A report released by LCH Research got widespread coverage with the Wall Street Journal making its headline, “Hedge-Fund Fees Eat Up Half of Clients’ Profits,” and Bloomberg chimed in with, “Hedge Funds Kept $1.8 Trillion as Fees, or Half Their Gains.” The coverage used words like “staggering” and “exploitation,” but I think this is an innumerate reaction
Before getting to the right way to think about these numbers, I want to address the idea of forming estimates to the nearest hundred million dollars of the total return and total fees of all hedge funds since Alfred Winslow Jones invented them in 1949. It’s difficult even to define all hedge funds, and few of them disclose results to the public. The disclosures some make to databases are not complete enough to make accurate calculations. But LCH has access to a lot of non-public information and a solid reputation for accurate research. I don’t think they know the numbers to the nearest hundred million dollars, but there’s no reason to think their numbers are wildly wrong. Moreover the ratio of fees to investor returns is easier to estimate than the absolute dollar totals of either one.
Let’s start with the numbers for 20 large hedge funds, which I think are more reliable than the totals for all hedge funds. Here we have a defined universe of funds, all very well known, and few enough that each can be examined in detail. According to LCH these 20 funds have generated $1,301.1 billion in total gains since inception, and taken $446.6 billion of that, 34.3%, in fees.
If you think about it, this is not meaningful information. What matters is whether the net investor returns beat the market. If the money invested in the 20 hedge funds had instead been in index funds, the fees would likely have been around $15 billion, one-thirtieth of what the hedge funds charged. But the index funds would not have beaten the market for their investors, only matched it before fees were subtracted. Traditional asset managers might have charged $100 billion, then lost to index funds on average.
Unfortunately, the 20 hedge funds represent a wide range of strategies with different benchmarks and fee structures, so we have no way of estimating the amount of excess return or alpha they delivered to investors. But we can still make sense of the numbers by assuming they were from a single fund that charged a 2% management fee and 20% of profits beyond a 3% hurdle rate (3% is about the weighted average one-month treasury bill rate over the period of operation). This is a reasonable guess for either a low-risk or market-neutral hedge fund.
In that case, the hedge funds’ gross return of $1,301.1 billion represented about 13% per year, and delivered $994.1 billion above the hurdle rate. The hypothetical fund took a performance fee of $241.9 billion, or 24% of the profit above hurdle. 24% is higher than the stated 20% performance fee because investors do not all redeem at high-water mark—both because investors cannot time peaks perfectly and also because they tend to redeem after losses.
But what if we treat this like a high-risk hedge fund run to a Beta of 0.5 to the S&P500. Based on weighted average stock returns over the period, that would suggest a hurdle rate of 6% rather than 3%. In turn, that would reduce the hypothetical excess return to $687.0 billion, and the performance fee would represent 35% of excess profits.
Since the actual funds are mix of high and low risk funds, with different correlations to major financial markets and different fee arrangements, all we can say is it seems these 20 hedge funds are taking something like 30% of excess profits as performance fees.
