Is there a case for higher fund management fees?

Weird robot investors © Getty Images
Human fund managers can’t afford to rest on their laurels

Some private-equity and hedge funds are trying it on and raising their already high fund management fees. Investors should not be fooled.

The fund industry, despite its seeming simplicity, has never been a low-cost one. And right now, a section of it seems to be getting more expensive than ever. In private equity, what is known as the “carried interest” for the partners in the fund has traditionally been 20%. In simple terms, they get a fifth of any profits the fund makes on its investments. They usually charge 2% of the funds under management as well to cover basic costs. In the last year, however, a group of leading private-equity funds, including big names such as Carlyle and Bain Capital, have raised the share of profits that go to the partners from 20% to 30%.

The hedgies make their move

Something similar has happened among the hedge funds. Traditionally, they had a “two and 20” fee structure as well, skimming a couple of percent of the assets under management to pay for the office and the lunch bill, and then taking 20% of the profits the fund made. But now a few at least have switched to a “three and 30” structure – meaning they take a 3% management fee and 30% of the profits. DE Shaw has introduced that structure on its flagship $14bn Composite Fund and no doubt plenty of asset managers are watching closely. If it sticks they may follow suit.

It is easy enough to understand why they are tempted. After all, there is no easier way to raise profits than to put up prices. A $1bn hedge or private-equity fund has a fixed level of costs to cover staff, administration, marketing and compliance, but it doesn’t make much difference to those whether the fees are “one and ten” or “four and 40”.

But it makes a huge difference to profits. The extra income drops on to the bottom lines.

Customers might even put up with the increase. The funds putting up their fees argue that they are charging a little more for exceptional performance. If you have money in a fund that is regularly delivering 20% or 30% a year, then maybe you don’t mind if a third of those profits go to the managers. After all, if you take it out you might end up in a fund that makes only 5%, and that would leave you a lot worse off. And it certainly means they will have plenty of incentive to make a lot of money – and you will benefit from that. Even so, it is still a mistake. Why? There are two reasons.

Why funds should be cheaper

First, technology is making it far cheaper to manage portfolios. Dealing costs have been slashed. Offices can be virtual. Compliance can be automated, and a lot of the marketing can be done via social media, or with targeted internet campaigns. Indeed, there are plenty of start-ups starting to offer no-fee trading. Private investors can run their own portfolios for next to nothing. That is not quite true of a major hedge or private-equity fund. In general, however, costs are coming down, and that should mean that fees come down as well.

Next, artificial intelligence (AI). There are plenty of robo-funds that can pick investments, often just as well as the pin-striped alternative. It might be a while before an AI program can run a private-equity fund. But many hedge funds can be run by computers for virtually nothing. And the more they charge, the more incentive there is for smart entrepreneurs to design AI programs that can replace them.

Funds should therefore be cheaper to run, and savings should be passed on to customers. Indeed, perhaps the reason fees are edging up among established fund managers is precisely because lower-cost rivals are starting to nibble away at their market and so they are charging those customers who remain more. But the more expensive they get, the more space they open up for rivals to undercut them.

The real challenge for the City is to work out how to offer a cheaper, better service, at lower cost. A few hedge and private-equity funds might get away with higher fees for a while, and a tiny handful might have the performance to justify it over the medium term. But for most of them, it will ultimately prove fatal – and will simply drive investors to lower cost alternatives.