What Level of Incentive Fees Are Hedge Fund Investors Actually Paying?

What Level of Incentive Fees Are Hedge Fund Investors Actually Paying? Abstract Long-only investors remove the effects of beta when analyzing performance. Why shouldn t long/short equity hedge fund investors do the same? Though the typical 2 and 20 hedge fund fee structure has come under pressure, we observe that most hedge funds still are paid incentive fees on market beta. More subtly, many long/short funds are also paid for exploiting the small capitalization return spread, one of the more obvious systematic sources of return. After accounting for these two exposures, we find that effective performance fees are substantially higher than 20%. In the long-only equity world, managers are judged by the alpha they deliver above the relevant market benchmark. The alpha is considered the return attributable to skill, while the beta-driven component simply represents market returns. Investors should pay their investment managers for skill: stock selection talent, in the context of equity market investing. Conversely, investors are rightly unwilling to pay much for beta, since equity market exposure can be achieved passively for annual management fees of single-digit basis points. In contrast to a long-only equity strategy, the central goal of a long/short hedge strategy is to enhance the tradeoff between return and volatility by shorting stocks. These strategies seek more consistent returns by hedging part or all of the market risk. Many hedge funds today present themselves as absolute return strategies that provide returns that are supposed to be positive regardless of broader market conditions and uncorrelated with equity market returns. To accomplish these goals, hedge fund strategies, in theory, are designed to deliver the bulk of their returns in the form of alpha, not beta. Under these assumptions, hedge fund investors are comfortable paying performance-linked incentive fees (typically 15% or 20%) on total returns. Strictly speaking, the implied benchmark returns 0% (or sometimes a risk-free rate), since hedge funds are not paid performance fees if they deliver negative returns. However, using a benchmark of 0% or a risk-free rate implies that the entirety of the return is attributable to manager skill, or alpha. The implicit assumption is that the fund has no beta in its portfolio. However, as illustrated in Figure 1, we find that long/short funds, in aggregate, and even market-neutral funds, exhibit materially positive betas. Moreover, these betas have increased steadily over the past two decades. * We are grateful to Professor Robert Stambaugh of the Wharton School of the University of Pennsylvania and the National Bureau of Economic Research for his review and helpful comments.

Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 March 2015 Long/short funds and even market-neutral funds exhibit materially positive, steadily rising betas. Figure 1. Trailing 36-Month Rolling Betas of HFRI Indices to MSCI World 0.7 HFRI Equity Hedge Beta to MSCI World 0.6 0.5 0.4 0.3 0.2 0.1 0.0-0.1 0.52 0.12 Source: MSCI, FactSet, HFRI. The HFRI Equity Hedge Index (which includes long/short hedge funds) has a current trailing beta to the MSCI World Index of 0.52 as of December 2014. Since the inception of the HFRI indices in 1990, the average is 0.43. The high level of beta implies that a large portion of the performance generated has not been due to manager skill, but rather to general exposure to the market. But how large is this effect on the payment of incentive fees? Using the average 0.43 beta, in Figure 2 we calculate the implied incentive fee on the non-beta component of returns. 2

