The rapid rise within the federal funds rate from near 0% in 2022 to a 15-year high of 5.25% in July 2023 provides each a possibility for hedge funds’ expected returns and a quiet increase in the value of alpha.
Given the trend in rates of interest, the alpha received by those that invested with a superb manager with an equity beta of 1 may very well have fallen by 36%.
So how can hedge fund investors optimize the value they pay for alpha?
The alpha capture ratio
The alpha capture ratio metric measures the price of alpha. To calculate it, we first apply the Capital Asset Pricing Model (CAPM) to measure the online alpha return for managers with different equity betas in several rate of interest environments under a given equity risk premium.
Net Alpha = Net Return – Risk Free Rate – (Equity Risk Premium * Equity Beta)
Since managers mustn’t charge energetic rates of interest on beta, we treat all management fees as a price of generating alpha and define gross alpha as follows:
Gross Alpha = Net Alpha + Management Fees + Performance Fees
The resulting alpha capture ratio allows us to check managers with different stock betas in several rate of interest environments.
Alpha capture = Net Alpha / Gross Alpha
How do different manager risk profiles affect the alpha capture ratio?
To answer this query, we created two hypothetical managers: a superb manager and a nasty manager, achieving a gross alpha of seven% and three%, respectively. Assuming a 2 and 20 fee structure with 2% management and 20% performance fees with no hurdle for risk-free rate of interest performance fees, how would their performance compare in an environment with a 6% equity risk premium?
When the risk-free rate is 0%, investors retain 40% to 54% of the Good Manager’s alpha at stock beta levels of 0.2, 0.5, and 1. However, when the risk-free rate increases to five%, the rate of interest decreases Alpha capture drops by 27% to 36%, indicating a major increase in the value of alpha.
This results in two observations: First, the upper the equity beta, the lower the alpha capture rate is since the returns generated by the equity beta drive up absolutely the performance fee charged by the fund and consequently reduce the online alpha. Second, the rise within the risk-free rate has a greater negative impact on the alpha price for managers with the next equity beta level.
Alpha Capture: Good manager with 2 and 20 fee structure
In the case of our bad manager with a stock beta of 0.2, alpha capture drops from 54% to 19% as gross alpha drops from 7% to three%. This downward trend in alpha capture rate continues as stock beta increases. Such a pointy decline reflects the importance of manager selection.
Alpha Capture: Bad manager with 2 and 20 fee structure
In each scenarios, because the risk-free rate of interest increases, the value of alpha also increases, assuming that the expected return on alpha and the equity risk premium remain unchanged.
Alpha Capture with different fee structures and risk-free plans
Alpha capture rates vary depending on the fee structure and risk-free rate of interest. To illustrate this phenomenon, let’s compare the performance of three different pricing structures: one with a 1% management and 20% performance fee, one other with a 2% management and 10% performance fee, and a 3rd with a 2% management and 20% performance fee. a performance fee and a performance fee hurdle.
Under the lower fee structures – our scenarios 1 and 20 and a pair of and 10 – the alpha capture rate increases. But the alpha recovery rate drops about twice as much—between 22% and 28%—when the management fee falls from 2% to 1% as when the performance fee falls from 20% to 10%. In the latter scenario, the alpha capture rate drops by 11 to 13%. This discrepancy highlights the impact of performance fees on alpha capture rates at the next risk-free rate.
Alpha Capture: Good manager with 1 and 20 fee structure
Alpha Capture: Good manager with 2 and 10 fee structure
Given the impact of rising rates of interest and performance fees on alpha capture, investors should work with managers to implement a risk-free rate of interest performance fee hurdle.
The following charts examine the alpha recovery rate under the various fee structures in a 0% and 5% risk-free rate of interest environment and compare the fee structure in base cases 2 and 20 with three alternatives: one with a 1% reduction within the management fee and a second with a ten percent reduction within the performance fee and one other with a risk-free rate of interest hurdle for the performance fee, which assumes that the investor has a positive belief within the manager.
These scenarios raise two small print. First, there isn’t any ideal fee structure for all scenarios. For a manager with a low beta of 0.2 in a 0% risk-free rate of interest environment, the fee structure of 1 and 20 could be optimal for an investor and would offer the best alpha retention of 65%. However, if the risk-free rate rises to five%, a lower performance fee structure – our 2 and 10 scenario – would work higher. Conversely, for managers with higher beta (0.5 and 1 beta), the structure with 2 and 10 would even be preferable.
Second, a risk-free performance fee hurdle may be an appropriate compromise if investors cannot negotiate discounts on management or performance fees. If the risk-free rate increases to five%, the alpha capture rate might be somewhere between the speed observed with lower management fees and that observed with lower performance fees.
looking ahead
In the present high rate of interest environment, investors should look to maximise alpha capture by negotiating a reduction on performance fees fairly than management fees. Failing that, they need to attempt to introduce a risk-free rate of interest performance fee hurdle.
Overall, investors should consider the impact of a performance fee hurdle when making conclusions a few manager’s future performance. Since the risk-free rate has historically been virtually zero, there was little to no track record distortion because of the potential performance fee hurdle. However, as rates of interest rise, investors would pay more for a similar skill level (alpha).
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Photo credit: ©Getty Images / Talaj
