Are Hedge Fund Fees Justified?

At the much-anticipated Delivering Alpha conference in New York, hedge fund managers were asked to justify their standard two percent management, and twenty percent performance fees.

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Were they convincing?

Steven Algert, Managing Director, J. Paul Getty Trust poses the first challenge: "It's harder and harder to find managers that can give alpha returns on a continual basis. And it's important to distinguish between management fees and performance fees. The 2 percent management fee does become a bit of a hurdle. If you do a 7 percent return gross, that's 5 percent net. That's how you pay a large amount of fees to these managers for what may not be an adequate return."

Shifting in their seats, the panel conceded — its a good deal for management. Yet, they also agree, there is an important distinction in fees when applied to large funds versus small.

Jonathan Jacobson, CIO of Highfields Capital Management contends: "Today, if you have big firms with tens of billions dollars of AUM, clearly the management fee incentive is not aligned with general partner and a limited partner, [who] would not take the same level of risk. We try to find managers with very parallel incentives with LPs. If the incentives are aligned, we're happy to pay the fees."

When it comes to hedge funds, it seems size matters.

Echoing Jacobson, critics say the largest funds are, by design, not motivated by the performance fee, given that they stand to gain so much from the 2 percent management fee. For example, with $40 billion in AUM, AQR Capital Management's management fee, at 2 percent, should generate about $800 million a year.

Delivering Alpha - presented by CNBC and Institutional Investor
Delivering Alpha - presented by CNBC and Institutional Investor

Responding to the charge, Clifford Asness,Managing and Founding Principal, AQR Capital Management says. "The fixed fees at our firm vary from around 2 and 20 to somewhere around 40 basis points. If you do the math, and compare true alpha, and compare it to mutual funds — it's not as ugly as it looks. Mutual funds tend to deliver the market plus 3 percent tracking returns. I think you have to look at that."

Asness also stresses that smaller managers have their own challenges, and don't necessarily perform better.

Smaller funds, says the panel, can be tempted to take outsized risks because a 2 percent management fee pales in comparison to the 20 percent share of the profit spoils.

If smaller managers take on high risk, and the risks pay off, the dollar value of the performance fee will justify the management fee.

Thus managers of both large and small funds can be tempted to act in their own best interests — either maximizing the management fee for large managers or shooting for a large performance fee by smaller managers.

On the subject of large funds, Algert adds, "I think the management fees should be reasonable, so that they can have the infrastructure, higher the right people they need, and cover expenses. They keep adding assets, and not adding people proportionately. I think that takes away part of the incentive to perform."

"Clearly, there is a balance between being too big to put money to work, and being to small to have the [best] talent," adds Jacobson.

Either way, no one disagrees that managers should be forced to earn the management fee by beating that benchmark by at least 2 percent or there is no alpha net of fees.

Ted Seides, Senior Managing Director of Protege Partners has the final say: "If you want to invest in a fund, you have to pay the fees. Your choice is either to invest or not."