Responding To Convergence: Fees and Assets Under Management

Mar 23 2007 | 11:45am ET

By Irene E. Aldridge and Steven F. Krawciw -- Maximizing a fund manager’s total compensation involves careful balancing of four magic numbers: performance, incentive fees, assets under management and management fees.  Recent trends point to the latter as the key factor.

Incentive Fees Converge

Incentive fees (Figure 2) were once stark differentiators of fund type. Those differences have narrowed as performance has converged (Figure 1). Retail’s traditionally lower incentive fees have been rising, as has its aggregate performance. The trend has held for hedge funds and funds-of-funds across all categories.

Management Fees Diverge

Management fees (Figure 3) tell a very different story. A decade ago, all funds essentially charged the same amount. Over time, what was standard practice morphed into profit-maximizing decisions. While institutional funds are dropping their fees, retail and high net-worth funds have been increasing them.

As Figures 2 and 3 illustrate, retail funds charge the highest management fees and the lowest performance fees: lower performance fees “subsidize” management fees. The figures also show institutional funds offering lower fees, but requiring larger investments.

With the highest minimum investment requirements, institutional funds are barred to the majority of retail and high net-worth customers. The attractiveness the institutional fee structure, however, may trigger a new wave of consolidation: Retail and high net-worth customers pooling resources in order to access institutional levels of sophistication and lower fees. Naturally, such pooling would come at a cost, but with a great value proposition for clients. 

Connecting fees and AUM growth

Figure 4 shows asset growth for hedge funds and fund-of-funds. While it has been established that median institutional and high net-worth AUM has risen explosively since 1991, a deeper investigation reveals that retail fund-of-funds experienced a slight decline, in perfect tandem with their rising average management fees (Figure 3). 

In fact, the management fee seems to hold the key to AUM for funds of funds: the lower a fund-of-funds management fee, the higher the fund’s AUM. The same does not hold true for hedge funds: median retail funds have twice the AUM of their high net-worth counterparts, while the median institutional hedge fund persistently triples the AUM of the median high net-worth hedge fund.  Different approaches to marketing across fund categories explain the discrepancy.

Many institutional and retail funds are operated by large financial firms with a lot of institutional and retail marketing experience.  High net-worth funds, however, are commonly run by portfolio management specialists who rely on their skill and track record to attract capital. The NASD prohibition of direct marketing of unregistered funds also contributes to the marketing conundrum faced by high net-worth hedge funds.  A potential solution is the third-party marketing industry that can deliver an increase in AUM, albeit at a significant expense to the fund manager.

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