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High performing hedge funds retain ability to charge standard '2 and 20' fee structure and above despite overall trend of declining fees

The global hedge fund industry has witnessed a trend of declining management and performance fees over the past decade, calling into question the traditional “2 and 20” fee structure the industry was famous for. Mediocre returns over recent years – as opposed to the double-digit annual returns investors had come to expect from hedge funds pre-2008 along with increasing competition within the industry and tighter regulation over alternative investment vehicles are some key factors which have contributed to this trend. Investor experience during the 2008 global financial crisis had resulted in more disintermediation within the industry, with institutional investors engaging hedge fund managers directly. Faced with more proactive and demanding investors, many hedge fund managers ended up lowering their fees, or adopting stricter hurdle rates and shorter lockup periods. Nevertheless, as we will discuss in this piece, a sizeable part of the hedge fund industry has continued to maintain leverage over fees by delivering superior net of fees returns to their investors.

Hedge fund management firms typically charge two kinds of fees to their investors: the performance fee which is based on the amount of performance-based gain of the fund, and the management fee which is charged based on the size of the investment, regardless of the fund performance. Typically performance fee and management fee are considered as the “variable cost” and “fixed cost” of hedge fund investing respectively.

Performance fees often come with additional conditions such as hurdle rate and high water mark. Hurdle rate indicates the minimum amount of performance-based gain that the fund manager has to exceed before charging the performance fee to the investors. Should the fund perform below this rate, the performance fee would be waived during that period. High water mark is defined as the peak value of a fund’s net asset value (NAV) over a period of time. Funds that adopt the high water mark system only charge performance fee over performance-based gains that exceed the high water mark. The high water mark value could be calculated over the whole lifespan of the fund since inception (perpetual high water mark) or over a fixed duration of time such as one year (annual high water mark). In the latter case, the high water mark would be reset at the start of a new period.

Management fees, on the other hand, are often tied to things other than a hedge fund’s performance. Various factors may affect the management fee charged to an investor, including the complexity of the hedge fund’s investing strategy, the liquidity of the asset classes traded by the fund, the lockup period of the investment, and the investment size of each investor. Some fund managers may charge higher management fees while offering other benefits which may include shorter lockup period, tiered fees that decrease as the investment size increases, and being domiciled in a low tax jurisdiction, for example. There are also funds that charge very low management fees while charging higher than average performance fees, vice versa.

The following two tables exhibit the average management and performance fees charged by hedge fund managers in the Eurekahedge Global Hedge Fund Database based on the year of fund launch, as well as investing geography.

Table 1a: Average hedge fund management fees by launch year and investing region

Launch Year

North America

Europe

Asia

Global

2006

1.62%

1.55%

1.60%

1.59%

2007

1.74%

1.51%

1.63%

1.63%

2008

1.56%

1.47%

1.60%

1.52%

2009

1.61%

1.46%

1.67%

1.54%

2010

1.61%

1.51%

1.60%

1.55%

2011

1.62%

1.43%

1.61%

1.50%

2012

1.53%

1.38%

1.55%

1.47%

2013

1.50%

1.24%

1.41%

1.34%

2014

1.47%

1.24%

1.46%

1.33%

2015

1.46%

1.16%

1.42%

1.29%

2016

1.34%

1.24%

1.40%

1.27%

2017

1.36%

1.08%

1.35%

1.17%

2018

1.34%

1.17%

1.32%

1.22%

2019

1.31%

1.19%

1.26%

1.18%

2020

1.22%

1.13%

1.30%

1.16%

Source: Eurekahedge

Table 1b: Average hedge fund performance fees by launch year and investing region

