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Hedge-Fund Rich List Shows Broken Fee Model, Investors Say

Investors want hedge-fund managers to put their big-boy pants on and split alpha fairly — or get used to shrinking paychecks.

Top-earning hedge-fund managers just had their leanest year for compensation since 2005, according to the annual Rich List released Tuesday by Institutional Investor’s Alpha.

The top 25 individual earners reaped $11 billion in combined compensation in 2016, based on their personal fund stakes and share of management and performance fees, and hedge-fund investors had no sympathy when told Alpha’s findings.

“I would like to see more of that income being generated from managers’ own investments in their funds,” said Robert Lee, Texas Tech University’s deputy chief investment officer. “I highly suspect that the lower numbers come from missed management fees over missed incentive fees,” said Lee, who’s also a board member at the Alignment of Interest Association, a non-profit group that advocates for fair deals between hedge funds and their investors.

Performance does not matter as much as it used to for hedge fund managers’ personal wealth, according to Stephen Taub, Alpha’s longtime reporter and architect of the Rich List. Nearly half of the 25 highest earners made the list despite leading their flagship funds to single-digit returns in 2016.

In a year with meagre industry alpha, many investors are worried that hedge-fund fees reward fund managers regardless of performance.

“I think that we’ve become better at measuring alpha, but we’re no better at compensating managers based on it,” Lee said. The Alignment of Interest Association pushes for compensation based on investing skill rather than market performance, he said, “and there is still much progress to be made.”

While Lee works to improve the hedge-fund model, many investors have examined the sector in its current state, and passed. Aflac’s CIO Eric Kirsch, for example, is building an alternatives program for the insurer’s $100 billion portfolio without including hedge funds.

“The value proposition has morphed and changed,” Kirsch said. “Markets have continued to become very, very efficient, and it’s clearly more difficult for hedge funds to produce alpha than it was 20 or 30 years ago.”

Kirsch cautioned that he’ll “never say never” on an asset class. But in the current economic cycle, and with cost-benefit tradeoffs unique to insurance investors, he said that “it’s not a fit.”

For the third straight year, asset allocators pulled more money from hedge funds in 2016 than they invested. And that trend has some managers embracing fee reforms that investors have been agitating for.

“We are getting offered better fee deals, and the managers are being proactive about it,” said Ryan Bailey, senior investment director at Children’s Medical Center in Dallas. “I think that’s them recognizing 2-and-20 is no longer market rate, and they would rather be in control of that conversation than having the allocator approaching them.”

Hedge fund managers have traditionally charged 2 percent for managing investors’ capital and 20 percent of any profits.

Quantitative hedge funds may be feeling the pressure less than traditional managers. Firms with quant strategies had strong representation in the Rich List’s top 10, including Renaissance Technologies (No. 1), Two Sigma (No. 2 and No. 3), and D.E. Shaw (No. 9). Investment consultant Greg Dowling of Fund Evaluation Group called the quant-heavy leaderboard “noteworthy,” saying that he’s “definitely seen quants rising over the last couple of years, and even firms not traditionally quantitative have pushed the envelope in that space.”

On the hedge-fund industry’s declining performance, Dowling echoed investors’ view that managers can put up or pack up.

“Hedge funds are Darwinistic: if managers do a great job, they get rewarded. If they don’t do, eventually they’re out,” he said. “There is no monopoly in hedge funds. And the compensation structure is a part of that.”

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