High Fees Reduce the Attractiveness of Hedge Funds

A recent study on the effect of the fees that hedge funds charge, “Portfolio Efficiency With Performance Fees,” was conducted by Mark Kritzman, president and chief executive of Windham Capital Management, a Boston-based money management firm.

Mr. Kritzman’s study shows that hedge funds’ high fees make it unlikely that investors will improve their long-term performance by putting money into hedge funds. Focusing on the standard fee arrangement in the industry, known as “2 and 20″, which is to charge 2% of assets under management and 20% of profits above a predetermined benchmark, Mr Kritzman found that the combined impact of such fees is so high as to greatly reduce the attractiveness of hedge funds.

In an interview with the New York Times, Mr Kritzman said the fees’ effect on the portfolio was so sizable because of the “asymmetry penalty” resulting from the 20% cut of profits that the hedge funds earn. The funds do not share in investor losses, but they reap a large share of the profits.

The study was similarly disparaging about funds of hedge funds, saying he found it difficult to justify any allocation to funds of hedge funds, because they earn fees above and beyond those earned by the hedge funds in which they invest, typically 1% of funds under management and 10% of profits above a benchmark. The bottom line, Mr. Kritzman told the New York Times, is this: “Because of fees, the optimal allocation to a group of hedge funds is a lot lower than you might think it should be.”