Launch Year

North America

Europe

Asia

Global

2006

18.96%

17.06%

18.24%

17.92%

2007

19.68%

16.67%

17.98%

18.07%

2008

18.51%

15.90%

17.96%

17.16%

2009

18.27%

15.64%

17.30%

16.91%

2010

17.94%

16.17%

18.80%

16.88%

2011

18.26%

15.82%

17.53%

16.69%

2012

17.64%

15.13%

17.59%

16.17%

2013

16.97%

13.63%

16.49%

15.00%

2014

16.20%

14.40%

17.08%

15.26%

2015

15.47%

13.48%

16.76%

14.47%

2016

16.81%

13.31%

17.76%

14.35%

2017

17.13%

13.02%

16.80%

14.29%

2018

16.06%

13.79%

17.60%

14.68%

2019

16.00%

13.69%

14.91%

14.09%

2020

17.60%

14.41%

13.96%

15.14%

Source: Eurekahedge

Table 2 below shows the percentage of hedge funds in the Eurekahedge Global Hedge Fund Database which adopt hurdle rates or high water mark provisions in their performance fee calculation. As of December 2020, roughly 81.3% of the live hedge funds tracked by Eurekahedge employ some kind of high water mark provision, compared to the 11.9% which use hurdle rates for performance fee calculation, with 79.3% of these funds adopting either a hurdle rate or high water mark. Approximately 6.9% of the live hedge funds adopt both a hurdle rate and high water mark provision.

Table 2: Percentage of hedge funds with hurdle rate or high water mark provisions

 

Hurdle Rate

High Water Mark

Either Hurdle Rate or High Water Mark

Both Hurdle Rate and High Water Mark

All Hedge Funds

7.5%

83.6%

81.5%

4.7%

Live Hedge Funds

11.9%

81.3%

79.3%

6.9%

Source: Eurekahedge

The following section of the report takes a closer look at the hedge fund industry assets breakdown based on the management fees charged. Following the 2008 global financial crisis, the subset of hedge fund managers charging less than 1.0% management fees has seen substantial growth in assets, reflecting the growing demand for lower fees within the hedge fund investor base. As of December 2020, US$554.5 billion or 24.7% of the hedge fund industry assets were managed by funds charging at least 2.0% management fees. In comparison, fund managers charging less than 1.0% management fees oversaw US$692.3 billion or 30.8% of the industry assets.

Figure 1a: Hedge fund industry AUM breakdown by management fee
Hedge fund industry AUM breakdown by management fee

Figure 1b below provides the percentage breakdown of the industry AUM by management fee. Despite the increasing prevalence of hedge funds charging less than 1.0% management fees, the proportion of assets managed by fund managers charging no less than 2.0% management fees has been relatively resilient to the pressure over the last 16 years. By the end of 2008, 34.5% of the hedge fund industry AUM were managed by funds charging at least 2.0% management fees. This figure has since dropped to 24.7% as of December 2020. Over the same period, the market share held by funds charging below 1.5% management fees has increased from 30.4% to 58.3%.

Figure 1b: Hedge fund industry AUM percentage breakdown by management fee
Hedge fund industry AUM percentage breakdown by management fee

Figure 2a provides the global hedge fund industry AUM breakdown based on the performance fee charged. Despite the continued downward pressure on hedge fund fees since the end of the 2008 global financial crisis, more than half of the global hedge fund industry assets is still managed by funds charging no less than 20% performance fees. On the other hand, fund managers charging below 20% performance fees have seen their market share grow remarkably post-crisis, from US$253.3 billion, or 17.2% of the industry assets by the end of 2008, to US$1,065.0 billion, or 47.4% of the industry assets as of December 2020.

Figure 2a: Hedge fund industry AUM breakdown by performance fee
Hedge fund industry AUM breakdown by performance fee

Figure 2b provides the percentage breakdown of the industry AUM by performance fee. The increase in demand for lower fees within the industry has contributed to the increase in number of fund launches charging less than 20% fees. However, similar to what we have observed with management fees, a sizeable part of the hedge fund industry has remained resilient to this pressure to lower fees. As of December 2020, US$1,183.6 billion, or 52.6% of the global hedge fund industry AUM was managed by funds charging at least 20% performance fees.

