Hedge fund performance isn’t just a matter of selecting the right strategy or analyzing market events. Performance is also impacted by the underlying costs associated with the entire operation of a fund and its portfolio investments.
A number of things can eat up the returns on your investment. I’m not just talking about market fluctuations or occasional downturns. It’s often the stealthy expenses and fees that creep into fund operations. While hedge funds are designed to deliver tantalizing returns, the associated costs can, sometimes, take a significant bite out of those potential gains.
But there’s an alternative. Some fund managers, like Warren Buffet and the team here at Oliva Partners, have chosen to forego a management fee in order to better align with the interests of investors.
In this article, we’ll examine standard hedge fund fees, their overall impact on net performance, and the less common, zero management fee approach combined with the wisdom of a long-term orientation.
At its core, a management fee serves to offset the operational costs of the hedge fund. These might include everyday expenses like staff salaries, office rent, utilities, legal and compliance, trading, back office and fund administration, technology, marketing, accounting and more.
Regardless of whether the fund performs well or poorly, this fee ensures that the basic operations of the fund continue unhindered.
Traditionally, management fees are levied based on a percentage of the total assets under management (AUM). These usually range between 1% to 2% annually, though variations can occur based on the fund’s structure and strategy.
A performance fee, also called an incentive fee, is only charged when a fund’s profits exceed a prior agreed-upon level. This is typically 20% of profits. For example, if the agreed-upon threshold is 8%, the fund manager may only charge the 20% performance fee if profits for the year surpass the 8% level.
Hedge funds that charge management fees tend to be more expensive for investors because those fees are paid regardless of the fund’s performance. Plus, those fees eat into net performance.
Performance fees, on the other hand, are paid only after the fund delivers the returns it promised. Typically calculated as a percentage of the fund’s profits, these fees are meant to incentivize fund managers to optimize performance.
The infamous “2 and 20” model, for instance, refers to a 2% management fee and a 20% performance fee.
Direct vs. Indirect Costs
Operational Expenses: These are the direct costs associated with running a hedge fund. These expenses are unavoidable and essential for the fund’s functionality, from office rent to employee salaries, from technology infrastructure to research tools.
Trading Expenses: Indirect costs like brokerage fees, transaction taxes, and spread costs can vary significantly based on a fund’s trading frequency and strategy.
This ratio represents the fund’s total expenses as a percentage of its average assets under management (AUM). A lower ratio indicates that the fund is more cost-efficient, offering potentially higher net returns to investors.
Soft Dollar Arrangements: These are indirect ways in which a fund might compensate brokers for their services, often through business other than straightforward transaction fees. While not a direct cost, they can affect the overall efficiency of a fund’s operations.
Turnover Rates and Impact: A high turnover rate, which indicates frequent buying and selling of assets, can lead to increased trading costs. It’s an indirect indicator of the potential expenses a fund might incur.
Some hedge funds are able to charge fewer administrative fees to their investors.
Warren Buffett’s early partnerships in the 1950s and ‘60s did not charge a management fee to investors, but they did charge legal, tax and compliance fees.
Few funds mirror the structure of the original Buffett partnerships. Those that do, like Oliva Partners, typically charge a performance fee above a hurdle rate, or minimum rate of return.
Improved Net Performance
The Appeal of Zero Fees: A zero management fee can be an unambiguous win for investors. Without the drag of regular costs, the fund theoretically has more room to provide a better net return to its stakeholders. This is especially attractive in years when a fund performs well since investors can enjoy the benefits of performance without the reduction caused by management fees.
Past Performance Data: Several zero management fee funds have showcased superior performance when juxtaposed with their traditional counterparts, especially during bullish market trends. This might encourage more investors to consider such funds, focusing on the opportunity for higher net returns.
Performance-Centric Earnings: With the bulk (or entirety) of earnings coming from performance, managers of zero management fee funds are inherently motivated to ensure optimal outcomes. This often aligns their objectives more closely with those of the investors, establishing a shared goal of fund success.
Potential for Long-Term Strategies: Since a consistent revenue stream from management fees isn’t guaranteed, fund managers might be more inclined to adopt strategies that prioritize long-term, sustainable growth over quick, short-term gains.
Funds with zero management fee and a long-term orientation present intriguing opportunities for investors.
Reduced Trading Costs
Less Frequent Transactions: Funds focused on long-term gains tend to trade less frequently, which can significantly reduce associated costs. These savings directly impact the net returns, as lower transaction costs mean fewer deductions from the fund’s total earnings.
Longer Holding Periods: Assets held for more extended periods typically benefit from favorable tax treatments, especially in jurisdictions where long-term capital gains are taxed at a lower rate than short-term gains.
Stability and Predictability
Fewer Market Shocks: Long-term-oriented funds are often less susceptible to short-term market volatility. Their extended focus allows them to weather temporary market downturns more effectively than funds that pivot based on immediate trends.
Operational and Research Savings
Strategic Focus: With a long-term strategy in place, funds can often save on research and operational costs. Instead of constantly searching for the next short-term opportunity, these funds can invest more in comprehensive research that seeks sustainable, long-term assets.
Oliva Partners takes the less common approach of the Warren Buffet partnerships — we pride ourselves on our zero management fee structure.
This not only ensures a deep-rooted alignment with our investors’ best interests but also eliminates the typical overhead costs that many funds pass on to their investors.
With an emphasis on maintaining low operational costs and a clear stance against soft dollar arrangements, we aim for genuine, unadulterated performance. Our low turnover rate and expense ratio, combined with a long-term perspective, often result in positive tax outcomes for our clients.
The hallmark of our confidence in our long-term, value-oriented strategy is evident: we only charge when we deliver, ensuring that our success is intrinsically linked to the success of our investors.
At Oliva Partners, it’s performance first, always.
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