New York (HedgeCo.net) – Only around one-third* of outperformance from skill** should go to hedge fund managers in the form of fees, with the rest going to the investor according to new research from Towers Watson, the global professional services company.

In the research, entitled Hedge fund investing – opportunities and challenges, the company argues that this is wholly appropriate given investors place 100% of their capital at risk. It says that a more equitable split of the skilled outperformance is a good basis for better-aligned fee structures, which for years have worked in favour of hedge fund managers, in many instances giving them the majority share.

Damien Loveday, global head of hedge fund research at Towers Watson, said: “In the past limited capacity led to rising hedge fund fees and structures that skewed the alignment of interests between investors and managers. Fee and term negotiations were limited and many managers hid behind Most Favoured Nation clauses which were originally designed to protect investors, but which became an excuse not to offer concessions. We believe skilled managers should be rewarded and we do not believe that ‘cheaper is better’. However, hedge funds terms should be structured to allow for a more reasonable alpha split between the manager and end investor than has previously been the case.”

According to Towers Watson, the events of 2008 and the subsequent pressures faced by many hedge funds led to a re-evaluation of the value they added and the way that this was shared with investors. The company says investors providing sizeable allocations, with a long-term investment horizon, now find themselves in a position of considerable negotiating power, with the traditional 2+20 fee model coming under increasing pressure.

Damien Loveday 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.

In addition to the usual annual management fee and a performance or ‘incentive’ fee, Towers Watson says that well-aligned structures will include (these are covered in more detail in the research):

·         Management fees that properly reflect the position of the business

·         Appropriate hurdle rates

·         Non-resetting high watermarks (known as a ‘loss carry-forward provision’)

·         Extension of the performance fee calculation period

·         Clawback provisions

·         Reasonable pass through expenses.

Damien Loveday said: “Regarding annual management fees – often set at 2% of assets – we would prefer to see these aligned with the operating costs of the firm, rather than in line with assets under management. Regarding performance fees, generally used to pay staff bonuses and equity holders and typically charged at 20% of returns, we believe historical performance fee structures do not sufficiently align manager and investor interests. Managers share profits, but there is often no mechanism for them to share losses so there is an incentive to take excessive risk rather than targeting high long-term returns. Structures that contain hurdles, high watermarks and those that defer fees with the ability to claw back in the event of subsequent drawdowns are therefore preferable.”

In the research Towers Watson says that while it has some sympathy with hedge funds’ desire to retain any perceived informational and analytical advantage through reduced transparency, it believes the dynamic of the industry has changed and managers must increasingly respect the fiduciary reporting requirements of institutional investors and their advisors.

Damien Loveday said: “The majority of hedge funds will now enter detailed discussions into the risks assumed and significant positions within a fund, however, some continue to offer limited transparency. We insist on an appropriate level of transparency in researching and monitoring managers and to encourage this, our entire list of favoured managers has been migrated onto a third-party risk management platform, which allows an independent verification of holdings and analysis of the portfolio risk.”

In the research Towers Watson recommends that, in addition to increased levels of transparency, significant contract negotiation between the investor and the hedge fund manager should include (these are covered in more detail in the research):

·         Liquidity

·         Gates

·         Side pockets

·         Key man clauses

·         Initial lock periods.

The company suggests that investors should remain mindful that the fee concessions offered by managers will often come at the cost of reduced liquidity, generally in the form of an initial lock-up period.

Damien Loveday said: “Skill is a scarce commodity and investors should expect to reward managers that are able to produce it consistently. Those rewards had become skewed but, since the events of 2008, managers are more responsive to engaging in discussions with investors on fees and terms. Many have moved towards structures that better align the interests of investors and managers, and this has been crucial to the revival and growth of the industry.”

The research publication covers other aspects of hedge funds and investment opportunities including:

• Industry trends in managed accounts and UCITS hedge funds
• Investment strategies: Event-driven funds; managed futures/systematic strategies; and active currency
• Alternative beta: opportunities in reinsurance, emerging market currency and volatility.

Craig Baker, global head of investment research at Towers Watson, said: “Despite the economic and financial crises and the resultant extreme volatility and liquidity challenges, we have continued to make significant allocations to a wide range of hedge fund strategies on a fiduciary basis on behalf of our clients. These strategies have proven to be a value-adding component of the overall portfolio, providing diversity as well as an attractive risk-return proposition, particularly more recently as fee structures have improved.”

* Total fees payable are assessed as a proportion of total gross alpha. Estimates are based on assumptions of expected alpha generation per 100% of gross exposure. This is married with the forward-looking estimate of gross and net exposures of the fund to calculate a gross alpha expectation.
**Alpha

Towers Watson Investment
Towers Watson Investment is focused on creating financial value for the world’s leading institutional investors through its expertise in risk assessment, strategic asset allocation and investment manager selection. It is a division of Towers Watson’s Risk and Financial Services business, has over 700 associates worldwide and assets under advisory of over US$2 trillion.

About Towers Watson
Towers Watson (NYSE, NASDAQ: TW) is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. The company offers solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Towers Watson has 14,000 associates around the world and is located on the web at www.towerswatson.com.