Ever since hedge funds came into vogue a decade ago, the so-called 2-and-20 has been the standard for fees. Investors, who pony up a 2% management fee and 20% of the profits each year, haven't had much reason to quibble. Few other investments have enjoyed outsize gains year after year.
But amid weak performance, the debate over expenses is heating up. Last year the average hedge fund gained 12.9% after fees, according to Hedge Fund Research Inc. The Vanguard 500 mutual fund, which tracks the Standard & Poor's 500-stock index and charges investors a slim 0.18% of assets, jumped 15.1%. "We have no problem paying high performance fees for a manager's selection, but we find taking on average market risk inherently unsatisfying," said Russell Read, chief investment officer of the $225 billion California Public Employees' Retirement System, at a recent conference.
CalPERS and other institutions aren't walking away. But high-net-worth individuals, at least, think they have better options. A study by Spectrem Group, a Chicago consulting firm, found that 27% of the nation's wealthiest households—those worth more than $25 million—own hedge funds, down from 38% in 2005. "In most cases, [managers] don't deliver enough to justify their fees," says Robert Discolo, head of hedge fund securities at AIG Global Investment Group. "Most funds are doing things that can be replicated much cheaper."
With the market maturing and competition for investors' dollars increasing, some hedge funds are realizing that one size does not fit all. A growing crop of managers now offers another share class: one that cuts costs for investors who commit to keeping their money in the fund for three years instead of the usual one-year lockup period. For example, the Laurus family of funds, a $1.6 billion hedge fund complex that specializes in private placements by small companies, lowers the expenses on one of its new funds to a 1.5% management fee and 15% of profits in exchange for a three-year commitment. The $300 million Sheffield Asset Management has a similar arrangement. Both follow the lead of $6 billion Satellite Asset Management, one of the first funds to introduce a second share class.
The biggest institutional investors can also use their financial clout to muscle their way into special deals. Investors employ so-called side letters to negotiate everything from lower fees to increased disclosure on a fund's holdings. That's controversial, since it essentially gives certain shareholders preferential treatment. But Ron S. Geffner, a New York lawyer who represents many hedge funds, says "some savvy investors require them."
Such moves may only become more commonplace as new hedge funds and kindred products enter the fray. Late last year, Wall Street investment firms Goldman, Sachs & Co. (GS) and Merrill Lynch & Co. (MER) rolled out several low-cost vehicles that use quantitative tools to create a portfolio that mimics the returns of such alternative investments. Investment firm Indexiq Inc. launched a similar offering in March with annual expenses of just 1%.
Don't expect hedge funds to roll back prices en masse just yet. For one thing, big investors have few places to park their billions. Indeed, despite disappointing returns, hedge funds still took in about $60 billion in the first quarter of 2007, about half what the industry collected in all of 2006. Most are betting they'll defy the odds and pick winners. It's the reason top performers such as Steven A. Cohen of SAC Capital Advisors can charge, on one fund, a 3% fee and keep 35% of profits. Says Catherine Banat, president of consultant C3 Capital: "The best managers don't need to negotiate and won't."
By Matthew Goldstein and Steve Rosenbush