Figure 2b: Hedge fund industry AUM percentage breakdown by performance fee
Hedge fund industry AUM percentage breakdown by performance fee

This section of the report takes a look at the hedge fund industry AUM breakdown based on both management and performance fees simultaneously. With the rise of demand for lower fees, hedge funds charging less than 2.0% management fees and 20% performance fees have gathered significant following post-crisis, growing their market share from US$243.9 billion, or 16.6% of the industry assets by the end of 2008, to US$1,031.2 billion, or 45.9% of the industry assets as of December 2020.

Figure 3a: Hedge fund industry AUM breakdown by management and performance fees
Hedge fund industry AUM breakdown by management and performance fee

Notwithstanding the severe scrutiny hedge fund fee structure has been subjected to over the recent years, fund managers charging at least 2.0% management fees and 20% performance fees still account for a not insignificant chunk of the industry AUM as seen in Figure 3b below. These fund managers have seen their market share decline from 33.6% by the end of 2008 to 23.7% as of December 2020. This observation, combined with the growing number of funds charging lower fees would point toward the compression of the two middle categories of funds charging at least 20% performance fees but less than 2.0% management fees, and funds charging at least 2.0% management fees but less than 20% performance fees. The combined market share of the two aforementioned groups of funds has declined from 49.8% by the end of 2008 to 30.5% as of December 2020.

Figure 3b: Hedge fund industry AUM percentage breakdown by management and performance fees
Hedge fund industry AUM percentage breakdown by management and performance fee

Redemption period is another variable that has come under serious scrutiny following the financial crisis in 2008, as investors demand more transparency and liquidity from the hedge fund managers. Table 3 takes a look at the hedge fund industry average redemption period breakdown based on both management and performance fees simultaneously by their launch year. Prior to the financial crisis, hedge funds which launched in 2007 had average redemption periods of 5.07 days, 13.85 days, 34.65 days and 43.24 days respectively across the fee buckets listed in Table 3. In contrast, hedge funds which launched in 2020 had generally experienced a sharp decline in their average redemption period over the past decade, with only hedge funds charging less than 20% performance fee and less than 2.0% management fee being the only exception as their average redemption period rose to 9.38 days over the past decade. It is also worth noting that hedge funds that charge less than 20% performance fee and less than 2% management fee are usually hedge funds utilizing fixed-income strategies. On the other end of the spectrum, hedge funds charging their investors more than 20% performance fee and more than 2% in management fees are hedge funds that employ the long/short equities strategy. The complexity of the trading strategy and the liquidity of the exposed market are factors defining the hedge fund fees. In addition, newly launched hedge funds with a strong track record usually charge their investors higher fees.

Table 3: Average redemptions period breakdown by management and performance fees

Launch Year
< 20% Performance Fee & < 2.0% Management Fee
< 20% Performance Fee & = 2.0% Management Fee
= 20% Performance Fee & < 2.0% Management Fee
= 20% Performance Fee & = 2.0% Management Fee

2004

4.51

57.38

38.39

36.99

2005

9.77

28.33

34.96

40.59

2006

5.00

20.08

34.23

42.06

2007

5.07

13.85

34.65

43.24

2008

5.76

44.67

33.78

37.29

2009

5.80

46.85

27.16

31.95

2010

5.59

31.55

21.82

25.82

2011

5.24

11.21

19.95

26.97

2012

7.80

19.67

25.54

24.56

2013

7.89

18.36

21.44

26.35

2014

8.84

19.67

17.39

21.73

2015

4.03

17.83

17.53

24.04

2016

9.13

17.47

16.86

17.45

2017

8.03

39.57

22.47

34.74

2018

8.44

62.75

16.00

25.84

2019

11.88

13.88

13.49

23.11

2020

9.38

2.67

13.60

31.71

Source: Eurekahedge

Table 4a provides the average management fees charged by hedge funds by their launch year and fund sizes since 2004. Generally, management fees have been subjected to a trend of decline over the past decade, owing to the increasing difficulty in raising capital from investors. Hedge funds with more than a billion dollars of AUM charged the highest management fees of 1.71% among their peers in 2004. In contrast, billion dollar hedge funds which launched in 2020 charged the lowest management fees of 1.29% among their peers, signifying their increased willingness to accept lower management fees to remain fee competitive against their other smaller peers. It is also worth noting that large-sized hedge funds have a competitive advantage over their smaller peers in terms of their ability to offer a lower management fee as their larger AUM allows them to generate sufficient revenue to cover their operational expense and research cost.

