I have argued before that hedge fund fees were poorly designed, and in that article had suggested a possible design for performance fees. Here I provide more detail into what I think is a practical solution which addresses some but not all of the problems with current fee structures.

 

 

Management fees:

 

This is the simpler issue to deal with. First of all, one has to question what is the purpose of management fees. In traditional long only mutual funds, management fees are the compensation for the manager for managing the fund. With the rise of absolute return funds, and their performance fees, management fees were no longer intended to be the primary compensation for managing of assets. The industry generally represents that management fees are compensation for overheads and the costs of running the asset management business.

 

If this is in fact the case, then the current flat percentage of assets management fee does not do as represented. The costs and overheads of running an asset management business are not linear in the size of assets under management. There are economies of scale. By charging a flat percentage of assets under management, these economies of scale accrue to the investment manager and not to the investor.

 

If management fees are indeed intended to cover overheads and costs, then a sliding scale is closer to the intended purpose. One can envisage management fees being charged as follows: 2% of assets as long as assets under management in the fund are under a certain amount, 1.5% when assets rise to a certain level, and 1% whenever assets are over a certain amount. This is just an example of course and there are other ways management fees can be designed to reflect the represented purpose.

 

A further finessing of management fees which is useful is to waive management fees for side pocketed investments. This encourages the manager to think carefully about side pocketing any assets. Certainly investors would not appreciate management fees being charged on assets that have been ‘gated’ or suspended.

 

Performance Fees:

 

Hedge funds fees typically include a profit share by the manager. This can range from 15% to 30% but for the vast majority of funds is 20% of profits. Pre-2005 there were a significant minority of funds which had a hurdle rate (strictly positive). That is, performance fees were only applied once the fund’s returns were higher than some positive return. In the later years, this practice had mostly disappeared as demand outstripped supply and hedge fund managers were able to increase their prices. Almost all hedge funds still operate a ‘High Watermark’ by which is meant that the investor pays fees only if the fund’s NAV is above the previous high. Should the fund’s value fall, performance fees are not collected until the previous high NAV is exceeded again.

 

This all sounds fair except that there are timing issues. Fees are accrued and at some point crystallized. This usually happens annually. A situation can arise therefore where performance fees are paid out at the end of the year or quarter, the NAV falls thereafter. Even if there is a recovery but the high watermark is not re-attained, fees paid out are not reclaimed.

 

A simple solution is as follows:

 

• Fees are accrued semi-annually.
• 50% of the performance fee is paid out semi-annually.
• 50% of the performance fee is retained in Escrow (not to be invested in the fund.)
• Each retained performance fee vests and is paid out 30 months later (for example, the delay can be made equal to the lock up for example).
• All retained fees in Escrow are subject to negative performance fees = 20% of loss from the NAV of last performance fee cal
  culation period.
• When redemptions are paid in full, fees held back are released to the manager.

 

This design has the following features:

 

• The investor pays performance fees on the net performance for their holding period, unless the performance is negative over the entire holding period. Unfortunately the manager cannot be expected to pay a negative performance fee over the entire holding period if the performance turned out to be negative over the holding period.
• The manager is incentivized to make money over the long term instead of making money only in a given year.
• The manager has 50% of their performance fee at risk on a rolling basis. On a cumulative basis, the manager may have a whole year’s performance fee at risk.
• It has the same kind of incentive as a private equity clawback fee structure.
• The above fee structure can be adjusted for the length of the holdback. The longer the holdback, the more performance fee is at risk.
• A manager who is confident in generating returns over the length of their lock up should not object to such a fee schedule.
• It incentivizes a manager to force redeem investors if they do not expect to be able to make money.

 

The Future:

 

Customers are the ultimate regulator of an industry, so it is investors who ultimately regulate the hedge fund industry. As long as investors are small and numerous, there may not be the aggregation of bargaining power to negotiate with fund managers. The huge concentration of assets under control in the fund of funds industry afforded funds of funds the opportunity to negotiate, not harshly but fairly with hedge fund managers. Not just on fees but on liquidity terms, transparency and controls. This was an opportunity that was missed. The battering taken by funds of funds in 2008 has greatly impaired their powers. We can only hope that investors find some way of communicating their needs to fund managers. And we can only hope that fund managers are enlightened enough to see that investors are not deliberately antagonistic, although it may seem so today.

 

Leverage. It always gets blamed whenever bad things happen to investments and markets. But leverage in itself is neither good nor bad. Leverage is a magnifier of returns, both positive returns and negative returns. The idea behind leverage is that it can be used to make a small return into a big return. Here is how it works. You have 10 dollars. You want to invest 100 dollars. You borrow 90 dollars. You pay for the 90 dollar loan, you get paid, hopefully more than that on the 100 dollar asset. And if it doesn’t you have negative gearing and you hope to high heaven that the asset appreciates in value. Of course asset values fluctuate.

