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**Hedge fund fees**

Which incentive fee is better for investors? Three years of 20% each year or 40% after three years? 3 x 20 is 60 so "only" 40% after 3 years must be better, right? WRONG. As with most performance measurement, conventional "wisdom" and assumptions are misleading. Here's a look at a "lower" fee structure. Lots of positive commentary on this "innovation" which is odd considering how BAD a deal it is.

Instead of assuming it's better let's compare the NET return of 40% triennial versus 20% annual incentive fees. Some quick algebra PROVES that the "cheaper" fee structure must have a negative year to have any chance of offering a better deal than annual performance fees! But minus years are unacceptable to hedge fund investors. I require absolute returns in all conditions. Clients would redeem well before the promised land of the 40% incentive fee kicks in.

Suppose two funds generate gross, before fee, performance of 10% above the S&P 1500 over the next three years. Assume the index itself stays flat to isolate the "pure" alpha fees. Both funds charge a 1.5% management fee but returns compound for 3 years and then levies the 40% cut of profits at the end of the 36 months. The other fund charges the standard 20% each year on NEW profits above the high water mark. Using these assumptions:

1.5%, triennial 40% 3 year net compounded return +16.64%

1.5%, annual 20% 3 year net compounded return +21.82%

A 40% triennial performance fee costs investors MORE than the usual 20% annual and rather than achieving symmetry actually has higher payoff asymmetry. Under the assumed return scenario, triennial is ONLY better if the incentive fee is LESS than 21.30%. In fact the 40% fee structure is only better if one or more of the three years is negative and even then not always.

If gross +10%, +10%, -10% 3y CAGR = +2.51% Other fund = +0.95% cheaper

If gross +20%, +20%, -10% 3y CAGR = +14.56% Other fund = +16.63% NOT cheaper

A 40% triennial performance fee solves no existing compensation issues and potentially creates new ones. If things have been rocky after 3 years and fund is flat to negative the temptation to "go for it" will surely be far greater than in a single losing year. And how to compensate employees while rival funds will have bonus paying ability every year? Investors are into teams, deep benches and REDUCING key-person risk these days.

Isn't the point of a proper hedge fund to make absolute returns no matter what? Seems to be a lot of chatter about stock picking abilities but not much mention of short selling, hedging and risk management knowledge. They are as important skills as buying the right stocks in the hedge fund world.

There is an inescapable fact of life in the hedge fund industry: investor impatience. People pay the modal 2 and 20 for consistent positive monthly returns. One negative month is not taken well, a negative quarter very badly, a negative year, sayonara. The standards of performance expected of hedge fund managers is brutal and rightly so, and I am not sure there are that many investors out there with the patience to stick around for years.

There are also added complications of equalization as clients join and redeem during a three year period. What happens to an initial investor who bails after 35 months? Or joins 1 month before the claim on 40% on all that massive expected alpha looms. And what interim numbers do you report for the first 35 months, gross or net?

You can't eat relative returns. You also can't eat arithmetical returns. There is yet another lesson here of the importance of path dependence in compounded performance. A big final year fee or drawdown can severely impair or even eliminate several previous years of good performance. A good chunk of the rip-roaring 1990s got taken out by 2000-2002. All that Japanese growth in the 1980s basically got taken out in a single year, 1990. The curse of the back-end clawback, be it from a performance drawdown, fees or taxes, is not to be ignored by any investor.

There is nothing threatening to real hedge funds about this "innovation". A revolution in hedge fund pay structures? No. Other hedge fund managers in a panic? Hardly. Might become the norm? Definitely not.

Instead of assuming it's better let's compare the NET return of 40% triennial versus 20% annual incentive fees. Some quick algebra PROVES that the "cheaper" fee structure must have a negative year to have any chance of offering a better deal than annual performance fees! But minus years are unacceptable to hedge fund investors. I require absolute returns in all conditions. Clients would redeem well before the promised land of the 40% incentive fee kicks in.

Suppose two funds generate gross, before fee, performance of 10% above the S&P 1500 over the next three years. Assume the index itself stays flat to isolate the "pure" alpha fees. Both funds charge a 1.5% management fee but returns compound for 3 years and then levies the 40% cut of profits at the end of the 36 months. The other fund charges the standard 20% each year on NEW profits above the high water mark. Using these assumptions:

1.5%, triennial 40% 3 year net compounded return +16.64%

1.5%, annual 20% 3 year net compounded return +21.82%

A 40% triennial performance fee costs investors MORE than the usual 20% annual and rather than achieving symmetry actually has higher payoff asymmetry. Under the assumed return scenario, triennial is ONLY better if the incentive fee is LESS than 21.30%. In fact the 40% fee structure is only better if one or more of the three years is negative and even then not always.

If gross +10%, +10%, -10% 3y CAGR = +2.51% Other fund = +0.95% cheaper

If gross +20%, +20%, -10% 3y CAGR = +14.56% Other fund = +16.63% NOT cheaper

A 40% triennial performance fee solves no existing compensation issues and potentially creates new ones. If things have been rocky after 3 years and fund is flat to negative the temptation to "go for it" will surely be far greater than in a single losing year. And how to compensate employees while rival funds will have bonus paying ability every year? Investors are into teams, deep benches and REDUCING key-person risk these days.

Isn't the point of a proper hedge fund to make absolute returns no matter what? Seems to be a lot of chatter about stock picking abilities but not much mention of short selling, hedging and risk management knowledge. They are as important skills as buying the right stocks in the hedge fund world.

There is an inescapable fact of life in the hedge fund industry: investor impatience. People pay the modal 2 and 20 for consistent positive monthly returns. One negative month is not taken well, a negative quarter very badly, a negative year, sayonara. The standards of performance expected of hedge fund managers is brutal and rightly so, and I am not sure there are that many investors out there with the patience to stick around for years.

There are also added complications of equalization as clients join and redeem during a three year period. What happens to an initial investor who bails after 35 months? Or joins 1 month before the claim on 40% on all that massive expected alpha looms. And what interim numbers do you report for the first 35 months, gross or net?

You can't eat relative returns. You also can't eat arithmetical returns. There is yet another lesson here of the importance of path dependence in compounded performance. A big final year fee or drawdown can severely impair or even eliminate several previous years of good performance. A good chunk of the rip-roaring 1990s got taken out by 2000-2002. All that Japanese growth in the 1980s basically got taken out in a single year, 1990. The curse of the back-end clawback, be it from a performance drawdown, fees or taxes, is not to be ignored by any investor.

There is nothing threatening to real hedge funds about this "innovation". A revolution in hedge fund pay structures? No. Other hedge fund managers in a panic? Hardly. Might become the norm? Definitely not.

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