Long/short funds have an effective 37.5% annual incentive fee after accounting for market beta. Figure 2. Implied Incentive Fee on Non-beta Component of HFRI Equity Hedge Returns Year Expected Return Equity Hedge = r risk free + 0. 43 (r MSCI World r risk free ) Actual Return Equity Hedge = r f + 0. 43 (Return MSCI World r f ) + Implied Alpha HFRI Equity Hedge Annual Return (Net) Implied 20% Incentive Fee¹ HFRI Equity Hedge Annual Return (Gross) MSCI World Risk-Free Expected Return Arithmetic Average 37.5% Note: Past performance does not guarantee future results. All percentages based on beginning of year assets. Reported HFRI returns are net of all fees, per the HFRI website. The beta of the HFRI Equity Hedge Index to the excess returns of the MSCI World Index using monthly returns from January 1990 through December 2014 is 0.43. Source: MSCI, FactSet, HFRI. ¹ 20% incentive fee assumes a high water mark. ² Risk-free rate represents annualized return of the B of A Merrill Lynch 3-Month Treasury Bill Index. Figure 2 starts with the reported net HFRI Equity Hedge returns, calculates the implied 20% incentive fees charged, imputes the gross returns (before incentive fees), calculates the non-beta component of gross returns assuming the average 0.43 beta to the MSCI World Index, and then calculates the incentive fee as a percentage of the non-market-driven alpha. Under this method, the average annual incentive fee is 37.5% of the (skill-based) alpha generated. Using this static beta, we implicitly assume that no value is added from varying beta over time (i.e. market timing). However, we believe this is a fair assumption given the dubious record of market timing on the part of hedge funds. Notice in Figure 1 how hedge fund betas closely track equity market performance, remaining elevated during the 2007/08 financial crisis and depressed during the subsequent equity market recovery. Rate² Return Implied Alpha Incentive Fee as % of Implied 1990 14.4% 3.6% 18.0% -16.5% 2.7% -5.5% 23.6% 15.3% 1991 40.1% 10.0% 50.2% 19.0% 2.1% 9.3% 40.9% 24.6% 1992 21.3% 5.3% 26.6% -4.7% 1.3% -1.3% 27.9% 19.1% 1993 27.9% 7.0% 34.9% 23.1% 1.1% 10.5% 24.4% 28.6% 1994 2.6% 0.7% 3.3% 5.6% 1.4% 3.2% 0.1% 100.0% 1995 31.0% 7.8% 38.8% 21.3% 2.0% 10.3% 28.5% 27.2% 1996 21.8% 5.4% 27.2% 14.0% 1.7% 7.0% 20.2% 26.9% 1997 23.4% 5.9% 29.3% 16.2% 1.7% 8.0% 21.3% 27.5% 1998 16.0% 4.0% 20.0% 24.8% 1.7% 11.6% 8.4% 47.8% 1999 44.2% 11.1% 55.3% 25.3% 1.6% 11.8% 43.5% 25.4% 2000 9.1% 2.3% 11.4% -12.9% 2.0% -4.4% 15.8% 14.4% 2001 0.4% 0.1% 0.5% -16.5% 1.5% -6.3% 6.8% 1.5% 2002-4.7% - -4.7% -19.5% 0.6% -8.1% 3.3% NA 2003 20.5% 3.7% 24.3% 33.8% 0.4% 14.7% 9.5% 38.9% 2004 7.7% 1.9% 9.6% 15.2% 0.4% 6.8% 2.8% 68.5% 2005 10.6% 2.6% 13.2% 10.0% 1.0% 4.9% 8.4% 31.7% 2006 11.7% 2.9% 14.6% 20.7% 1.6% 9.8% 4.9% 60.2% 2007 10.5% 2.6% 13.1% 9.6% 1.6% 5.0% 8.1% 32.5% 2008-26.7% - -26.7% -40.3% 0.7% -16.9% -9.7% NA 2009 24.6% - 24.6% 30.8% 0.1% 13.3% 11.3% NA 2010 10.5% 0.2% 10.7% 12.3% 0.0% 5.3% 5.4% 4.3% 2011-8.4% - -8.4% -5.0% 0.0% -2.1% -6.2% NA 2012 7.4% - 7.4% 16.5% 0.0% 7.1% 0.3% NA 2013 14.3% 3.1% 17.4% 27.4% 0.0% 11.8% 5.6% 55.3% 2014 1.8% 0.4% 2.2% 5.5% 0.0% 2.4% -0.1% 100.0% Alpha 3

Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 March 2015 Though the effective incentive fee jumps from 20% to approximately 37.5%, this still may sound reasonable to some investors if the alpha generated is sufficiently large. However, beta is not the only systematic factor at work in most long/short hedge funds. In a paper investigating the unique risk factors underlying hedge fund returns, Professors William Fung and David Hsieh discovered that many long/short hedge funds also heavily exploit the spread between the returns of small and large capitalization stocks. 1 More specifically, they found that many hedge funds have a small-cap bias in their long positions and a large-cap bias in the short positions. This bias comes from two sources. On the long side, a large body of research exists showing that over long periods of time, small-cap stocks outperform large-cap stocks. 2 On the short side, larger capitalization stocks are less prone to liquidity-driven short squeezes in which stock prices rise swiftly. We tracked the capitalization bias since mid-1995, the beginning of the MSCI World Small Cap Index. We see in Figure 3 that the capitalization bias adds incremental explanatory power and that market beta and small capitalization exposure alone explain nearly 93% of the variation in HFRI Equity Hedge returns. Market beta and small capitalization bias explain an increasingly large percentage of the performance of the HFRI Equity Hedge Index. Figure 3. 36-Month Trailing R² of HFRI Equity Hedge to MSCI World and to MSCI World + Small-Large Capitalization Spread 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% One Factor R² (Beta to MSCI World) Two Factor R² (Beta + Capitalization Spread) 92.6% 84.5% Note: Values represent trailing 36-month multivariate Coefficient of Determination ("R-Squared") when monthly returns of the HFRI Equity Hedge Index from 1990 to 2014 are regressed against the MSCI World Index and excess returns to size ( Capitalization Spread represents the MSCI World Small Cap Index - MSCI World Large Cap Index). Source: HFRI, FactSet, MSCI. 1 Fung and Hsieh (2004). 2 Banz (1981), Reinganum (1981), Fama and French (1992). 4

The question that naturally follows: What other systematic factor spreads are hedge funds exploiting? Academic research has identified at least four systematic factors that influence returns: market beta, size, value, and momentum. 3 For the HFRI Equity Hedge Index, the trailing 36-month multivariate coefficients for these four factors are plotted in Figure 4. As the chart suggests, and as a regression confirms, there is a slight momentum bias and a slight growth bias within the long/short universe over the full period. Both are statistically significant, but the market beta and small capitalization effects are more consistent and have a greater impact on returns. Long/short funds exhibit persistent net exposure to market beta and to small caps. Figure 4. 36-Month Trailing Coefficients of HFRI Equity Hedge returns to the four standard Fama-French/Carhart 4 factors (market beta, size, value, and momentum) 0.8 Beta to MSCI World Small Cap - Large Cap Value - Growth Winners - Losers 0.6 0.4 0.2 0.46 0.30 0.0-0.2-0.11-0.11-0.4-0.6 Note: Values represent multivariate coefficients when trailing 36-month returns for the HFRI Equity Hedge Index from February 1997 to December 2014 are regressed against returns of the MSCI World Index, excess returns to Size ( Small Cap Large Cap represents the MSCI World Small Cap Index - MSCI World Large Cap Index), excess returns to Value ( Value Growth represents the MSCI World Value Index - MSCI World Growth Index), and excess returns to Momentum ( Winners Losers represents the float-weighted return of top half of price performers in MSCI World Index from previous 12 months - float-weighted return of bottom half of price performers in MSCI World Index from previous 12 months). Source: HFRI, FactSet, MSCI. How does the capitalization bias affect the implied performance fee analysis we examined in Figure 2? A multifactor regression reveals that the average beta coefficient from 1991 2014 is 0.45 (very close to the univariate analysis), and the average coefficient to the capitalization spread is 0.31. With these coefficients, we calculate implied alpha and the effective performance fee in Figure 5. 3 Fama and French (1992) and Carhart (1997). 4 Fama and French (1992) and Carhart (1997). 5

