Practical analysis for investment professionals
18 August 2015

Hedge Fund Fees: The Rorschach Test of Investing

If you want to get to know an investor in an abbreviated period of time, you really only need to ask them one question:

“What do you think of hedge funds?”

There are three possible answers, all involving management fees, but only one signals an enviable degree of insight.

The most common answer runs along the lines of “Those guys are crooks! How could they ever justify those massive fees?” This response suggests a lack of creativity — it’s the sort of answer you get from investors who feel like they have figured everything out. The best way to continue a conversation is usually to ask probing questions about the lens they see the world through. If they’ve constructed it thoughtfully, you might be able to pick up some great nuggets of wisdom.

A second, less common answer is the polar opposite: “I love ’em! The haters don’t know what they’re talking about. Hedge funds must be worth the fees, or how would they stay in business?” This answer implies a lack of basic intelligence. If you can say “uncorrelated,” “research intensive,” and “unique” enough times, you might be able to continue the conversation by pitching this sort of investor on the hedge fund you’ve recently decided to start.

The third answer is the sort you only get at places like the CFA Institute Financial Analysts Seminar (FAS). It’s less quotable but much more nuanced.

“For some sorts of strategies, I see some value,” these respondents say. “But it’s really a function of how the fund fits in the context of a portfolio.” Even better responses note that “It really depends what the client wants to achieve.” This conversation should largely take care of itself. It turns out that folks who are passionate about giving clients their preferred outcome are easy and engaging to talk to.

So, what does this third sort of investor really think about hedge funds?

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Relationship Status: It’s Complicated

The short answer is simple: Hedge funds are useful if their fees relate to value. The long answer is more complicated, because ascertaining the value that active managers provide has only gotten more difficult. A morning case discussion at FAS about CALPERS’s decision to leave hedge funds, which was led by the excellent Yiorgos Allayanis of the Darden School of Business, weighed a host of issues and featured vehement (yet polite) arguments both in favor of hedge funds and against them. The case was far from decided by the time the 90-minute forum came to a close.

We focused on a specific situation: Was it a good decision for CALPERS to move away from alternatives? We quickly honed in on the question of whether these managers had beaten their benchmarks. If you’ve thought about hedge fund benchmarking at all, you know there are many different aspects to consider. And the question is important! Hedge funds can be thought of as organizations that spring up to produce alpha, which is only possible to calculate in relation to a benchmark.

It was fitting that the FAS ended with a presentation entitled “The Decline of Alpha,” delivered by Benjamin S. Appen, CFA, of Magnitude Capital and a discussion moderated by Michael Falk, CFA, of Focus Consulting Group. Appen acknowledged that it is possible to replicate the work of some hedge funds at a much lower cost via passive approaches to investing, but he stressed a belief that I tend to agree with: Passive investing is a sub-optimal strategy for expert investors. Not everybody is resourced to pursue investment opportunities, but it’s worth it when you have the capital, aptitude, and inclination.

How Do You Do It?

For starters, you’ll need a benchmark — the bulk of Appen’s presentation centered on a benchmarking strategy he and his colleagues have constructed and made available to the public at They see it as a streamlined approach to the exercise.

The intellectual thrust of Appen’s thinking is simple: Investors should evaluate an investment manager by separating returns attributable to readily available market factors (beta) from the returns that come from manager skill (alpha). But implementation is tricky. How do you get started?

The method Appen laid out is somewhat “quick and dirty.” He takes the beta of a manager’s track record with respect to equity, credit, and bond market risk, and then he generates a passive benchmark using those same risk exposures. This should make it clear whether a manager is adding value relative to the risks they are taking. A more detailed analysis, in which additional factors are considered, should give a substantial amount of insight into the sources of a manager’s returns — and whether they are truly worth paying a hefty “two and twenty” for.

The exercise left me with two big takeaways. The first is that even though it’s important to specify a manager’s benchmark at the beginning of their mandate — and to evaluate them in the context of that benchmark — it probably is not enough. Especially when a manager has a broad mandate and lots of operational flexibility, it makes more sense to deconstruct their returns, breaking them down into specific contributing factors. If most of the returns are coming from a factor that can be accessed inexpensively, then there’s little reason to pay substantial management fees to an intermediary.

The second takeaway is perhaps less intuitive. If these methods of analysis are more widely applied, and the subset of managers that are not providing a value-added service go out of business, what happens to the managers who remain in the game? After all, there are strategies and firms producing returns not clearly attributable to an easily accessible factor. Will their fees decrease as allocators of capital bring more scrutiny to the world of hedge funds?

It seems that fees on hedge funds could just as likely go up as down. In a world where there are fewer manufacturers of hedge fund products and those who stay in business are very closely observed, managers might become more confident in asserting their value.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Sloane Ortel

Sloane Ortel is the founder of Invest Vegan, an ethics-first registered investment adviser that manages distinctive discretionary portfolios of public equities on behalf of aligned individuals and institutions. Before establishing her own firm, she joined CFA Institute’s staff as a sophomore at Fordham University and spent close to a decade helping members adapt to a changing investment landscape as a collaborator, curator, and commentator. She is also a co-host of Free Money, a podcast for sustainability-oriented investors with a sense of humor.

8 thoughts on “Hedge Fund Fees: The Rorschach Test of Investing”

  1. Dmitriy says:

    Another great post, Will. I think you hit the nail on the head in terms of people’s perceptions towards hedge funds. They are useful investment vehicles, but only in the right context and for patient investors. Benchmarking is, of course, critical to determining the value of any hedge fund strategy, however it seems to me that too many investors reference this benchmark on a quarterly or annual basis. This is dangerously short-sighted in an industry where market cycles can sometimes take a decade or more to play out. You can’t fault investors for increasingly demanding more transparency and shorter lockup periods, but those things aren’t really conducive to long-term investing and therefore can be a drag on performance.

  2. Ron Surz says:

    A factor-based custom benchmark is a good first step, but we can and should do even better. Please see the movie “The Future of Hedge Fund Evaluation and Fees” at

  3. Fred says:

    “What do you think of hedge funds?”
    A 4th possible answer would be along the lines of:
    “they aren’t that much different than other collective investment vehicles (such as mutual funds), the returns that they advertise tend to be materially better than the performance that their clients achieve from them. Some explanation for this is offered by various behavioural biases that have been well documented over the years. Where they differ is that the “returns-advertised / performance-achieved” gap comes packaged inside of a higher-fee product.”

  4. Peter Urbani says:

    Good Article. And good initiative from betterbenchmarking. However, I think they need to go a bit further for a retail audience and show the fees as proportion of the total return and ‘alpha’ streams. This would help differentiate between funds with the same return and alpha but different fee structures.

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