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Benrud’s Model Analyzes Changes in Hedge Funds

December 11, 2012

By offering potential investors more choices with respect to fees charged and the required time for keeping their capital invested, Erik Benrud, Ph.D., clinical professor of finance at Drexel LeBow, demonstrates in his recent article in Financial Decisions that hedge fund managers can keep more capital invested even in the face of a financial crisis and a declining number of such investors.

Prior to 2008, there was generally one hedge fund fee-structure known as “2 and 20”: a 2 percent annual management fee and a 20 percent incentive fee taken out of profits. Benrud says hedge fund managers didn’t engage in price competition largely because investors perceived a manager who charged a lower fee as offering an inferior product. But after the 2008 financial crisis, in order to attract and retain more investors, some began offering a choice: the standard fee of 2 and 20, or a lower fee, perhaps 1.5 and 15, if the investor agreed to keep the capital invested for a longer period of time.

Benrud says this method has been effective. “My article proves mathematically that offering investors choices can keep more of them in the market and more capital invested even when the total number of potential investors declines.”

Other changes have also developed within the industry to accommodate investors. Managers are offering investors more transparency into funds’ investment processes, as well as more liquidity after the required lock-up period.

“Managers are probably doing this in response to changes in the industry, such as mutual funds’ new ability to engage in strategies once only associated with hedge funds,” Benrud says. “Also, investors are showing more willingness to move from one manager to another when dissatisfied with performance.”

Benrud says he also sees a decline in the size of the average hedge fund because smaller funds are more flexible and can react more efficiently to changing financial conditions. Other changes include more outsourcing, with funds hiring outside firms for some services such as trading and risk assessment to get the benefits of specialization, as well as more regulation in response to the financial crisis.