The average effective annual incentive fee (after adjusting for beta and small-cap bias) for the HFRI Equity Hedge Index is well above 20% and is higher in the past decade compared to the late 1990s and early 2000s. Figure 5. Implied Incentive Fee on non-beta, size-neutral component of HFRI Equity Hedge Returns Year Expected Return Equity Hedge = r risk free + 0. 45(Return MSCI World r risk free ) + 0. 31(Return MSCI World Small Cap Return MSCI World Large Cap ) Actual Return Equity Hedge = r f + 0. 45(Return MSCI World r f ) + 0. 31(Return MSCI World Small Cap Return MSCI World Large Cap ) + Implied Alpha HFRI Equity Hedge Annual Return (Net) Implied 20% Incentive Fee¹ HFRI Equity Hedge Annual Return (Gross) MSCI World Risk-Free Return Arithmetic Average ('91-'14) 46.2% Arithmetic Average ('03-'14) 72.3% Note: Past performance does not guarantee future results. All percentages based on beginning of year assets. Reported HFRI returns are net of all fees, per the HFRI website. The beta of the HFRI Equity Hedge to the excess returns of the MSCI World using monthly returns from January 1991 through December 2014 is 0.45 and the coefficient to size (MSCI World Small Cap Index - MSCI World Large Cap Index) is 0.31. Source: MSCI, FactSet, HFRI. ¹ 20% incentive fee assumes a high water mark. ² Risk-free rate represents annualized return of the B of A Merrill Lynch 3-Month Treasury Bill Index. Stripping out the portion of HFRI Equity Hedge returns that are due to market exposure and small capitalization bias, we find that estimated performance fees paid over the last twenty four years comprise a staggering 46% of the alpha generated. The data indicate that this fraction has been steadily rising. In the late 1990s, it appears that hedge funds were actually delivering more alpha. Over the past decade, however, lower hedge fund returns, coupled with higher betas to the equity market and to smaller capitalization stocks, have caused the average effective incentive fee since 2003 to jump to 72% of the alpha generated. That doesn t leave much for the investor! Finally, our focus on fees has ignored the elevated tail risks inherent in market beta Rate² MSCI World Small - Large Cap Return Expected Return Implied Alpha Incentive Fee as % of Implied 1991 40.1% 10.0% 50.2% 19.0% 2.1% 9.7% 12.7% 37.5% 26.8% 1992 21.3% 5.3% 26.6% -4.7% 1.3% 5.1% 0.2% 26.4% 20.2% 1993 27.9% 7.0% 34.9% 23.1% 1.1% -0.9% 10.7% 24.2% 28.8% 1994 2.6% 0.7% 3.3% 5.6% 1.4% -2.9% 2.4% 0.9% 72.5% 1995 31.0% 7.8% 38.8% 21.3% 2.0% -10.7% 7.3% 31.5% 24.6% 1996 21.8% 5.4% 27.2% 14.0% 1.7% -5.3% 5.6% 21.6% 25.2% 1997 23.4% 5.9% 29.3% 16.2% 1.7% -23.4% 0.9% 28.4% 20.6% 1998 16.0% 4.0% 20.0% 24.8% 1.7% -26.2% 3.8% 16.1% 24.8% 1999 44.2% 11.1% 55.3% 25.3% 1.6% -2.3% 11.6% 43.7% 25.3% 2000 9.1% 2.3% 11.4% -12.9% 2.0% 14.4% -0.2% 11.5% 19.7% 2001 0.4% 0.1% 0.5% -16.5% 1.5% 19.4% -0.5% 1.0% 9.9% 2002-4.7% - -4.7% -19.5% 0.6% 3.9% -7.2% 2.5% NA 2003 20.5% 3.7% 24.3% 33.8% 0.4% 27.4% 24.0% 0.3% 100.0% 2004 7.7% 1.9% 9.6% 15.2% 0.4% 11.6% 10.7% -1.1% 100.0% 2005 10.6% 2.6% 13.2% 10.0% 1.0% 7.3% 7.4% 5.9% 45.0% 2006 11.7% 2.9% 14.6% 20.7% 1.6% -2.9% 9.2% 5.4% 54.2% 2007 10.5% 2.6% 13.1% 9.6% 1.6% -9.3% 2.3% 10.8% 24.2% 2008-26.7% - -26.7% -40.3% 0.7% -1.9% -18.4% -8.3% NA 2009 24.6% - 24.6% 30.8% 0.1% 15.3% 18.7% 5.9% NA 2010 10.5% 0.2% 10.7% 12.3% 0.0% 15.9% 10.6% 0.1% 100.0% 2011-8.4% - -8.4% -5.0% 0.0% -4.2% -3.5% -4.8% NA 2012 7.4% - 7.4% 16.5% 0.0% 1.7% 8.0% -0.6% NA 2013 14.3% 3.1% 17.4% 27.4% 0.0% 5.8% 14.1% 3.3% 95.6% 2014 1.8% 0.4% 2.2% 5.5% 0.0% -3.2% 1.5% 0.8% 59.5% Alpha 6

