PAAMCO urges greater focus on hedge fund expenses

Operational Risk
06 Aug, 2013

Investors should be increasingly diligent when reviewing hedge fund expenses, while managers ought to be more specific about what they intend to charge to the fund in offering memoranda, says PAAMCO, the $8.7 billion emerging manager focused fund of funds.

Investors will usually pay fees in addition to the 2% management and 20% performance fee, which might cover administration, legal and director costs, stock loans, custody and research expenses.  Some managers though are charging questionable costs to the fund – namely salaries, technology, insurance, trade errors, non-research related travel and entertainment, which should be covered by the management fee. Oftentimes, these charges are found in line items titled “other expenses” or “research costs” contained in financial statements or legal documents provided by managers to their investors.

“Some hedge funds are not wholly transparent about their expenses, and investors might not always know what they are looking for when they are reviewing legal and offering documents outlining expenses. Investors should educate themselves on these issues and be more thorough when looking at these documents to help them identify these hidden charges. Once they have this information, investors will be able to determine whether or not it is worthwhile investing in that manager,” said Joshua Barlow, associate director in operational due diligence at PAAMCO in California.

Investors are placing more emphasis on fund expenses amid thinning hedge fund margins. A survey of operational due diligence professionals by Deutsche Bank revealed the majority of respondents had little or no tolerance of certain expenses, such as non-research related travel or employee compensation being charged to the fund. Other expenses that were frowned upon included outsourced compliance and marketing, although managers have been become more sensitive to what they charge to the fund post-crisis.

“We have been investing in hedge funds through managed accounts since 2005 so for many of our investments we have a clear line of sight over the expenses our managers are charging us thanks to the transparency we receive. We think it is essential that other investors are fully aware of what they are paying for too,” said Barlow.

Managers were also advised to be more specific on what they expense to the fund. “A lot of offering documents and governing documents are highly legalistic and broad, which sometimes gives managers too much flexibility in what they can charge to the fund. It would be much better if managers could be more detailed about what they will and won’t charge to the fund,” commented Barlow.

Both the Securities and Exchange Commission (SEC) and the recently rebranded Financial Conduct Authority (FCA) in the UK are delving deeper into hedge fund expenses. The SEC, according to reports, has said it will be scrutinising hedge fund fees and expenses charged to investors, such as travel and entertainment. “Regulators are certainly looking at whether expenses have been properly disclosed to investors. However, I believe the catalyst for change at hedge funds will be driven by investors rather than regulators,” said Barlow.



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