Climateer Investing: "Fee reduction and alpha generation: Why fee reduction is the purest form of alpha"

Thursday, November 14, 2013

"Fee reduction and alpha generation: Why fee reduction is the purest form of alpha"

Small quibble, the quote sounds made up.
Private Equity thinks they are God.

From All About Alpha:

“After the wheel, God’s greatest invention was the carry.”–Private Equity Titan

In this note, we examine the relationship between the hedge fund fee structure and how it impacts alpha.

In the early days of the industry, higher management fees were designed to cover costs of a deep and rigorous research and investment process; performance fees were meant to reward the manager for alpha generation. The standard 2/20 fee structure made sense when hedge funds were smaller and either truly hedged–offsetting long and short positions and hence little market exposure–or focused on markets like commodities where beta alternatives were not obvious.

Over the past decade, several changes in the industry have drawn attention to the issue of whether the standard hedge fund fee structure is equitable. Today, a good portion of the industry–event-driven, equity long/short–has consistent and identifiable exposure to equity market beta; likewise, as we’ve gained a more comprehensive understanding of hedge fund performance, it has become clear that more diverse forms of beta explain the majority of returns. This raises the question of whether investors are overpaying for sources of return that can be obtained more cheaply and efficiently elsewhere. Finally, the concentration of capital among larger funds has created windfall profits for managers as management fees no longer just cover costs but have become a valuable profit center.

As shown below, we argue that high management fees can be a direct transfer of valuable alpha from investors to the managers. In fact, a reduction in management fees results in a dollar for dollar increase in expected alpha. In this way, fee reduction is the purest form of alpha.

Less intuitively, we also argue that performance fees can be equally problematic. As beta returns rise, fund returns generally increase as well. However, the absence of a hurdle rate means that investors often pay incentive fees on beta. Consequently, as markets rise, alpha received by investors can actually decline.

Breakdown of hedge fund returns

Investors today are much more knowledgeable about the composition of hedge fund returns. A framework that includes multiple forms of beta has supplanted the simple model of equity beta/alpha. The very definition of beta has broadened to include benchmark strategies and other investment programs designed to efficiently deliver returns from more exotic risk premia. The net effect of this is that over time, betas have come to explain a greater and greater portion of returns, which leaves less and less in the “pure alpha” category.
The current thinking is that there are four primary sources of returns: static beta, dynamic beta, alternative beta and alpha. A brief description of each is included in the box below.
In practice, when looking at an individual fund, it can be difficult to cleanly distinguish between different categories.

Should we consider the decision to cut risk prior to a market drawdown alpha, dynamic beta, or simply luck? As the firm evolves and markets change, at one point does a shift in static betas represent a form of dynamic beta? Into which category should we place dynamic allocations to alternative betas? More broadly, as investor sophistication grows, will we continue to move more and more sources of alpha into defined beta categories?...MORE