Hedge Funds Squeezed by Rising Costs and Falling Management Fees

Hedge funds are being squeezed between rising costs and falling management fees, resulting in little profit for managers who do not perform, according to research.

The Citi Prime Finance 2013 Business Expense Benchmark Survey, which questioned 124 hedge fund firms in North America, Europe and Asia, found the traditional "two and 20" model of investment manager compensation - 2% management fee and 20% of the profits - has declined to fee levels as low as 1.58% of assets under management for all but the largest managers.

The study explained that means hedge fund managers, unlike their counterparts in traditional, long-only funds, "barely" break even simply collecting fees.

Funds with $500m (£304m, €363m) in assets under management, for example, realise operating margins of 69 basis points, rising to 82 basis points for a manager overseeing $900m, the study found.

"Fee compression continues to reshape the business of hedge funds, lowering fees even as expenses rise, all but eliminating fee-only operating margins, and raising the level of assets needed for a hedge fund business to succeed," said Alan Pace, global head of prime brokerage and client experience at Citi.

"While it's clear that there is little room for additional downward pressure on management fees, at current average fee levels, investor-manager interests are well aligned - both parties are focused on performance."

In addition, the report revealed "emerging" hedge funds - those with assets of less than $1bn - struggle to cover expenses based solely on management fee collections and do not realise comfortable operating margins.

The study also said average management fees for institutional size managers are well below the "historical" 2.0% level, ranging from 1.58% to highs of only 1.76% for the largest firms in this band.

The research revealed, on average, management fees for franchise-size firms were 1.53%.

The survey also found firms operating margins based solely on management fees were slightly above the 1.0% level noted for institutional managers, rising to 1.2%.

Citi said this illustrates that adding lower-fee products actually helps expand operating margins.