The True Cost of Asset Management: Beta-Adjusted Fees

Abstract

With the extraordinary growth of assets under management in the hedge fund industry over the last decade, there has been a corresponding surge in academic research on various facets of the hedge fund industry. The majority of this research has focused on the return and risks of hedge funds, and, in particular, on their performance as an asset class. The purpose of this paper is to provide another look at this issue through a novel approach to assessing the risk-return tradeoff and more generally a hedge fund's performance profile. Specifically, we analyze the different sources of a hedge fund's payoff to better understand how much investors pay for alpha ex ante. Using the valuation methodology of Goetzmann, Ingersoll and Ross (2003) and the fund flow extension for mutual funds in Boudoukh, Richardson, Stanton and Whitelaw (2005), we characterize the value of hedge fund contracts in terms of the parameters of interest, namely alpha, idiosyncratic volatility, market-wide volatility, fund flow determinants and features of the contract (such as high water marks, the management fee and performance fee). In particular, one important practical contribution of the paper is improving our understanding of the role of alpha and beta and the two related sources of volatility as sources of value in hedge fund contracts. We incorporate the interaction between fund flows and performance in light of the existing empirical evidence about hedge fund flows. For example, we are able to quantify the cost of hedge funds taking market risk. The main idea is quite simple: beta risk is nearly free (e.g., for institutional money <5 basis points to buy S&P500 exposure, and not much more for MSCI Global). Presumably, though, what the investor is or should be willing to pay for in terms of performance fees is alpha. Since hedge funds, venture capital funds and private equity funds charge a fee which is a function of total volatility (market risk plus fund specific alpha-related risk), one can quantify in our framework how much more alpha is required by the funds facing large market risk.