What rising rates mean for hedge fund returns after fees
As we continue to migrate towards a world of higher short-term interest rates, hedge funds and other active managers have the potential to capitalize on an environment of increased dispersion in global asset price movements. We have already seen hedge fund alpha begin to improve in certain areas, despite a record level of assets under management (“AUM”) in the hedge fund space.
Hedge fund fee structures, if not aligned properly, have the potential to prevent investors from fully benefiting from increased alpha. Informed investors are mindful of the fact that fee structures vary across hedge funds, and there is no one agreed-upon standard for properly aligning incentives between fund managers and fund investors. Investors who pay keen attention to the economics of varying fee structures and select their investments accordingly can improve their returns, being sure that any increases in alpha are more equally shared with both the fund manager and the fund investor.
How do interest rates interact with these incentives? Some investors argue that in a low-interest rate environment, the low return expectations of hedge funds are due to the resulting lower rebate that fund managers earn when shorting securities. The argument goes like this: as rates increase, hedge funds will start to perform better as the short rebate that investors receive when shorting securities increases. This may be true on an absolute basis, but hedge funds typically charge performance fees on total returns, and thus on this rebate, which acts very much like a cash-like security. So, higher interest rates may actually make it harder for hedge funds to outperform liquid markets, unless alpha improves.
As interest rates begin to rise from historically low levels, we should understand how the interaction of higher risk-free rates and performance fees on absolute returns can impact hedge fund performance, especially since AUM in the hedge fund space was 75% higher at the end of 2016 than it was a decade prior, a time when interest rates were substantially higher (see Graph 1).
Importance of cash yields.
Hedge funds, like every investment, should be compared to a risk-free investment (e.g. “cash” or T-bills), since every investment should earn you this risk-free rate plus a risk premium. The return of a long/short equity hedge fund, for example, could be evaluated on an excess-of-cash basis. A market-neutral long/short equity fund that is 100% long SPY (S&P 500 ETF) and 100% short IVV (a different S&P 500 ETF) is remarkably similar to a cash investment: a cash-like rebate is earned on the short position, and the performance of the short position almost exactly offsets the performance of the long position. But most long/short equity managers charge a performance fee on the total return of the fund, usually 20%. In this example, the long/short equity fund is like a cash-yielding fund that only gives investors 80% of the cash yield and pays itself the other 20%.
This is not a big deal in a world of near-zero interest rates. However, it becomes a bigger deal as interest rates start to rise. The absolute returns of the short rebate will certainly go up, but a fund’s ability to outperform cash goes down on a net-of-fees basis.
Let us call this effect the “performance fee drag from the cash rate.” A hedge fund manager is no smarter because cash yields are higher, but can very well charge investors a higher fee for the higher returns that cash will provide.
Consider the following scenario: a portfolio manager takes an investor’s money, gives the investor the promise of steady returns, and charges a 20% fee on total performance (no management fee). Cash rates are 3% per year. At the end of the year, the manager earns 3%, charges a 20% performance fee (0.6%), and gives the investor 2.4%. The manager could say that it must have been smart, because the manager made the investor money, and thus the manager should get to keep some of that money. The investor should say “Wait a minute. I could have put my money in cash and earned 3%, but you made me 2.4%. You underperformed.” To determine whether the manager’s fees were justified, the investor should look at the exposures the manager took in order to earn this return. Perhaps the manager put the investor’s money in cash in the first place, in which case the fees were clearly not justified (see Graph 2).
As cash rates increase, managers need to create more and more alpha in order to pay for the performance fee drag from the cash rate. While alpha may improve in the forward-looking environment, this performance fee arrangement shifts more of the alpha to the manager.
A more optimally-aligned fee model would require managers to outperform a cash hurdle before being paid performance fees. This would work well for market-neutral funds. For beta-oriented funds, a more optimally aligned fee model, would require managers to outperform a market-oriented benchmark before being paid performance fees (this is the case in the long-only space).
Inquiries or comments concerning this article may be addressed to:
Dan Covich, CFA®, CAIA®, FRM
Pavilion Alternatives Group, LLC
Alex Da Costa,
Managing Director, Head of Hedge Fund Research
Pavilion Alternatives Group, a division of Pavilion Advisory Group Ltd.
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