Hedge Funds’ Lucrative Fee Model Seen Facing Smart Beta Threat

  • Smart beta pools typically charge from 50 to 75 basis points
  • Citi estimates the funds will manage $1.2 trillion by end-2019

Hedge funds, shrinking at the fastest pace since the financial crisis, face a challenge to their lucrative fee model: “smart beta” money pools that charge a quarter of the levy and often don’t demand a share of the profits.

The search for lower fees will help propel the assets managed by smart beta funds more than fourfold to $1.2 trillion through 2019 from 2014, Citigroup Inc. estimates. The money pools, which operate like exchange-traded funds, typically charge as little as half a percent for managing money. That compares with the traditional 2 percent of assets and 20 percent of profits charged by hedge funds, a model criticized by Warren Buffett and pension funds.

"The hedge fund brand is under fire," said Ben Johnson, a director of global ETF research at Morningstar Inc. "Lower fee alternatives are going to represent a serious competitive threat irrespective of whether you are a hedge fund or an active equity or fixed income manager."

Two smart beta funds managed by Goldman Sachs Group Inc. now have $1.1 billion after starting in September, and the amount overseen by WisdomTree Investments Inc.’s hedge-fund like strategies doubled in the last 12 months as investors opt for cheaper funds that can be exited quickly. The contrast with hedge funds is stark. They’re having their worst performance since the financial crisis, leading Dan Loeb’s Third Point in April to describe the industry’s performance as a “catastrophic period.”

Smart beta funds use quantitative models to profit by using factors other than market value to rank securities. The simplest ones track value or growth companies, betting prices will rise, and an increasing number use strategies such as merger arbitrage, shorting equities or macro trading as they seek to make money in falling as well as rising markets.

In a survey of investors overseeing almost $1 trillion, 86 percent said they expected to increase exposure to smart beta funds over the next three years, Citigroup Inc. said last week.

Bubble Trouble?

That popularity can bring its own problems. Rob Arnott, co-founder of Research Affiliates LLC and one of the founders of the discipline, in a paper in February warned that a bubble is forming in smart-beta funds. Many strands of the investing style succeeded only because of a stampede in popularity, and they are poised to crash, he wrote. Arnott’s conclusions are without merit and investors should follow diversified strategies, Cliff Asness, co-founder of AQR Capital Management, said in a paper in April.

Goldman Sachs’s ActiveBeta Emerging Markets Equity ETF now manages $640 million compared with about $20 million in September, according to data compiled by Bloomberg. Its U.S. large cap equity ETF now manages more than $500 million, according to the company’s website. Assets at a multistrategy tracker fund managed by IndexIQ Advisors LLC’s have risen 180 percent to $1.1 billion over the last three years, Bloomberg’s data shows.

Britain’s railway pension manager RPMI Railpen has cut its investments in hedge funds to 300 million pounds from 2 billion pounds in 2014. It now has about a third of its 22 billion pounds invested in alternative risk premia, another name for smart beta.

“The cost differential between hedge funds and alternative risk premia is very significant, and therefore costs of investing have decreased considerably,” said Ciaran Barr, investment director at RPMI Railpen, said.

Hedge funds may respond to the threat by starting or expanding smart-beta strategies of their own because the opportunity to manage significantly more money, even at lower fees, will appeal to some managers.

"This is a real positive for those hedge funds that have genuine insight and skill, but there are relatively few of these funds," said James Price, a senior investment consultant at Willis Towers Watson Plc. The firm’s clients invested $7 billion into smart beta strategies last year, bringing the total exposure to around $46 billion. Funds with unique strategies can charge more than 75 basis points, Price said.

Worst Start

Hedge funds lost 0.6 percent in the first quarter, their worst start to a year since 2008, according to the HFRI Fund Weighted Composite Index. There’s no industrywide return available for smart beta funds. Clients pulled a net $15 billion from hedge funds from January through March, the most since the second quarter of 2009, and the low returns led to criticism of the fee model.

Large investors should be frustrated with the fees they pay hedge funds, Warren Buffett said in April, while billionaire Steve Cohen said he’s astounded by the limited number of skilled people employed. Some of the best-known names in the $2.9 trillion industry, including Crispin Odey, Bill Ackman and John Paulson, posted declines of at least 15 percent in some of their funds in the first quarter.

"Much of what hedge funds do can be replicated much more cheaply and, gradually, big investors are working out how to do this." said Peter Douglas, principal at CAIA Association, a global group for alternative-investment education. "For once it seems like institutional investors are doing the sensible thing at the right time." 

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