Hedge Fund Fee Philosophy of Teacher Retirement System of Texas
Written by Brad Gilbert
Brad Gilbert is a Senior Director of Hedge Funds at the Teacher Retirement System of Texas (“TRS”). This blog entry reflects the views of TRS, not necessarily those of Aon Hewitt Investment Consulting. It is not known whether the client approves or disapproves of AHIC’s advisory services. In a subsequent blog entry, we will provide commentary on Aon Hewitt Investment Consulting’s views on this topic.
TRS is committed to a fee philosophy that leads to retaining at least 70% of the gross alpha generated by its external managers. Recent performance by the hedge fund industry has exposed a flaw in the traditional hedge fund fee structure. In low return environments, management fees consume a disproportionate amount of the gross alpha generated by managers.
The illustration below highlights the problem. It is a graphical representation of a 1.5% and 20% fee structure. Gross returns are shown along the x-axis, fees paid along the left y-axis and the percentage of gross alpha retained by TRS on the right y-axis. As you can see, TRS does not retain 70% of gross return until the manager delivers a 12% gross return. Over the five years ending 12/31/2016, the average hedge fund (as represented by HFRI Fund of Funds Composite) has annualized roughly 4% gross return. Disregarding any market beta included in that number, at that level, the gross return is split evenly with both the manager and TRS retaining 50%. Taking 50% of gross return (and a higher percentage of alpha) for 4% gross absolute returns is an unsustainable model for the industry.
Management fees and beta are the biggest impediments to an equitable alpha split with managers. TRS believe’s the best way to solve this problem is to introduce hurdles to offset their impact.
TRS has worked to design, improve and implement a better structure for fees, which we colloquially call “1 or 30”. Under this structure, a manager will receive the greater of 1% of NAV or 30% of gross alpha on an annual and cumulative basis. This structure accomplishes three goals: 1) protects TRS in low return environments 2) makes the manager relatively indifferent between fee structures at target returns and 3) rewards a manager with higher compensation if performance exceeds expectations.
Management Fees: Management fees should be set at a reasonable level to operate the manager’s business and should not be a profit center. If a manager requires a higher management fee, the structure can be adjusted to accommodate. Under the “1 or 30” structure, management fees are an advance on future performance fees. It is the only fee paid if 30% of gross alpha is less than 1% (or whatever level of management fee is agreed upon) of NAV. In other words, performance fees are not paid until 30% of gross alpha exceeds 1% of NAV. (Note: This structure is equivalent to a hard hurdle of 2.33% = 1%/30% - 1%)
Performance Fees: To offset the impact of the management fee hurdle, TRS is willing to pay an incentive fee of 30% on alpha. This increases the slope of the fee curve and allows a manager to earn higher performance fees if their alpha exceeds expectations. The following graph highlights the difference between a traditional fee structure and TRS’s proposal. For the “1 or 30” structure, TRS would have retained 70% of gross return over the last five years (~4% gross). At target 12% gross returns, total fees paid are identical. Above 12% gross, TRS pays more under the new structure than the old structure. Note that this example ignores any beta impact.
Beta and Cash Hurdle:TRS does not believe in paying hedge fund fees for beta or cash. In the instance of persistent beta exposure, TRS will include a beta hurdle to offset a fund’s market exposure. Appropriate benchmarks and beta levels will be discussed and agreed to at the onset of implementing the “1 or 30” fee structure. The beta hurdle will redistribute performance fees to environments when the manager generates alpha. This means a manager can earn an incentive fee in a negative absolute return year when they have generated positive alpha. It also means that a manager will not receive incentive fees in a positive absolute return year if there is negative alpha. This structure should be fee neutral/positive for high performing managers over a market cycle.
Hurdle structures such as “1 or 30” are the path forward for TRS hedge fund investing as they materially improve the alignment between TRS and its managers. For TRS, “1 or 30” provides a consistent alpha split across return environments while ensuring that fees compensate alpha, not market beta. For managers, it provides fee equivalency over a market cycle, allows higher returns for outsized performance and potentially provides fee diversification in a broader range of return environments.To date, TRS has been successful in implementing this across much of the hedge fund portfolio. We are pleased that many managers see its benefit and are offering the fee structure as an “alpha share class” for other investors. TRS continues to discuss this structure with many market participants, including hedge fund managers and allocators. We believe this trend is gaining momentum and can greatly improve the sustainability of the hedge fund industry.
The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.