A few legendary hedge fund investors have been able to overcome the burden placed on them by the nature of their fee structure. Paul Tudor Jones is one of these managers. According to a recent Wall Street Journal article, his flagship fund has had average annual returns of 17% over the last three decades, after fees, compared with a 7% return for the S&P 500 over the same period. Even more impressive, in the last thirty years, his only down year was 2008, when the fund dropped just 4%.
But returns like these have attracted a lot of competition, which has driven down returns and made it harder for hedge funds to justify these fees.
To understand what they do to returns, let’s take a simple example. I’m using the fees PTJ charged as recently as January 2016; a 2.75% management fee and a 27% performance fee. Assume a year in which the fund earns 15% (evenly distributed every month) and that the fees are charged quarterly and the performance fee is taken at the end of the year.
The 15% gross return drops to 9.4% after fees. A 6.37% annual fee, in this simplified example, is just too high a hurdle to scale over the long-term.
The trend from high to low(er) cost investing is not going away. For the hedge funds to remain a viable option in the future, fees will have to come down. There is a reason why there are so few hedge fund managers that are household names, taking such a large bite out of the pie doesn’t leave enough to satisfy investors’ appetites.