In August, the SEC voted to pass new regulations that target disclosure standards for private fund managers who collectively control $25 trillion in assets. While the result of these changes is yet to be seen, the intention behind these new regulations is to put institutional investors and managers on more equal footing.
Over different time periods, managers may underperform broad market indices while still collecting management fees. Recent legislation focuses on expense disclosures and consistency of investment terms which is noble, but it doesn’t actually align investment incentives.
But first, it’s important to establish some differences between hedge funds and mutual funds. Mutual funds are pooled investment vehicles offered publicly, hedge funds are pooled investments offered privately to qualified purchasers and accredited investors. In terms of fees, mutual funds had historically charged a “sales load” in addition to an operating fee. However, that structure has evolved.
Today, most mutual funds do not have a sales load, instead fund sponsors pay distributors out of management fees. Turning to hedge fund managers, they often charge a management fee along with a performance fee, set by the manager in accordance with investor demand.
There are some managers who charge minimal management fees – enough to “keep the lights on” – preferring to be paid meaningfully for performance alone. Practically, the only viable way to do so is by opting for a hedge fund structure over a mutual fund, regardless of whether underlying strategies involve both long and short positions.
Under current regulations, non-hedge fund advisers are typically banned from charging fees for outperformance. As a result, money managers face a dilemma - do they go the mutual fund route where they cannot be directly incentivized by results? Or do they opt for hedge fund structures that can come with longer sales cycles, costly due diligence for investors and inherently negative media coverage – all so they can deliver on their dedication to investor/manager alignment?
The investment management industry, and the trillions of dollars that comprise it, could be better served if Congress allowed advisors to charge performance fees. Just as investors drove an evolution in mutual funds’ sales load structure, so too could the market demand the ability to weight performance fees more heavily than management fees to better align investor and manager objectives.
The resulting dynamic would mean both managers and investors have skin in the game whether they invest capital through mutual fund or hedge fund vehicles. In brief, changing the way performance fees are structured would go a long way toward shoring up equal footing between individual investors and managers, just as regulators' recent legislation has sought to do for institutional investors.