Loyalty Rewards: A Better Fee Structure for All

Hedge funds have not met spending needs net of fees in the challenging zero interest rate policy environment, despite generally producing returns since the financial crisis that met investor expectations gross of fees.[1] One outcome has been an outcry for a reduction in fees, but for the most part fees have not changed.

The structure of the industry needs a framework that turns a zero-sum game (less for the managers, more for the investors) into a positive-sum game in which both managers and investors benefit. Allocators to the largest funds generally hold no market power to sway managers. Nearly $3 trillion is invested with hedge funds, every dollar of which represents an existing fee agreement between managers and investors. No matter how much allocators would like to pay less, the managers of these funds are unlikely to change without some give and take.

A resolution must create a win-win for both managers and allocators, and we believe the tradeoff between fees and duration of investment is a good place to start. A number of established managers offer long duration share classes that charge below market fees, but many allocators are uncomfortable or unable to accept illiquidity in a relatively liquid investment area. A better fee structure for more participants might be one that rewards investor loyalty with reduced management fees over time. Consider the following structure for a hedge fund’s management fee:

 Years 1-3:   1.50%

Year 4:         1.40%

Year 5:         1.30%

Year 6:        1.20% (continuing to decline 10bp/year)...

Year 14 and beyond: 0.50%

Loyalty Rewards Promotes Investor Longevity

In this ‘loyalty rewards’ arrangement, allocators pay less over time and managers build subtle incentives to promote lower client turnover. Most allocators enter new manager relationships with the intent of investing for the long-term, but in aggregate allocators collectively fall short.[2] The current structure of the industry carries few incentives to elicit long-term behavior from allocators.

Allocators do not have staying power because unanticipated change tends to throw a wrench in their plans. Investors dedicate tremendous effort to their new investments, conducting exhaustive searches, spending countless hours in meetings and due diligence, writing lengthy reports detailing their work, and preparing thoughtful presentations for their boards. But all of this work goes for naught when changes in personnel, markets, or mindset takes hold, often falling into one of the following categories:

• Change in personnel
  • New CIO
  • New consultant
  • New board members
• Change in markets
  • Asset allocation rebalancing
  • Liquidity needs
  • Revised investment strategy
• Change in mindset
  • Grass is greener mentality
  • Response to subpar short-term performance
  • Changing of minds

 A fee structure that rewards loyalty encourages allocators to behave like long-term investors by creating a switching cost to churn. Imagine the difference in a board discussion if an allocator considering replacing a longstanding manager with another would incur a higher management fee. Allocators and boards at least would give serious consideration to the cost of changing managers. Other factors aside, the lower headline fee becomes an irreplaceable asset.

Investor Longevity Benefits Returns and Stabilizes Businesses

This arrangement rolled out across the industry could meaningfully reduce aggregate fees paid to managers and more efficiently allocate capital to longer duration providers. Were we to assume that investors have roughly the same skill in selecting managers, then those who are more patient with their managers would generate higher returns than their peers over time by the amount of fee savings. These more patient investors might get rewarded through inflows (for for-profit businesses) or bigger roles (for non-profit CIOs), putting more of the industry assets in the hands of those less inclined to churn their portfolios.

Managers would also recognize the benefit to this structure. By creating a positive switching cost for existing clients that does not exist in the industry today, managers would benefit from more asset stability.

Innovation Starts with New Allocations

Loyalty rewards provide a rare advantage for newly launched funds over established ones. Twenty-year old firms with billions under management may struggle to properly reward clients for loyalty since many of their clients have paid full fees for many years. Slashing the base revenue of a business overnight would be too disruptive for these organizations to bear. Established managers may want to consider how to build in switching costs for their clients over time. Start-up managers, in contrast, can structure their business for long-term success by adopting this model quickly.

It Takes A Village

This modest proposal of a ‘loyalty rewards’ fee structure could go a long way to gradually accruing more of the value added generated by hedge fund managers to their long standing supporters in exchange for promoting long-term investment relationships to the benefit of all. As you engage in your daily investing practice, I encourage you to suggest this fee structure to your legal advisors, managers, and prime brokers, those best positioned to enact the innovation.

[1] www.hedgefundresearch.com. Assuming an investor seeks an equity-like expected return of 6% real from their hedge fund investments, over the five years from January 2010 – December 2014 the HFRI Fund Fund Weighted Composite has returned 4.6% net. Should the average manager charge a 1.5% management fee and a 20% performance fee, the gross return of the index would have been approximately 7.2%, essentially matching the return expectation.

[2] www.dalbar.com. Dalbar’s annual Quantitative Analysis of Investor Behavior, in its 20th year in 2014, consistently shows that the dollar-weighted returns earned by clients lag the time-weighted returns reported by managers.