- Andrey, good day. Why did you suggest the topic of hedge fund fees and liquidity for this interview?
- Good day!
We would like to discuss something topical. In recent years, we have been observing certain trends in the industry regarding changes in liquidity terms and in fees of certain managers.
Let us first speak about liquidity.
As we mentioned in one of our previous articles, the liquidity of a hedge fund is the amount of time necessary for investors to redeem the capital from the fund. Liquidity depends on the strategy applied by the fund and can vary greatly from fund to fund, often including withdrawal restrictions at the investor level (investor-level gate) and sometimes at the fund level (fund-level gate).
Often, at the inception of the fund, managers propose relatively relaxed conditions for withdrawal of capital, and many investors are attracted by the possibility of fast withdrawal of capital. When managers grow their business and expand their investor base and assets under management, they may tighten liquidity terms, relying on investors’ loyalty.
Recently, we have been witnessing an active tightening of liquidity terms by leading hedge fund managers, including funds in our portfolio. This trend is particularly noticeable among multi-strategy platform hedge funds, which are hiring many portfolio managers to run the business. Famous examples of platform managers include Millennium, Citadel, Point72, Marshall Wace, and Balyasny Asset Management.
In general, the average liquidity for multi-strategy platform hedge funds is estimated to be a redemption period of 1 year with investor-level gate of 25% per quarter, assuming that the core exposure of the fund is in liquid instruments. Currently, we are seeing many successful hedge fund managers tighten or plan to tighten liquidity terms, increasing the period for full redemption of capital to 2-3 years. Some managers try to maximize the redemption period even further. For example, since 2018, the Millennium hedge fund has started to forcibly return capital to investors, while giving them the option to maintain their positions in the fund by switching to the less liquid share class. As a result, the majority of investors in Millennium have a withdrawal limit of 5% per quarter and can make a full withdrawal of capital in 5 years.
- How do you, as an investor, perceive the tightening of hedge funds liquidity terms?
- Given that we manage a portfolio consisting of a dozen hedge funds, the tightening of liquidity terms is a negative factor for us, especially from an operational perspective. At certain times, we need to rebalance our portfolio by withdrawing capital from one fund to invest in another fund. Sometimes it may be necessary to withdraw capital from hedge funds for opportunistic investments in other asset classes.
On the other hand, the tightening of liquidity terms has a number of positive implications.
Firstly, restrictions on withdrawal of capital increase the stability of assets under management of the hedge fund manager and prevent sudden outflows of investors' capital, which could lead to the destabilization of the fund and to losses for investors that remain in the fund. Secondly, the longer duration of the fund’s asset base allows the manager to realize a wide range of investment opportunities, while offering more competitive terms for portfolio managers. Thirdly, tighter liquidity terms allow hedge fund managers to enter into more favorable agreements with counterparties and brokers for trading with leverage and also allow managers to invest in infrastructure, given the more predictable income stream from management fees.
Tighter liquidity terms are typically set by hedge fund managers that demonstrate exceptional results. The main share of assets under management of such hedge funds belongs to institutional investors, who mostly have a long-term investment horizon and are ready to accept the limited liquidity of the funds, while getting strong results.
- Andrey, what about hedge fund fees? What corresponding trends do you see in this direction?
- When we talk about hedge fund fees, we mean expenses that are paid by investors. The main hedge fund fees are the management fee, which on average is 2%, and the performance fee, which averages 20%. The third important component of fees is part of the costs associated with the investment process that are transferred to investors (pass-through expenses). The pass-through component can differ substantially for different hedge funds. This item may include the costs associated with investment analysis, legal and tax expenses, bonus payments, and other expenses.
Speaking about the trend in terms of hedge fund fees, what is happening is somewhat reminiscent of the liquidity situation. Successful managers with a large and diversified investor base increase the pass-through component of expenses. As with the case of liquidity, an increase in pass-through costs is observed among platform multi-strategy hedge funds. Well-known examples of managers that transfer a significant part of their costs to investors are Citadel, Millennium, Point72, and Balyasny Asset Management. Recently, additional pass-through expenses were introduced by Brevan Howard and Marshall Wace.
- How do you assess the trend of increasing hedge fund fees?
- We view it negatively, but at the same time, we understand that such cost increases for platform funds are necessary to maintain a competitive position. The most successful hedge fund managers demonstrate outstanding results, primarily due to first-class investment professionals. Currently, almost all platform hedge funds are pointing to increased competition to hire and retain portfolio managers, and in order to attract the best investment professionals, hedge funds need to propose attractive terms.
For us as investors, a strong investment result is the main goal, regardless of how much fees have to be paid to managers.
Let's take a close real-life example, a multi-strategy hedge fund with assets under management of $20 billion and an investment team of more than 200 portfolio managers has an average annual return over the past 5 years gross of fees of 20% per annum. The main expenses for investors in this fund are the performance fee (20% of profit received), bonuses, and other expenses related to the investment team, which are accounted for as a pass-through component and equal to 20% of profit received, as well as the annual management fee of 2% of assets under management. As a result, the return net of all fees for the fund equals to approximately 10% per annum. For comparison, the weighted average gross return of the index of multi-strategy hedge funds over the past 5 years equals 11%. Most of the hedge funds included in this index have similar management and performance fees, but a much smaller component of pass-through costs. Assuming that the funds included in the index do not have a pass-through expense component, the average net return of the funds included in the index is about 7% for investors.
From the example above, it is clear that higher fees are acceptable for investors, but only when hedge funds provide high returns. In the example provided, the increased component of the manager's pass-through expenses can be explained by higher bonuses paid to portfolio managers, which allow the hedge fund to attract the best investment professionals in the world, including hiring from competing hedge funds.
Our task as investors is to ensure that all significant expenses of hedge funds and any increase in them are aligned with the improvement or maintenance of strong results. We carefully monitor that all the main components of expenses, and especially any increase in expenses, are aimed at return maximization and do not conflict with our interests.