Money Manager Fees: Who Gets Paid How?
Understanding why different types of funds charge different fees.
Before the advent of hedge funds and crypto prop trading firms, the world of money management was mostly limited to trust departments at banks, and later mutual funds, starting with the formation of the Massachusetts Investors Trust in 1924. These funds allowed wealthy individuals to pool their assets so that they can be managed—mutually—by an individual, or a group of individuals that we can refer to (loosely) as money managers.
In exchange for their services, money managers decided to charge investors based on how much that investor invested in the mutual fund. That amount, a fraction called the management fee, quickly became the standard way of doing things. So it was a big deal when Alfred Winslow Jones started his hedge fund in 1949, and decided not just to charge investors 2% per year on the assets they invested, but an additional 20% on the gains he made by investing those assets. This comp structure, referred to colloquially as "two and twenty", is nice and alliterative, but it raises the question: what do money managers charge, and why does it vary?¹
By the time hedge funds entered public consciousness, some time in the 90s with the success of Soros and Tiger and the collapse of Long-Term Capital Management, part of the narrative around them was that because they gave money managers a percentage of the profits (in addition to a percentage of the assets), they were a better way for good money managers to monetize their skill.
Today, it's actually better to view hedge funds as sitting in the middle of the fund continuum: where at one end money managers are paid entirely for providing market exposure, and at the other end they are paid entirely for skill. Hedge funds happen to be right in the middle of that group, where they're paid both for exposure to a market (investors probably don't invest in a tech hedge fund because they hate tech, even if the fund is going long and short) and for skill within that market.
So here's the fundamental law of fees: when a money manager is getting paid mostly for providing market exposure, fees are a small percentage of assets that pay for administrative costs and marketing with a bit left over for profits—those are management fees. To the extent that the key input into a strategy is skill rather than capital, managers get paid a percentage of gains—those are performance fees.
What does it mean to charge for providing "market exposure?" Well, there's over a century of data on the performance of stocks, corporate bonds, government bonds, and commodities. We know roughly what the annual returns are from buying these, how much those returns vary, and what they correlate with. So an investor buying mostly stocks will tend to do well when the economy is growing; a holder of government bonds wins when growth is slowing and inflation is declining; commodities holders benefit from higher inflation. And once this is well-known, someone who is merely offering that kind of exposure can basically compete on fees.
At the other end of the spectrum are purely skills-based strategies. These strategies are still taking positions in financial assets, but they are some combination of 1) balancing one against another, and 2) temporary. A long/short industry-and-factor-neutral fund, for example, will have short positions offsetting its long positions, not just in dollar amount, but in terms of exposure to different sectors and different sources of returns—so if it owns oil stocks, it's also short oil stocks; if it owns companies that have outperformed the market over the last six months, it also owns some that have underperformed; if it owns statistically cheap stocks, it's also short some of the same. These strategies, in other words, are trying to identify all of the differences within the same broad categories for which it's cheap for investors to buy exposure.
Some of the “money managers” that exist at this spectrum are proprietary traders, who tend to run strategies that have extremely high turnover, very low volatility, high returns on investment, and limited capacity to scale the amount of capital they're managing. These proprietary traders only manage their own capital, do not need much of said capital to produce high returns, and have what amounts to negative marketing—their websites are vague or nonexistent, employees sign strict nondisclosure agreements, and they pay some of the world's finest PR firms top dollar to articulate complex messages to the media such as "No comment," or "I will get back to you" (they won't!). What this means has evolved over time; when markets weren't very automated, the profits of prop trading were partly limited by how many stocks a single trader could keep an eye on at any one time. Now, some strategies are sufficiently automated that attention isn't a limiting factor for them day-to-day, but attention remains important because any given strategy's profits will rapidly decay, and because some strategies have blow-up risk.
For proprietary traders, the deal is effectively a 0% management fee and a 100% performance fee, because low-scale strategies won't run outside money. But it's almost a category error to call these "investment" strategies, both because computer-generated trades that last a second are not exactly "investing" as it's traditionally understood, and because skill rather than capital is the primary input. There are many non-scalable strategies out there, sometimes practiced by people who got their capital grubstake working in more traditional asset management and then struck out on their own.
One case that looks like an exception to this general model is the idea of "pass-through fees": instead of charging a fixed percentage of assets under management, some funds will just bill all of their expenses—research, employee compensation, office rent, etc.—and continuing to charge a performance fee on top of this. But in that case, we need to be very thoughtful about how we define capital. A big multi-strategy fund may have a pretty good idea of what a given portfolio manager can produce, and what other resources might be required to achieve this. So when a big multi-strategy fund decides to allocate, say, $500m to a portfolio manager trading industrials, whom they poached from some other multi-strategy fund where the portfolio manager traded the same thing, they're investing a certain amount of capital in dollars, a certain cost in terms of management overhead and attention, and betting that the combination of these monetary, human, and technology factors will produce a predictable return that adds to their total return stream. (And, if this doesn't work out, they of course can and will fire the unfortunate portfolio manager.)
The thing for investors to watch out for is not the total fee load, to look at what they're paying for compared to what they're getting. A multi-strategy fund can plausibly be undercharging if the pass-through fees and performance fees eat half the gross return, if what's left is an uncorrelated return that beats other alternatives. And a mutual fund can be overcharging when it asks for 50 basis points a year if it claims to be offering stock-selection alpha but is really delivering market-tracking beta at a high markup.
And this applies to individuals, too: you can decompose your own compensation into the beta-like returns from what line of work you're in, what your educational background is, and your location. But it's hard to get upside trading one kind of beta for another; for example, if you move somewhere for a high-paying job, you’ll make more, but a lot of that extra income compensates for a higher cost of living.² Alpha is whatever value you add on top of what's expected based on superficial and commoditized traits. Selling beta at a markup can be a very good living, but delivering alpha is more lucrative and ultimately more satisfying.
1. The colloquialism “two and twenty” also makes it very easy for aspiring hedge fund managers to dream of how much they could be earning—is it a coincidence that the first hedge fund manager previously worked as a journalist and sociologist, and might have had a knack for memorable phrasing? How much money and talent has moved into the hedge fund space as a consequence of this?!
2. As with investors, there are cases where individuals can opportunistically accept different kinds of beta: if you're saving half your money while living somewhere cheap and working remote, your annual savings-dollars will probably go way up if you move to San Francisco, London, or Dubai. As long as you avoid that lifestyle creep!
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