In a recent Bloomberg article, columnist Barry Ritholtz underscores his long-standing criticism of the traditional “2 and 20” hedge-fund industry fee structure as “expensive and unnecessary.”
Expensive, Ritholtz writes, “because one can capture market-average returns, or beta, for a few basis points in fees in a low-cost mutual fund or exchange-traded fund; and unnecessary because investors are paying a 20 percent surcharge for beta rather than outperformance, or alpha.”
Ritholtz points out the “puzzling” fact that many hedge-fund investors believe they are paying up for the skill hedge-fund managers bring to the table. “Few seem to realize,” he writes, “that often, fund managers are really being paid for their ability to both deliver market-based returns and pull in assets.”
He introduces the idea of a “fulcrum fee,” a system that “rewards managers for delivering above-average performance and does not overpay them when they don’t.” There are various types of fulcrum fees, Ritholtz points out, but he adds that none of them charge an additional performance fee for beta, which makes the total cost “appreciably lower.”
“A quick survey shows more firms are embracing the sort of fee structure that better aligns the interests of investors and managers,” writes Ritholtz, but adds it isn’t easy to determine exactly how many managers are using fulcrum fee structures.
“Fulcrum fees,” Ritholtz concludes, “are turning the hedge-fund model on its head. In an era of low-cost indexing, the rest of the active-management world should take notice.”