 

Leverage is often quantified as the ratio between debt to equity. Another useful measure is simply asset value to equity. And here is why. If the ratio of your asset value to equity is P, then if the asset depreciates by 1/P, your equity is gone. Your concern therefore is that you are not levering an asset by P whose loss in value is likely to be anywhere close to 1/P, otherwise, you have lost everything.

 

So, if you have a volatile asset, you can leverage it more, and if you have a less volatile asset, you can leverage it less. It is that simple.

 

Here are two charts. The first is the VIX which is the implied volatility of the S&P 500 and the second is the realized volatility of the S&P500.

 

 

 

 

 

Looking at the VIX, it is obvious that you can afford to use more leverage in the years 1992 – 1997 and 2004 – 2007.

 

Looking at the S&P realized vol, the periods where you could use more leverage were the mid 1940’s, the early 1950’s, the mid 1960’s, the mid to late 1990’s and the mid Noughties.

 

That’s all very obvious. Of course what is less trivial is when do you reduce your leverage? Volatility graphs are unique in that you can tell if you have been presented with one upside down. Volatility tends to spend more time declining than rising, but when it rises, it tends to do so very abruptly.

 

So, a few quick points about leverage: 

• Don’t lever it if it’s too risky. The normal fluctuations of the asset price could wipe out your equity. 
• Don’t lever it if it’s not liquid.  When volatility spikes, you need to deleverage, and you can’t do that if it’s illiquid. 
• Illiquid assets almost always look less volatile than they really are. There are technical, mathematical reasons for this. So if you are going to lever an illiquid asset, take care that you measure the volatility correctly. 
• Volatility is an indication of risk. But apparently low volatility investments can be highly risky. If it’s volatile, it’s risky. If it’s risky, it may not be volatile. Ultimately it’s the potential downside and not the volatility that is important. 
• If the asset is already risky or volatile, you don’t need a lot of leverage, or any leverage, to make a decent return.

Current market volatility is high which means that it doesn’t take a lot of leverage to make money. Or lose it.

 

 

Dear China,

 

Thank you for being a good partner over the last decade. You have been a great help in helping to keep inflation low by being a low cost producer. We have been happy to export our productive capacity to you. We have been happy to buy your exports. While this has created a large trade deficit for us against you, we have been very happy with getting more stuff in return for giving you more dollars.

 

Thank you for providing us the capital to continue to be your trading partner. As a provider of vendor finance, few have your capacity and favorable terms. You make GE Capital look small time. Your purchase of our government debt has been helpful in keeping our long term interest rates down and allowing us to expand the level of debt in our economy.

 

Thank you for your interest in investing in our country. We do have a patchy track record of cooperation in this area. Feel free to continue to invest in our country, particularly in our debt markets, particularly the public sector debt. We thank you. There are, however, some strategic industries where we would prefer to remain self sufficient. Throughout your own history you have sought to be self sufficient as well and I am sure you understand our position. We can’t sell you our resource assets, or our strategic assets, or our politically sensitive assets. Trophy assets are fine, and for that we have a special discount. We offered the same to the Japanese some twenty years ago.

 

There are, however, a number of issues we need to discuss. The global economy has gone to pieces, growth is weak, trade is weak, credit has fallen off a cliff, and so have our stock markets and bond markets. As valued partners in global growth we feel that a frank discussion towards cooperation to stabilize and rebuild the world economy is in order.

 

While we have been happy to buy your cheap exports, the trade balance and current account have now become quite imbalanced. Part of this has probably been because the terms of trade have been distorted by your keeping your currency undervalued against the dollar. A market level of exchange rates would serve you and us and the rest of the world far better and would probably help to unwind some of these imbalances.

 

We need your help.

 

Our corporates are not investing but are retrenching. They are reducing inventory, capacity, headcount, debt and they are hoarding cash. Our banking system is under great stress. Our banks are acutely undercapitalized, they are holding toxic assets that nobody seems to know how to value, there is a slow creeping return to the mutual mistrust between banks in the wholesale funding market. Our central bank and treasury have plans to address both the capital adequacy of the banks as well as their problem assets. This will take time and money but we will not allow our banks to fail.

 

Our people are now in saving mode. With unemployment and falling wages combined with high debt service obligations, they are in fact in forced saving mode. They cannot afford to consume. We need you and your people to step in where our people are now absent. We could use some demand for our exports. We can offer capital goods and industrial supplies. We can offer technology and high value added services. We need your people to start saving less and consuming more, whether it is domestically or on imports.

 

A perverse situation has now arisen where even if our people could afford to consume, they would not. Collectively, it is rational to increase consumption whereas individually, it is rational to save. This is one of the arguments for Keynesian policies and believe me when I say that we would love to step in and spend and invest on behalf of the private sector. Unfortunately, we ourselves, the government, are also broke. Fiscal reflationary policies would involve accumulating even more debt. We have little choice but to go down this route in any case but we hope that as we do, you will be a continued customer of our debt issuance. The United States is good for its obligations in USD, rest assured. If your appetite for risk is somewhat higher, and we recognize how astute the Chinese are as investors, there is also our private sector corporate debt and asset backed securities which are very attractive.