and style tilts. Strategies that are heavily exposed to systematic risks in the form of beta and style factors are vulnerable to severe shocks given the negative skewness of their returns. Conclusion Investors should take a closer look at their equity long/short hedge fund managers. Many may not realize the magnitude of performance fees they are paying relative to the actual skill-driven alpha. Investors in long-only funds typically analyze managers on the basis of their alpha in excess of market beta and other factor exposures. It is time that long/short managers are held to the same standard. 7

Sources Cited Banz, Rolf W. The Relationship Between Return and Market Value of Common Stocks. Journal of Financial Economics 9 (1981): 3-18. Carhart, Mark. On Persistence in Mutual Fund Returns. The Journal of Finance 52, 1 (1997): 57-82. Fama, Eugene F. and Kenneth R. French. "The Cross-Section of Expected Stock Returns." Journal of Financial Studies 47 (1992): 427-465. Fung, William and David A. Hsieh. "Hedge Fund Benchmarks: A Risk Based Approach." Financial Analyst Journal 5 (2004): 65-80. Reinganum, Marc R. A New Empirical Perspective on the CAPM. Journal of Financial and Quantitative Analysis 4 (1981): 439-462. 8

For Investment Professional Use Only - Investor Distribution Prohibited. This presentation expresses the authors views as of March 3, 2015 and should not be relied on as research or investment advice regarding any investment. These views and any portfolio characteristics are subject to change. There is no guarantee that any forecasts made will come to pass. MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products. Alpha is a measurement of performance return in excess of a benchmark index. Beta is a measurement of sensitivity to the benchmark index. A beta of 1 indicates that a portfolio s value will move in line with the index. A beta of less than 1 means that the portfolio will be less volatile than the index; a beta of greater than 1 indicates that the security's price will be more volatile than the index. The MSCI World Index is a free float-adjusted market capitalization index, designed to measure developed market equity performance, consisting of 23 developed country indexes, including the U.S. The Index is gross of withholding taxes, assumes reinvestment of dividends and capital gains, and assumes no management, custody, transaction or other expenses. The HFRI Monthly Indices ("HFRI") are a series of benchmarks designed to reflect hedge fund industry performance by constructing equally weighted composites of constituent funds, as reported by the hedge fund managers listed within HFR Database. HFRI Equity Hedge strategies maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. Equity Hedge managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities - both long and short. HFRI Market Neutral strategies employ sophisticated quantitative techniques of analyzing price data to ascertain information about future price movement and relationships between securities, select securities for purchase and sale. These can include both Factor-based and Statistical Arbitrage/Trading strategies. Factor-based investment strategies include strategies in which the investment thesis is predicated on the systematic analysis of common relationships between securities. In many but not all cases, portfolios are constructed to be neutral to one or multiple variables, such as broader equity markets in dollar or beta terms, and leverage is frequently employed to enhance the return profile of the positions identified. Statistical Arbitrage/Trading strategies consist of strategies in which the investment thesis is predicated on exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices; high frequency techniques may be employed and trading strategies may also be employed on the basis on technical analysis or opportunistically to exploit new information the investment manager believes has not been fully, completely or accurately discounted into current security prices. Equity Market Neutral Strategies typically maintain characteristic net equity market exposure no greater than 10% long or short. It is not possible to invest directly in an index. A "high water mark"(or "loss carryforward provision) means that a manager s performance fee only applies to net profits; i.e., profits after losses in previous years have been recovered. R 2 or R squared is a statistical measure that represents the percentage of a fund or security's movements that can be explained by movements in a benchmark index. 9