Back in 2009, the hedge fund AQR raised eyebrows when it offered many of its strategies in the mutual fund universe and thereby reduced fees for exposure to strategies normally available in the 2-20 hedge fund fee structure only.
Cliff Asness of AQR Capital Management, the ex-Goldman Sach’s quant strategist (AQR stands for Applied Quantitative Research), told Forbes in a recent interview (see video below) that he believes most hedge fund fees of 2-20 are unjustified.
Mr. Asness paints a broad spectrum of fees and how they should apply to different market exposures and strategies.
On the one extreme, there are simple index funds or ETFs. The appropriate fees are in the range of 5 to 20 basis points. One can add a slight layer of sophistication by combining indices and achieve portfolio diversification, and for that one should be able to charge up to 40 basis points.
On the other extreme, there is unique alpha generation (what most hedge funds claim, but only a few achieve). To generate unique alpha, the manager has to (1) Believe that there is alpha, (2) Find that alpha, and (3) Implement or hedge that alpha in a unique manner unknown to most other investors. Only this can justify a 2-20 (or even a 1-20) fee structure.
Between the two above extremes, there are active strategies that have proven to be very unlikely to fail and are well known among investors.
First, Mr. Asness takes the example of value investing. Through decades of observable investments, it is clear that picking cheap or undervalued assets by using metrics such P/E, price to book, price to cash flow, etc. generate alpha.
Further, a manager can add layers of sophistication through active risk management such as shorting overvalued assets. While this is indeed effective, it does not justify the 2-20 fee structure – instead the fees for such known strategies should fall somewhere between the index strategies and purer alpha.
Second, Mr. Asness takes the example of the seemingly more complex strategy of Merger Arbitrage. Fifty or so years ago, there were only a few managers focused on this niche strategy – thereby the label of uniqueness applied to the strategy and the 2-20 fees were justified. But today this is a well-known strategy and practiced by many.
So while there still might be some managers who have a unique angle on Merger Arb, the majority of them are sprinkling it with some marginal value-add. Of course this is not an index strategy at all, so the fees should be higher, but they should not be 2-20. According to Mr. Asness to charge 2-20 for that is “a crime, and a crime that happens often”
In the final analysis, Mr. Asness believes in charging fees (“especially if they come to me”), but not a blanket fee. There should be proper fees for index, well known strategies, and unique alpha generators – and the three should not be confused.