Table 4a: Hedge fund management fee by launch year and fund sizes

< US$100
US$100 < US$500
US$500 < US$1000
US$1000 >

2004

1.50

1.50

1.55

1.71

2005

1.53

1.54

1.48

1.67

2006

1.56

1.54

1.56

1.55

2007

1.56

1.57

1.53

1.47

2008

1.57

1.58

1.61

1.50

2009

1.56

1.55

1.67

1.42

2010

1.54

1.56

1.51

1.45

2011

1.54

1.54

1.46

1.46

2012

1.51

1.50

1.54

1.41

2013

1.49

1.47

1.48

1.41

2014

1.47

1.45

1.46

1.36

2015

1.45

1.43

1.45

1.33

2016

1.44

1.43

1.41

1.29

2017

1.43

1.39

1.41

1.25

2018

1.42

1.38

1.35

1.27

2019

1.41

1.36

1.34

1.31

2020

1.40

1.36

1.36

1.29

Source: Eurekahedge

Table 4b shows the average performance fees charged by newly launched hedge funds aggregated by launch year and fund sizes. Hedge funds that launched in 2004 charge on average 19.13%, 19.20%, 20.19% and 19.46% performance fee respectively across the fund size buckets, close to the “2 and 20” fee structure commonly adopted by many hedge fund managers before the 2008 financial crisis. Increasing competition within the industry, and from other alternative investment vehicles have put considerable pressure on hedge fund fees over the past decade. Hedge funds that launched in 2020 charge on average significantly lower performance fees, with hedge funds with more than a billion dollars of AUM experiencing the largest decline in performance fees.

Table 4b: Hedge fund performance fee by launch year and fund sizes

< US$100
US$100 < US$500
US$500 < US$1000
US$1000 >

2004

19.13

19.20

20.19

19.46

2005

19.13

19.19

19.23

19.45

2006

19.17

18.95

19.38

19.62

2007

19.04

18.93

19.07

19.12

2008

18.72

18.89

19.42

18.06

2009

18.61

18.39

19.23

17.31

2010

18.37

18.15

17.90

17.20

2011

18.18

18.11

17.45

16.86

2012

17.98

17.36

16.88

16.54

2013

17.74

17.12

17.33

16.01

2014

17.37

17.11

16.11

15.90

2015

17.07

16.76

16.25

15.11

2016

16.69

16.87

16.04

14.47

2017

16.82

16.53

16.17

14.14

2018

16.73

16.22

15.98

14.17

2019

16.73

15.67

16.26

14.68

2020

16.72

15.72

15.77

14.32

Source: Eurekahedge

Figure 4a below provides the global hedge fund industry annual launches breakdown by the management fees charged since 2006. Since 2008, launch activities have been on a declining trend as the total number of hedge fund launches fell from 1,231 in 2008 to 571 in 2020. Fund launches in the industry have also been moving towards charging lower management fees over the years. In 2008, 526 hedge funds launched over the year were charging a management fee of at least 2%. This figure has since declined to only 80 in 2020 as more hedge fund managers choose to charge lower management fees to remain competitive.

Figure 4a: Hedge fund industry annual launches breakdown by management fees
Hedge fund industry annual launches breakdown by management fees

Figure 4b below provides the global hedge fund industry annual launches percentage breakdown by the management fees charged since 2006. In 2006, hedge funds that charge a management fee of 2.0% accounted for 37.4% of the launches over the year, the largest percentage share among the fee buckets. Hedge funds that charge a management fee between 1.5% and 2.0% followed closely behind, accounting for 35.1% of fund launches in 2006. Over the years, the hedge fund industry has moved away from the standard “2 and 20” fee structure. In 2020, hedge funds that charge a management fee of between 1.0% and 1.5% accounted for 32.4% of launches over the year, the largest percentage share among the fee buckets. In contrast, the share of hedge funds charging the standard 2.0% management fee has declined to only 13.3% in 2020.

