Back in 2008, Warren Buffett made a bet with Protégé Partners, a fund of funds hedge fund manager, that the S&P500 would beat a group of hedge fund managers selected by Protégé. The bet officially started on January 1, 2008, and runs for a decade, ending on December 31, 2017. The performance is being measured by netting out fees, costs and expenses that go into running the hedge funds. Buffett made the bet to prove his contention that hedge funds underperform due to the fact that “costs skyrocket when large annual fees, large performance fees and active trading costs are all added to the active investor’s equation.”

So far, he appears to be right. At the annual Berkshire Hathaway shareholder’s meeting in May, 2013 in Omaha, Nebraska, he detailed that the S&P 500 was beating Protégé’s basket of hedge funds. The standard management fees charged by hedge funds, including a common 2% annual management fee and as much as 20% of the profits over a certain hurdle rate, are certainly to blame. But so are other costs. Many, including legal and accounting fees, are reasonable and a normal cost of running a fund. But more exotic expenses, which can be as ridiculous as the high management fees, are much more controversial. They can also be harder for investors to spot.

Acceptable Hedge Fund Fees and More Reasonable Expenses
As introduced above, hedge funds charge management fees where the hedge fund manager, generally known as the general partner, gets paid to run the fund for the underlying investors, or limited partners.

The acceptable management fee level for a hedge fund can be as much art as science. Fundamentally, a manager with a proven track record of earning high returns for the underlying investors that is both high on an absolute level and significantly above a stated benchmark should be able to charge a higher fee and take a higher cut of the profits. Hedge funds are built to outperform an index by a wide margin, and those that do so are generally able to charge a 2% management fee (2% of the hedge fund’s assets) as well as a performance fee for as much as 20% of the annual gains. Those with less of an aptitude to earn high returns above a predefined bogey won’t be able to charge as much.

When it comes to passing through applicable expenses, common sense rules should apply. In particular, does the expense help the manager perform his or her function, and is it reasonable? Other fees that are necessary to run a fund, including accounting fees and those that go toward regulatory compliance, are also acceptable, provided they are again reasonable and within industry averages. Below is an industry study that breaks down common expense categories, by size of the manager.

The manager is also able to pass along reasonable expenses and other costs that are needed to run the hedge fund. As there are no hard and fast rules or industry standards on cost allocation, managers have widely different views on which expenses should and should not be passed on to investors and many are left to guess where to draw the line.

What constitutes an exotic expense?
The vast majority of hedge funds stay within the lines and charge fees and expenses in line with the industry. A number of investors and industry experts, including Buffett, will contend that charging a 2% management fee and 20% of the profits are in themselves exorbitant, which would qualify them as exotic charges. He, as well as others highly critical of the way hedge funds are organized, believes that high management fees make it nearly impossible for investors to earn adequate returns above the market. The fact that Buffett is winning his current bet against the industry serves as a case in point.

When it comes to truly exotic expenses, certain hedge funds cross the line and do the industry a great disservice. Hedge funds are known to host lavish events to both impress current investors and attract new ones. Many high profile events feature famous bands and musicians, but charging existing investors for the hedge fund events definitely could be considered unnecessary, and even unethical.

Beyond entertainment, specific exotic expenses that a hedge fund can charge include travel, entertainment and consulting arrangements, the last of which may help them gain new investors. Mutual funds are able to charge 12b-1 fees to current investors for the ability to market to potential investors. In many cases, these fees should be considered exotic, as should hedge funds marketing expenses that are run through their funds as valid expenses.

A Business Week article shed light on exotic fees that hedge funds were charging prior to the financial crisis. Beyond fees, it estimated that “extras” that hedge funds charged included bonuses to traders, spending on technology, and an “other” category that collectively amounted to nearly 2% of assets under management. Added to the standard annual management fees, it calculated an all-in annual fee of 3.5% of assets. This was nearly double the annual fee that mutual funds charge. Hedge funds that invest in other hedge funds had the most egregious expenses as they roll up many layers of different hedge fund management and incentive fees, as well as operating expenses. The article estimated total costs to investors of 3% annually, as well as sales charges that again go to brokers for helping sell the funds.

The Bottom Line
Industry regulations stipulate that hedge funds need to charge expenses and fees that are fair to investors. The stance of regulators is that general partners serve as fiduciaries, which by definition means they have to run the fund in the best interest of the partners and investors. Anything that isn’t fair conflict with this fiduciary responsibility, though fair is certainly open to interpretation and a very subjective matter.

At the end of the day, there aren't specific regulations that clearly spell out what qualifies as a fair expense and differs from an exotic one. Any investor should hold a hedge fund to a fiduciary standard and ask for historical details of a fund’s expenses. As with most things related to investing, investors should take a common sense approach and do their homework. The bottom line is to ask hedge fund general partners for a fee and expense detail, and ask them to clarify anything that looks suspect or exotic.

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