Towers Watson calls for fundamental shake-up of hedge fund fee model
Tower Watson, one of the world’s largest pension consultants, have advocated a fundamental change to the basis for calculating hedge fund fees, arguing investors should only pay a portion of the alpha managers generate rather than a typical 20% of net new profits.
The firm with $2trn of assets under advice says hedge fund investors should pay only “around one-third of outperformance from skill to the manager”, as opposed to the typical 30% to 40% of alpha, or in some cases more, that managers keep at present.
Towers Watson said managers accepting a smaller proportion of their alpha as a fee is “wholly appropriate, given investors place 100% of their capital at risk”.
“Fee structures [have] for years worked in favour of hedge fund managers, in many instances giving them the majority share,” Towers Watson said.
The firm’s views were voiced in a week another hedge fund, run by Lyxor, increased its incentive fee to 50%.
Damien Loveday, global head of hedge fund research at Towers Watson, said: “Hedge fund managers should be compensated for their skill and not for delivering market returns. The separation of these two elements is complex, but in our view worth analysing in detail.
“The structure of both hedge fund fees and terms has evolved since the financial crisis and we believe that both are equally important in achieving a structure that better aligns interests.”
Most funds charge a proportion of net new gains as incentive fees – regardless of whether those gains came from manager skill (alpha) or market moves (beta). The proportion has ranged from 18%, anywhere up to 50% for a select group of about 10 funds in the industry.
Loveday said the limited capacity in the $2trn industry has historically “skewed the alignment of interests” between investors and managers – in favour of managers.
He added most fee and term negotiations were limited, and managers took refuge behind agreements with individual investors to give them equal-best terms, “origiinally designed to protect investors, but which became an excuse not to offer concessions”.
Loveday said Towers Watson was not averse to rewarding skill – “we do not believe that ‘cheaper is better'” – however he said a “more reasonable alpha split between the manager and end-investor” was necessary.