What's the Optimal Size of Hedge Funds? | Chief Investment Officer

Under the current fee structure, the optimal size for hedge fund performance differs substantially from the optimal size for managers’ compensation, a newly released academic paper concludes.

(August 12, 2012) — Hedge fund managers have strong incentives to increase fund sizes when it comes pay packets — but at what cost?

A recently released academic paper by Chengdong Yin of the University of California aims to answer that question. According to Yin, there is still a conflict of interest between fund managers and fund investors under the current hedge fund incentive contracts.

Yin concludes: “We first document that diseconomies of scale exist in the hedge fund industry, and thus optimal sizes in terms of fund performance can be identified. If the incentive fee contract is effective and managers behave in the investors’ interest, assets under management should be restricted around the optimal sizes for fund performance.”

He continues: “However, managers’ compensations are also related to fund sizes and our empirical results show that the optimal sizes for managers’ compensations are larger than the optimal sizes for fund performance.”

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In other words, according to the author, fund managers have strong incentives to increase fund assets, even when the growth of fund sizes will erode fund performance. The author concludes that in order to attract capital inflows and avoid capital outflows, fund managers need to maintain average performance.

Click here to read the full paper.

aiCIOrecently explored a new fee structure being implemented by the $6.5 billion Wyoming Retirement System, which says it’s time for “capital owners,” or public pension funds more specifically, to change the way they compensate their fund managers. At the moment, the managers are often the ones getting most of the benefits — even when they underperform, the fund’s investing heads said.

Thus, according to the public pension fund’s John Johnson, chief investment officer, and Jeffrey Straayer, a senior investment officer, the Wyoming scheme is changing its methodology of fund manager compensation. It has introduced a revised fee structure in a request for proposal in March and is expecting implementation by mid to late August. While traditionally, fund manager fee structures used by pension funds lead to overpaying managers when they’re doing well, managers maintain that payment when they’re underperforming, according to Johnson.

Jibing with some of the themes expressed in Yin’s paper, Johnson noted that most asset owners have fund manager fee structures that include a high fixed active fee with a performance fee added to it, which leads to a tendency among fund managers to index and gather assets to attain the highest fees. “That business model shifts risk to the pension fund rather than the risk being on the fund managers,” he said.

(August 13, 2012) – Rating agency Fitch is concerned about the risks of multiemployer pension plans (MEPP) to participating companies’ solvency, and has calculated the nine firms most exposed to these typically “significantly underfunded” plans.

And they sent aiCIO the list.

1. Safeway Inc.

2. Supervalu Inc.

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3. Kroger Co.

4. Harsco Corporation

5. Dean Foods Company

6. Rite Aid Corporation

7. News Corporation

8. US Airways Group Inc.

9. Del Monte Group

With multiemployer pension plans, participating companies and their employees bear the risk of investment losses despite having limited control over plan administration and investment decisions. Fitch’s report further noted that “when a participating employer files for Chapter 11 or liquidates, that employer’s share of the funding shortfall would land on the remaining employers in the plan to the extent it is not recovered in the courts.”

Fitch’s issuer default ratings for these companies range from decent to marginal, with Dean Foods and Del Monte pulling passable Bs, and Supervalue bringing up the rear with a CCC.

The ratings agency is watching MEPP exposure closely as they periodically adjust their ratings. “Fitch does not expect any near-term rating actions resulting from MEPP liabilities,” the report said. “However, growth in MEPP contributions due to funding shortfalls, which can be exacerbated by employer insolvencies, could result in further downward pressure on supermarket EBIT margins, which have already narrowed significantly in recent years, and, over time, lead to rating downgrades.”