Earlier this week, the Wall Street Journal's Gregory Zuckerman, Juliet Chung, and Michael Corkery published an insightful and well-researched article about hedge funds reducing fees in response to pressure from investors.
The article notes that the two main drivers of fee cuts are poor fund performance and the growing preference by investors to invest in large hedge funds--leading smaller funds to cut fees to remain competitive. It also notes that the standard 2% management fee--which is supposed to cover overhead costs and base salaries--is more difficult to justify for funds that have now grown in size to manage billions.
It is true that a general reduction in fees seems like a welcome trend in an industry that keeps growing and is increasingly facing competition from lower cost alternatives such as "hedged" mutual funds and hedge fund-like exchange traded funds.
However, it is a great oversimplification to think that any cut in fees will benefit investors. This is because fees have an important impact on hedge fund manager incentives. Academic studies often find an association between higher fees and better performance. For example, a 2011 article (working paper version) that studied the performance of over 3,500 hedge funds over a 15 year period found that hedge "[f]unds that charge a high performance fee appear to outperform those that charge a relatively low fee."
Higher performance fees may help investors because higher fees may in fact get managers to produce better returns. A higher performance fee also means that a managers have more to miss out on if they don't perform well. Better managers may also require high performance fees as part of their compensation package.
Accordingly, the savings hedge investors obtain from lower fees may come with the cost of reducing incentives for managers to perform well or even want to be employed by the fund in the first place. While fees are probably too high on an industry-wide basis, not every reduction in the fees investors pay will help their returns.
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