 

We hope we can engage each other in a constructive dialogue on these matters. As the two mutually largest trading partners, it makes sense that we look after one another’s interests.

 

Yours truly, Uncle Sam

 

 

 

 

Dear USA,

 

Thank you for your kind words. We consider you a good customer for our exports. Please continue to buy our products. We are happy to continue to run a large trade surplus. We will consider providing you further vendor financing, although the terms may have to reflect new economic realities.

 

We are not interested in trophy assets. As a country, there are many other things we lack and we are happy to buy those. We can discuss what those things are in the fullness of time.

 

To your point about the banking system, ours is still functioning well. We have instructed our banks to lend. They will do so. We notice that there has been some reluctance to borrow. Do you see the same thing at your end?

 

Our people are also saving. If you think you have problems with unemployment, you should see ours. Thanks to your consumers retrenching, we have millions unemployed. Our people have grown up with a culture of fiscal rectitude. Rising unemployment will only make them save more. We are doing what we can to make up for the fall in consumer spending. An infrastructure expansion plan is underway. We will not only encourage the private sector to employ and spend and invest, we will be employing directly ourselves. Since the 1980s we have been privatizing large portions of our economy. We will be temporarily reversing this campaign. We will resume again when things stabilize. Until we can stabilize unemployment, do not expect our people to be spending. Our own expenditure will be to invest in infrastructure and improving the potential of the economy in the long run.

 

Thank you for your offer of your public debt securities. We have plenty of that. We will be purchasing at a more measured rate from now. Note that a strong Renminbi is equivalent to a debt default by your government with a recovery rate equal to 1 minus the depreciation of your currency relative to ours. We have already sustained losses in our local currency terms. This is very much interrelated to our discussion on exchange rates. We are not intervening significantly in the currency markets, and when we are, it is not always one sided. There are periods of natural strength in the USD. You have frequently encouraged us to operate under capital account convertibility. Be careful what you wish for. We are happy to support the USD as the de facto reserve currency of the world. We are equally happy to consider the CNY in the same competing role.

 

 

Yours truly, Regular Zhou

 

With the meltdown in financial markets and the near collapse of the banking system last year, hedge funds have come under increasing regulatory scrutiny. Whether or not this is justified is another matter. There is certainly justification for more scrutiny and more useful regulation with the emphasis on the useful. Unfortunately the trend has been away from understanding the role and position of hedge funds in the financial system towards a reactionary approach towards regulating them.

 

It is fair to expect increased regulation as deeper and broader investigations are initiated into the financial crisis. This can be good or bad. The hedge fund industry needs regulating. It is the nature of that regulation that is in question. Regulation should be driven towards providing investors with sufficient and adequate information to make informed investment decisions. Investor protection needs to be measured lest it creates moral hazard, or creates unnecessary barriers to entry. The provision of information is by the few, the receipt of information is by the many. There are asymmetries of costs of free flow of information. Raising the bar in terms of disclosure and information can create barriers to entry which later encourage the type of concentration in the industry that was seen in the fund of funds industry which came to a head in 2008.

 

Regulation can be driven with the participation and cooperation of the hedge fund industry or it can be unilaterally established by regulators and imposed upon the industry. It is in the interest of the hedge fund industry to actively engage regulatorsto find a joint solution that will satisfy both the industry and the regulators alike. If we are lucky the solution might even satisfy investors. In any case, the complexity of the hedge fund industry means that regulators will need to gain deeper insight into hedge fund strategies and industry dynamics before they can even begin to contemplate policies.

 

 The market is therefore self regulating in some respects. A 50% shrinkage in assets under management is clear evidence of investor driven policing. Yet this investor driven ‘regulation’ has come too late. The concentration of investor power in the hands of the funds of funds was an opportunity to reform the hedge fund industry, to encourage it in a more investor friendly direction. Instead little was done. With the investor community in as much distress as the hedge fund community, one can only hope that there remains enough left to reorganize and regroup, and to address those missed opportunities.

 

Investor demand for greater disclosure and transparency will increase. Investor’s acceptance of inefficient terms and structures will diminish. Here is an opportunity for industry self regulation. Regulation, especially self regulation, should encourage the establishment of standards of disclosure and reporting. There should be no mandatory imposition of such standards, only the publication of such standards so that investors can price any deviation from these standards in their investment decisions.

 

Regulator driven standards is a likely reaction. It is important that standards are not mandatory since compliance or non-compliance provides useful information about the qualities of a hedge fund manager. Making something mandatory simply suppresses all that information. And some investors are more sophisticated than others. And investors all have different tolerances for risk.

 

 as eligible investors is a likely reaction which I think is misguided. I have argued elsewhere the need for opening up the hedge fund industry to the retail market. There lies in this an opportunity for funds of funds to reinvent themselves to in a more relevant form to a new audience.

 

This is just one simple person’s view. I would be interested in your views on what form should hedge fund regulation take and would love to hear from you on how would you propose hedge funds should be regulated.

Please go to the Forum on my website and make your views heard.