Why Aren’t Hedge-Fund Fees Dropping?

Competition, as any freshman economics student will tell you, brings down prices. It works for computers and for phone calls and for cars. Why not for hedge funds? Investors have been paying the same fees since practically the dawn of the hedge fund: a 2 percent management fee plus 20 percent of profits. Now that there are thousands of funds competing for capital, why hasn’t “2 & 20” become “1 & 10” or even “0 & 5”?

Quality is a major concern; no discounted fee will ever be deep enough to compensate for the cost of investing money with an incompetent manager. (Heart surgeons don’t tend to compete on price, either.) A hedge-fund manager who cuts his fee is signaling that he can’t persuade other investors to trust him. Then again, there’s no guarantee that an expensive hedge fund is going to be a good one. Past performance provides an important clue, but the difference between luck and skill can be hard to differentiate. When consumers are confused, more competition need not reduce prices at all.

Hedge-fund fees are worrisome not just for their size but for their structure. If, for instance, I were managing a million dollars of your money for a fee of 2 & 20, I could do worse than go to Las Vegas and dump it all on black. If the roulette wheel favored me, I’d make $200,000 for myself; if not, I’d lose nothing—and still get to claim my “management” fee. Investors are supposedly protected against such behavior by the promise that hedge-fund managers have their own money in the same pot. But even if that tends to prevent blatant gambling, it might not stop a manager from becoming convinced of his own infallible brilliance. Consider the hedge funds that regularly make money from high-risk, high-return strategies mixed in with the occasional catastrophic wipeout.

Ultimately, investors have to decide which funds make the fees worth paying. Some fees might eventually be lowered, but those tempted to do that might choose to simply close their doors. Despite the boom, some funds have already done that. That’s exactly what we’d expect from a competitive industry that refuses to cut prices. The laws of economics haven’t been suspended, after all.

Tim Harford is a Financial Times columnist and author of The Undercover Economist.

Why Aren’t Hedge-Fund Fees Dropping?