No wonder hedge fund investors have finally woken up and started running for the door. And a new study published by NBER confirms that, just like private equity, high fees are the reason for underwhelming results. The level of extraction found in a study of 4000 funds from 1995 to 2016 is eyepopping. From the article:

After including management fees, investors collected about 36 cents for each dollar of gross excess return generated by funds on their invested capital. The other 64 cents were paid as management and incentive fees. Adding insult to injury, these results are obtained before adjusting fund returns for risk.

We’ve embedded the paper by Itzhak Ben-David, Justin Birru and Andrea Rossi at the end of the post.

The high fee levels are no doubt a big part of why hedge funds haven’t lived up to their return promises. In our very first post in 2006, we pointed out that CalPERS had admitted that hedge funds were underperforming. As it told the New York Times:

This year ”is the third straight year that the global equity markets and long-only managers outperformed hedge funds,” said Christy Wood, senior investment officer for global equities at the California Public Employees’ Retirement System. ”If you threw all these in an index fund net of fees, you would have done better than if you put it in the hedge fund industry.”

A key part of the analysis is in the second section, where the authors ferret out why actual fees wind up being so much higher than nominal fees, which is what just about everyone thinks they are paying. The researchers determined that while the nominal incentive payment, aka the “carry fee” averaged 19% (in keeping with 20% in the prototypical “2 and 20”), in reality hedge fund managers took a whopping 49.6% of cumulative gross profits. One of the stunning features of both hedge fund and private equity fund investing is that the fund managers skim off the carry fees, as they decide to calculate them, and pay only the net income to the investors. That puts the investors in the position of having to parse the agreements very carefully (to make sure they haven’t agreed to clever clauses that work to their disadvantage) and then check the amounts remitted against what they think they were owed. Most don’t bother, as we can see from carry fee abuses in private equity.

The first is that in private equity, US investors allow the fund managers to take carry fees on each and every deal that show a profit once a hurdle rate is met. The problem with that is that private equity firms sell their good deals early and their dogs later, meaning it’s pretty common for investors to have been charged carry fees on early deal profits wiped out by later losses.

There are “clawback” provisions that are supposed to take care of that but they don’t. First, the private equity firms pretty much never volunteer to pay a clawback when one is owed; the limited partner has to make a stink. Second, the general partners virtually never cut a check, despite their legal obligation to do so; the cowed and captured limited partners too readily accept the vague promise of getting a “deal” on the next fund…which pre-commits them to invest with someone who underperformed and would not live up to his contact.

But third is that the limited partners have accepted tax language that guarantees they will never get back the full amount they were shortchanged. This 2014 post recapped an analysis by Lee Sheppard at Tax Notes:

The clawback provisions stipulate that the clawback amount be the lesser of overpayment or the after-tax overpayment. Taxes are assumed to be at the highest conceivable individual rate for someone living in high-tax New York City or San Franscisco. The agreements even assume that the managers cannot benefit from taking capital losses on the dogs. Does anyone believe these men, who typically hire top tax experts to advise them on their personal tax filings, pay the statutory tax rate?

And why should investors be responsible for manager tax problems? Mind you, tjis is just the basic level of chicanery. The post describes additional ruses.

So the short version of the private equity story is that because investors are stuck in private equity funds until the private equity firms return the money, they don’t have straightforward ways to recoup overpayments of performance fees resulting from profits on good deals being reduced by losses on bad deals. And the private equity firms play games to take advantage of holding their investors hostage.

So what is the hedge fund version? Because the academics didn’t have access to the hedge fund contracts (as we have, and even more so experts like Ludovic Phalippou and Lee Sheppard), there may be ruses in addition to the mechanisms they found. But they identified two.

One was that losses on one hedge fund could not offset gains on a different fund. The authors contend that hedge fund managers take advantage of this by operating like mutual fund families, of offering multiple funds with no offsets across funds run by the same hedge fund manager.

The second is that the greater liquidity of hedge funds works against investors. Many institutional investors are trend-chasers (witness again with CalPERS, dumping its tail risk hedge at the worst possible moment). They exit hedge funds when they are doing badly, even if they showed profits earlier so they give up the opportunity to have the losses offset against later gains:

….investor withdrawals and fund exits destroy potential fee credits. The magnitude of this mechanism is exacerbated by the fact that investor withdrawals and fund exits tend to occur after poor aggregate fund performance (and tend to occur for funds that are the worst performers in the cross-section), resulting in the subsequent relatively high returns being experienced by a relatively smaller aggregate AUM relative to the large AUM of the fund industry experiencing losses in the crash.

However, from what I infer, only a minority of hedge funds have fixed terms, as in a pre-set wind-up date. The implication is that most of the rest will shutter after adverse events, like big withdrawals forcing a fund liquidation (as happened to some of the biggest quant funds in 2008). Thus it seem the way most funds wind up or investors decide to depart winds up leaving them shortchanged. It’s a reasonable to assume that the fund documents are heavily skewed toward the managers in the event of investor exit or unexpected fund liquidation.

The authors also point out that the efforts of some in the hedge fund industry to change the fee structure from “2 and 20” to “1 and 30” would only make the fee problem worse:

Our results suggest two reasons for caution [regarding a “1 and 30” fee structure]. First, investors end up paying a signicantly larger fraction of their profits as incentive fees than what the contract species, e.g., the 30% incentive fee rate could be easily doubled ex-post. Second, in the long run, a signicant portion of incentive fees will likely be uncorrelated with actual lifetime fund performance, hence looking more like management fees than incentive fees.

Even though yours truly tends to be cynical, the apparent result that high effective hedge fund fees result more from accidental than intended “heads I win, tails you lose” than in private equity does make a certain amount of sense. Hedge funds, with only limited exceptions, are subject to monthly independent valuations of fund assets and prompt reporting of the resulting AUMs. That level of outside scrutiny, combined with most funds offering liquidity (on a quarterly or annual basis) may well curb the investor chicanery that is prevalent in private equity.

00 Pensions and hedgies etc. NBER