Our Insights

August 2013

Hedge Funds: Value Proposition, Fees, and Future

Jon Hansen, Gordon Barnes, Elizabeth Warren

  • Manager selection is critical when investing in hedge funds. Every analysis of a potential hedge fund allocation boils down to a granular assessment of a fund’s value proposition as reflected in its investment philosophy, terms, and business operations. Equally important is the need to identify the specific role each fund serves as part of an overall portfolio.
  • Successful hedge funds exhibit three basic characteristics: consistent alpha-generative security selection, portfolio management expertise, and business proficiency. Exceptional managers blend proprietary research with portfolio construction in a way that allows them to leverage their best ideas while maintaining sound risk management. Position sizing, entry and exit timing, strategy rotation, and internal prioritization of investment ideas all contribute to performance. Net returns matter most, but the path taken to achieve those returns is important, too. Good hedge fund managers are good business partners, and tend to have long-term relationships with their investors. Investors should look to allocate capital to managers they believe will treat all investors equally and honorably both in good times and through any rough patches.
  • Each hedge fund represents a unique line item in a diversified portfolio and should serve a specific role (e.g., growth engine or diversifier). As part of the due diligence process, limited partners (LPs) should understand the attributes each fund offers and consider how much they are willing to pay for those attributes. To achieve the investment goals of individual long-term investment pools, LPs must exercise discipline and be willing to redeem from managers if the value proposition offered is no longer attractive or if a more compelling value proposition exists elsewhere.
  • Hedge fund investments carry several basic costs, among them, advisory fees (including management and performance fees), fund expenses, and indirect costs; an effective evaluation looks at the full carrying costs of the investment. Management fees are intended to allow the manager to run the business and should not be a primary source of profit. Today, the trend is clear—fees are under pressure and will continue to be so. Although the base compensation structure of management and incentive fees is likely to remain, the industry continues to evolve. Management fees that scale down as assets grow or over time to reward investor loyalty are likely to become more common.
  • Regulatory uncertainty remains the biggest wildcard for hedge fund managers. Additional regulatory requirements have added to the cost of running any hedge fund and for newer firms with smaller asset bases, these increased costs will be even more meaningful. What today is deemed as legal, in-depth research may be viewed in a different light in the future.
Successful hedge funds exhibit three basic characteristics: consistent alpha-generative security selection, portfolio management expertise, and business proficiency.