns as just one example of peer benchmarking.
The approach to expenses can be an equally convoluted matter, especially given the wide variety of expense categories and the ways in which they are dispersed.
Expense categories broadly fall into port-folio and non-portfolio related, with the non-portfolio expenses comprising multiple buckets such as legal, administration, audit, regulatory compliance, operations, back-office and technology. It is generally agreed that trade and portfolio related expenses can be fully charged to the funds, including regulatory compliance, such as Form PF or Annex IV, because it is portfolio-related and hence a cost of doing business. Similarly, counterparty engagements with legal, audit and administration service providers are re-chargeable; whereas shadow accounting performed either in-house or outsourced, and a manager’s use of technology tend to be greyer areas that need to be justified if re-charged.
As an administrator, we are seeing far greater focus on the integrity of the GL that we maintain on behalf of the funds we administer, namely how expenses are being classified, because this enables managers to understand their expense ratios and to track overall trends. It is, after all, powerful for a manager to be able to demonstrate that they have maintained fund expense ratios within a certain accept-able range, in particular in the context of the increased costs in areas such as transparency reporting and regulatory compliance.
For their part, sophisticated investors are looking for detailed expense breakdowns; some have even developed their own financial statement templates for us to complete (for a modest fee!), that enable them to aggregate and compare expenses across their fund universe.
They may not be blinking, but managers are certainly adjusting to a new reality where the nature and extent of fund expenses are being monitored closely in the context of the fund, its strategy, structure and liquidity profile. Managers are responding by providing more precise disclosure around fund expense categories, and ensuring that the level of expenses remains within an acceptable range in the con-text of the fund’s activities; nevertheless, expect the pressure on margins to continue.
Published in HFM Week
13th November 2014