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Hedge Fund Fees Are On the Rise, And That’s Good

The conventional wisdom is that everything on Wall Street gets cheaper over time. From trading costs to management fees, capitalism forces competition and efficiency.

In the hedge fund industry, with performance lagging since the financial crisis of 2008, it makes sense that everyone is talking about fee compression and better terms for investors. Almost every day you hear that the days of 2 and 20 are over.

CalSTRS Chief Investment Officer Christopher Ailman, on CNBC’s “Squawk on the Street,”recently said, “Two and 20 is dead. People have to understand that. That model has been broken.”

He’s right. 2 and 20 is dead. Welcome to the days of 3 and 30.

The initial downward price pressure

When the technology bubble burst in 2000, institutional investors had little to no exposure to alternatives. When sifting through the wreckage of their portfolios and in need of risk mitigation, they noticed that the university endowments fared markedly better during the decline due to their large allocation to alternative investments.

When the bubble burst and the S&P 500 was down almost 15%, the average university endowment was down only about 3.5%.

report by the Center for Social Philanthropy and Tellus Institute found that:

“Because endowments such as Harvard and Yale had limited their exposure to domestic public equities, they managed to avoid the worst damage done by the tech bubble’s bursting in 2000. Institutional investors that had suffered from their exposure to U.S. domestic equities during the tech run-up found in the Endowment Model a potential way to avoid the negative effects of another major market correction and the promise of winning back their losses.”

This created an unprecedented wave of demand for hedge fund strategies. But the hedge fund industry was still developing, and there were just a handful of institutionally viable hedge fund managers.

This supply/demand imbalance is why the typical fee structure of 1 and 20 quickly became 2 and 20 – and beyond. Fees went up because institutions demanded the diversifying alpha of hedge fund products and were happy to pay for it.

Then the financial crisis of 2008 crashed onto the scene.

Another market correction brought another rush into alternative investments. But this time, after the crash, came a long period of underperformance from many hedge funds. The report continues:

“It took the financial crisis for many of those responsible for these strategies to take a fuller measure of the risks they were taking by plunging into alternative investments, without adequate regulation or transparency. The Endowment Model of Investing failed to control volatility, and its leading exemplars generated performance far worse during the crisis than investors that focused on security of income over growth.”

Raising the bar

A rush into the hedge fund industry raises the fees. But it also exposes the cracks.As more and more firms reported disappointing performance in the years after the financial crisis, and the stock market was compounding nearly twice its historical averages and even hitting all-time highs this year, the seemingly logical 2 and 20 model lost its luster.

Technology advancements now make it possible to build investable indexes that go beyond market beta, and include the factors that active managers have used for decades. Fewer active managers are expected to outperform these increasingly popular enhanced beta benchmarks.

BRI Meg 1

This latest trend will beget a change that the mutual fund industry has seen already. The egocentric world of the “heady” hedge fund days will pass, and be replaced by larger more institutional firms that are less dependent on one individual. Think less “I’ve got money with Ray Dalio” and more “I’ve got money at Bridgewater.”

Today we witness a huge shift to passive investing and away from active managers. According to a Morningstar Direct Asset Flow study, in 2016 alone over $300 billion was redeemed from active strategies and over $500 billion flowed into passive.

Empowered with enhanced passive options, investors will likely continue to vote with their dollars. The active to passive movement will be ongoing, and fewer and fewer active hedge funds will survive the shift. The ones that do will reap the benefits, and so will the investors who allocate to them.

With demand for the risk mitigation that hedge fund strategies provide remaining, even growing in 2016 by .73% to $3.04 Trillion according to eVestment, and the number of hedge funds decline, supply and demand will once again force fees up. Even as the new benchmark indexes capture more and more beta, and shrink the amount of available alpha, investors will be happy to pay more to the active managers that actually deliver it.

Paying more, costing less

Hedge fund investors, much like investors did with traditional strategies years ago, will seek to barbell their alternative allocations between the enhanced beta indexes,at a very low cost and the alpha-producing active hedge fund managers. And they will be happy to pay 3 and 30 to the managers that perform (maybe even more).

In this scenario, the overall cost of their alternative allocations will be lower than the days of paying 2 and 20 to everybody.

In many instances, less is more. But in the hedge fund world, sometimes more really means less.