Figure 4b: Hedge fund industry annual launches percentage breakdown by management fees
Hedge fund industry annual launches percentage breakdown by management fees

Figure 5a provides the global hedge fund industry annual launches breakdown by the performance fees charged since 2006. Since 2008, launch activities have been on a declining trend as the total number of hedge fund launches fell from 1,231 in 2008 to 571 in 2020. Fund launches in the industry have also been moving towards charging lower performance fees over the years. In 2008, 910 hedge funds launched over the year were charging a performance fee of at least 20%. This figure has since declined to 306 in 2020 as more hedge fund managers choose to charge lower performance fees to remain competitive.

Figure 5a: Hedge fund industry annual launches breakdown by performance fees
Hedge fund industry annual launches breakdown by performance fees

Figure 5b below provides the global hedge fund industry annual launches percentage breakdown by the performance fees charged since 2006. In 2006, hedge funds that charge a performance fee of at least 20% accounted for 79.3% of fund launches over the year. Over the years, fee pressure caused by increasing competition has pressured fund managers to charge lower performance fees. In 2020, the percentage of hedge funds that charge a performance fee of at least 20% declined to 53.6% as the share of hedge fund launches charging less than the standard 20% performance fee saw their share more than double from 20.7% in 2006 to 46.4% in 2020. In contrast to Figure 4b where only around 15% of newly launched hedge funds in 2020 charge their investors at least 2% management fees, Figure 5b shows that more than 50% of hedge funds charge their investors at least 20% performance fees. This shows that investors have a stronger demand for lower management fees than performance fees as the management fee will be charged regardless of the performance of the funds. On the other hand, hedge funds will only charge performance fees to their investors if they managed to outperform their imposed hurdle rate or break the previous high water mark recorded, better aligning the interests of the hedge fund managers with their investors.

Figure 5b: Hedge fund industry annual launches percentage breakdown by performance fees
Hedge fund industry annual launches percentage breakdown by performance fees

Considering the asymmetric nature of performance fee – in the sense that a fund manager would take a share in profits made, but not losses, it is not surprising that there is a strong demand for lower performance fee, as well as other provisions to minimise potential conflicts of interest and deter fund managers from undertaking excessive risk in their investment decisions. Fund managers may also offer customised fee terms to their investors or invest a significant amount of personal capital into the fund, to ensure that their interests are aligned with their investors. Nevertheless, fund managers who have successfully distinguished themselves by delivering exceptional returns may still be able to attract investor capital without lowering their fees, as ultimately what matters the most to investors is the fund performance net of fees.

We expect the trend of declining hedge fund fees to persist into the future, driven by strong competition due to the presence of low fee products such as exchange-traded funds and mutual funds, investor demand for lower fees and government regulation such as the UCITS regulation. In addition, since the aftermath of the 2008 global financial crisis, passive investment strategies have managed to outperform global hedge funds on average, supported by the low interest rate environment which served as a tailwind for equity market performance. Therefore, the ability of fund managers to generate alpha and superior risk-adjusted returns will be a strong determining factor influencing their fee structure. Fund managers with little to no track record will have little choice but to offer much lower fees to remain attractive to investors.

On the other end of the spectrum, despite the increasing competition in the industry driven by investor demand for lower fees, some newly launched hedge funds are still able to charge their investors using the standard fee structure of “2-20” or even higher. These hedge funds are usually managed by fund managers with proven track records or by an offspring of a well-known hedge fund in the industry. This indicates that investors are still willing to pay higher fees as long as the fund managers are able to generate positive alpha for their investments. In the same vein, hedge funds that have been in the market for a longer period and consistently reap positive returns also have the privilege to charge their investors higher fees as well.

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