A Hedge-Fund Fee Plan That Only Charges for Alpha

One of my biggest criticisms of the hedge-fund industry has been the mismatch between fund performance and management fees. A traditional fee structure of “2 and 20” (a 2 percent management fee plus 20 percent of any gains) is both expensive and, truth be told, unnecessary. Expensive, because one can capture market-average returns, or beta, for a few basis points in fees in a low-cost mutual fund or exchange-traded fund; and unnecessary because investors end up paying a 20 percent surcharge for beta rather than outperformance, or alpha. (To be fair, a good number of hedge funds have lowered their fees to about 1.5 percent of assets and 15 percent of investment gains.)

What’s so puzzling is that hedge-fund investors typically believe they are paying a premium for a manager’s superior investing skills. Few seem to realize that often, fund managers are really being paid for their ability to both deliver market-based returns and pull in assets. The bottom line: This business model is an expensive wealth transfer mechanism from those who desire alpha to those who promise it but typically fail to deliver.