Be it resolved: Hedge funds (might) be worth the price

 ^[1]Just about the only folks who don’t seem to appreciate the ongoing banter and debate regarding hedge fund fees are those that have to pay them. Since the Alfred Winslow Jones ^[2] first introduced the concept of a hedge fund in the 1950s, the argument over whether paying a premium for alpha is worth it has raged on.
AllAboutAlpha.com touched on this in our “Dazed and Confused ^[3]” piece last week, highlighting a recently updated survey from Ernst & Young showing that more than half of hedge fund professionals have either already made changes or plan to make changes to their redemption terms and / or fees. And we’ve certainly covered it in the past (click here ^[4] for a recent newsreel of  “fee”-related articles on AllAboutAlpha.com)
In a case of great timing, the Alternative Investment Management Association’s Canada chapter ^[5] last week hosted its annual parliamentary-style debate, with this year’s focus being whether hedge funds are worth the price. Arguing in favor (the government) was Jim McGovern, founder and CEO of fund of hedge fund firm Arrow Hedge Partners. And arguing against (the opposition) was Som Seif, founder and CEO of ETF firm Claymore Investments. (Click here ^[6] for Jim’s slide presentation, and here ^[7] for Som’s).
The expected fireworks did not disappoint. In a room heavily populated with those either directly or indirectly dependent on hedge fund fees to earn a living, the debate focused on whether the actual 2 and 20 structure of hedge fund fees – long accepted as the norm – are truly reflective of performance, or whether they are a cash grab that awards managers based on the level of assets they oversee.
McGovern came out swinging, noting that the “correct” incentive structure – i.e. the one all hedge funds currently utilize – leads to better results.
“Incentive fees are a critical part of compensation, and obviously, very motivating,” he said. In other words, hedge fund fees are justified by the fact that they produce higher returns and lower volatility than equities. He pointed to the chart below showing the drawdown for hedge funds between 2007 and 2009 was far less than for equities.
 ^[8]
Indeed, in years when hedge funds failed to produce positive returns, such as 1998 and 2008, McGovern pointed out that the losses incurred by hedge funds were less severe than those incurred by equity markets – in particular noting that hedge funds did not get paid on the performance side of the equation during those down years.
A gentleman all the way, Seif chose not to argue what many present for the debate had expected: that hedge fund returns, and hence alpha, can be replicated at a fraction of the cost, say, in an ETF. Rather, Seif argued the industry as a whole should adopt a fee structure that more effectively ties managers’ compensation to the performance of their funds.
“There has been an enormous influx of capital into the hedge fund industry,” he said. “It all but guarantees that hedge fund pay in the coming years will not be as closely tied to performance as it has been in the past.”
To illustrate his points, Seif utilized this chart showing returns versus performance for single-manager funds over 12-24 months. What the chart demonstrates is a fairly solid correlation between fees and returns.
 ^[9]
Both agreed that hedge fund managers who produce alpha deserve to be compensated for their skill. Said Seif: “The better you are, the more assets you should have and the higher your fees should be.”
Alas, Seif did not win the debate. As duly noted by the “stacked” audience, it is difficult to defeat an issue close at heart to the government, particularly so when the government has a significant majority.