Hidden Fees in Hedge Funds

Jul 30 2013 | 12:49pm ET

By Joshua Barlow, PAAMCO -- Hedge fund fees have been a key focus for investors and the media for a number of years now, and with good reason: For many investors and reporters, the phrase “hedge fund fees” refers to charges by an investment manager for management and performance. The typical hedge fund has a stated 2% annual management fee on the overall net asset value of the fund, and a 20% performance fee,  commonly referred to as “2 and 20.” Despite the pressure from investors to lower fees, many hedge fund investors still pay close to the standard 2 and 20. But is this a comprehensive enough look at fees, or are there other levies that investors unwittingly pay?

Determining Basic Fees

There are a number of fees that investors may pay beyond management and performance fees. It is important to know where to find and review them. Each hedge fund’s income statement (hedge funds refer to this as the “Statement of Operations”) lists the fund’s revenues and expenses. In the list of fund expenses (what the investor is expected to pay), there are typically line items besides the management and performance fees.

There may be items such as interest expenses; dividend expenses; professional fees (administration fees, audit fees, legal fees and director’s fees, for example); stock loan fees; bank, brokerage and custody fees; research expenses and other costs. This may sound like quite an extensive and surprising list of additional costs, but these are all common fund expenses that investors are routinely paying in addition to management and performance fees. Many times these fees may be lumped into just a couple line items under the category “other expenses.” These basic expenses are directly related to the management of the fund, and the majority of investors consider it acceptable to pay trade-related expenses and professional fees.

Identifying Hidden Fees

Other fees paid by investors are actually hiding in plain sight. Fund expenses are detailed in audited financial statements, which are distributed to the investor each year. They are also disclosed within the fund’s legal documents, which each investor receives prior to investing. But investors may not know what they should be looking for in these statements and documents. The more difficult-to-determine fees can often be found in the line items “other expenses” and “research expenses.”

What is tucked away in these categories? A number of surprising costs, including employee salaries, technology, regulatory filings, fund portfolio and accounting systems, outsourced middle office, insurance, trade errors, travel and entertainment. In some situations, these items become so large that they raise the question, “What is the management fee I am paying going towards?”

What Should Investors Be Doing?

It is important for investors to be fully aware of the fees they are paying. Once investors have full information about all of the expenses for the particular hedge fund, they can make the decision about whether the investment makes sense. The fund’s offering memo or private placement memo details what the manager is allowed to charge to the fund. This is typically written in a way to encompass most things imaginable. Investors should push back on the legal language and ask the manager to nail down more specifically which expenses will be charged. In addition, the investor should specifically ask what is currently being charged to the fund. Many managers include items in the fund’s legal documents that they haven’t charged to the fund and don’t plan to. This is important to know and investors are protecting themselves from unanticipated future charges by insisting that the manager update their documents to better reflect actual practices.

Once invested in the fund, investors should request detailed supporting documents on the fund expense line items. In particular, investors should request detailed backup for the “research expenses” and “other expenses” line items to ensure the manager is only charging those items that they are contractually allowed to.

Investors who invest through separate accounts are in a position of greater strength to obtain a fund expense policy that is more favorable to them. However, hedge fund managers have a duty to allocate fund expenses fairly across the funds they manage, and this could cause complications in negotiating a different expense policy for a managed account.

There is often more being charged to hedge fund investors than simply management and performance fees. To discover and limit hidden hedge fund fees, investors should review offering documents prior to investing, conduct robust negotiations to trim fund expenses, and review expenses on an annual basis. At PAAMCO it is our practice not only to work to negotiate lower headline fees for our clients but also to verify that excessive and inappropriate charges are not being added elsewhere by the manager. President Ronald Reagan made the phrase “trust, but verify” famous, but with regard to hedge fund expenses it may be most prudent simply to verify.

Joshua Barlow, CPA, CAIA, is an associate director in investment operations and a member of the PAAMCO operational due diligence committee. He joined PAAMCO in March 2006. He is responsible for operational due diligence on new and existing hedge fund managers based in the U.S. and Europe. Barlow spent nearly two years in the firm’s London office, responsible for operational due diligence for managers in Europe and Asia, and led PAAMCO Europe and PAAMCO Asia’s business and investment operations. Josh is a member of the valuation committee. Prior to joining PAAMCO, he was a senior auditor at Deloitte & Touche, where he worked on audits of investment funds and firms and public companies.

Josh graduated from Brigham Young University Marriott School of Business with a B.S. in accounting.

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