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The Cost of Exotic Pursuits

Cerulli Associates

May 2008

 

The issue of so-called “alpha and beta separation” has come to dominate almost every discussion of asset management trends in the US, and to a lesser extent, the European and Asian markets. This development has mirrored the rising interest in, and availability of, alpha-generating hedge funds on the one hand, and beta-tracking exchange-traded funds (ETFs) on the other. Juxtaposed against this polarisation of investment products is the polarisation of fees – that is, how much more can managers continue to charge for alternative products and absolute returns and how much less can investors pay for simply accessing beta.

In the Asian markets, while the theoretical debate appears to have gained much ground, practical changes have been mitigated by the limited number of retail hedge funds and ETFs, and for now, there are only cautious flows into such products from institutions and retail investors alike. That said, managers in Asia should be prepared for the eventual unfolding of fee trends that reflect those prevalent in the more developed markets; that is, fees for passive funds heading further south, while at the other extreme, a succession of new highs for fees charged by alternative funds.

Product Innovation

Despite much fuss about hedge funds in Singapore and Hong Kong over the past few years, the bulk of investment assets held by mass retail and mass affluent investors in these markets remains in conventional fund types. Conventional equity funds charge around 1.35-1.75% management fees, while bond funds typically charge between 1% and 1.25%. While an overseas invested fund typically charges more than a domestic fund, these funds have experienced only minimal management fee revisions in the past three years.

What has changed in recent years is the speed of product innovation and level of investor sophistication in countries such as Hong Kong and Singapore and to a lesser extent, Korea and Taiwan. Although the original excitement around hedge funds has dissipated somewhat, the reverse can be said of funds investing in more exotic asset classes or using more exotic financial instruments and methods.

The popularity of such funds can be attributed to the general euphoria surrounding Asian markets in 2006 and 2007, and as a result, fund managers may have successfully side-stepped the thorny issue of fees. In fact, these funds come not only with higher management fees than their more conventional cousins, but a surprising number also adopt the use of performance fees, previously the exclusive hallmark of hedge funds.

JPMorgan’s Asia Frontier Market fund, launched in the Hong Kong retail market in November 2007, charges a 1.5% management fee and a 15% performance fee. Macquarie is also charging management and performance fees of 1.5% and 10%, respectively, for its MQ Infrastructure Strategies Fund, launched in January 2008 to Hong Kong retail investors. Fee-wise, these funds are blurring the once-distinct boundaries between traditional and alternative funds.

Management Fee Range for Hong Kong
Registered Mutual Funds, 2006 vs 2007
Funds launched in 2007 carry higher fees in some cases and lower fees in others.
figure1

Click on the image for an enlarged preview

Revenue Challenges

The emergence of performance fee-bearing funds is perhaps unsurprising, given the need for managers to compensate for a more onerous fee-sharing trend emerging in Asia. Here, as in many other marketplaces, fund managers are having to accommodate local distributors’ demands for a larger cut of management fees.

Until recently, only foreign banks and brokerages were able to command a 50% share of fund management fees, by dominating the investment market and restricting the managers with which they partner. Today, local distributors are gaining market share, and not surprisingly, demanding similar fee-sharing deals as their foreign counterparts.

However, hedge funds continue to suffer from regulatory constraints and both investors’ and distributors’ lack of familiarity. Even in Hong Kong and Singapore – the only two Asian jurisdictions to allow the retail distribution of hedge funds – approvals so far have been restricted to a small number of funds of hedge funds, which in turn have suffered from disappointing performances and bad press.

ETFs, too, have made little headway in Asia’s retail marketplace. Due to the dominance of banks and the lack of advisory fee-based distribution channels, ETFs’ low-cost structure has yet to generate the level of retail interest that might be expected. Index funds have also met with similarly anaemic sales, despite the fact that they are more suitable instruments for momentum-chasing Asian investors. Given that liquidity and size are keys to a successful ETF or index fund, thin trading volumes on locally listed ETFs are leading to a spiral of higher costs and lower demand. The most costly ETF listed on the Singapore bourse is the iShare MSCI India ETF, which has an annual management fee of 0.99% – not far from that of an Indian equity fund.

Global Hedge Fund Fee Structure
Newer hedge funds charge higher performance and management fees, with performance fees showing a faster uptrend. figure2

Click on the image for an enlarged preview

Core vs Satellite

While average institutional fees have stayed fairly constant in Asia on the whole, there appears to be a slight uptick for some of the larger institutional investors. This is because the larger volume of assets held by these institutions allows them to adopt separate investment approaches for their core and satellite portfolios.

It appears to Cerulli that many Asian pension funds are now looking more closely at ways to lower the fee charges on their core portfolios. Fund managers who fail to provide competitive pricing risk lose mandates to other fund houses or in-house asset allocation teams that achieve market returns via low-cost ETFs and passive funds. With the emergence of new state-owned and highly fee-sensitive pension funds such as those in India, China and Korea, institutional players are willing to manage more conventional mandates at lower fees in order to get their foot in the door. The recent mandates awarded by India’s New Pension System (NPS) to State Bank of India (SBI), UTI Asset Management Company (UTIAMC) and Life Insurance Corporation (LIC) epitomise this intense competition among fund managers, with SBI charging a management fee of just 0.03%.

On the other hand, pension fund managers are also fulfilling their satellite portfolios through more specialised mandates and in this regard, fees appear less crucial given that the institutions are more focused on performance as the key criteria for selection. Average fees for such mandates appear to be in the region of 0.6-1%, with alternative investments such as infrastructure, real estate private equity, commodities and country/sector-specific funds featuring prominently. Absolute return funds combining hedge and conventional strategies also seem to be of increasing interest, especially to corporate pension funds and insurance firms; although hedge fund managers tell Cerulli that Asian institutional interest in pure hedge strategies is still minimal.

Changing Fee Structures

Given the structural difficulties prevalent within the institutional and mass retail market, it appears that hedge funds and ETFs have gained greatest traction with high net worth investors, in particular those targeted by the burgeoning number of foreign private banks. This segment of investors appears to be sufficiently large to prompt an evolution of hedge fund fees.

Cerulli’s interviews suggest that a small pocket of specialist funds and hedge funds are diverging from the dominant “2% management fee and 20% performance fee” structure in an effort to break away from the pack. These include funds with lower management fees but longer lock-up periods and some offering a pure performance fee-based structure. Data from hedge fund consultant Eurekahedge shows that globally, management fees of hedge funds launched in the last three years are slightly higher than their predecessors and tend to have considerably higher performance-related fees. Similarly, the entry of new players is redefining the shape of ETF fee schedules. While a large-cap ETF typically charges 0.07% in management fees, fees can go up to as much as 2% for an emerging market ETF or actively managed index fund.

In general, fee movements in Asia do not appear to be in a single direction, but there is conclusive evidence that fee bands are widening in both institutional and retail markets, driven by manufacturers’ initiatives in product innovation on the one hand, and investors’ desire for portfolio diversification on the other. In the medium term, this polarisation of fees is likely to become even more pronounced and rooted, as regulatory reforms diminish the differences between retail and institutional product offerings, and the search for non-correlated and absolute returns takes on ever wider significance. Even in markets resistant to hedge- and derivatives-based investing, the popularity of specialist themes including infrastructure, green energy and frontier markets will prevent a fall in average management fees.

 


T
his article first appeared in the April 2008 issue of The Cerulli Edge Global Edition.

If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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