Fund of funds eyes radical fee structure

Jan 16, 2006 @ 12:01 am

By Jeff Benjamin

DETROIT - As hedge funds come under increased criticism for charging steep fees while underperforming, one firm is taking the unusual tack of appealing to well-heeled investors by underpricing the competition.

While some hedge fund purists contend that fees are a low priority when it comes to evaluating an alternative asset class designed to generate absolute returns, the new fund of hedge funds offered by Belstar Group in New York aims to test that theory.

The Belstar Multi-Advisor Fund LP, which has been managing less than $10 million worth of seed capital since October and will start taking money from outside investors Feb. 1, could rock the boat in an otherwise cozy industry where fees have been climbing in stride with asset inflows.

Unlike most funds of hedge funds that apply a layer of fees on top of the fees charged by the underlying managers, the Belstar fund will apply a single layer of fees that includes a 2% management fee and 20% performance fee. Belstar is believed to be the first to approach fees in this manner.

The management and performance fees charged by the underlying hedge funds are absorbed by the Belstar general partners and not passed on to investors.

For example, if the Belstar fund included one hedge fund that gained 50% and another that lost 50%, the Belstar fund's total performance would be flat, but the hedge fund manager who gained 50% would still be due a performance fee.

Assessing fees

The traditional fund-of-funds fee structure would require the investor to pay the underlying manager's performance fee, but the Belstar fund's "netting risk" structure charges a performance fee only on the overall fund.

"I think this is where the industry is going, and as first adapters, we'll have a big advantage," said Kenneth Orr, who helped design the fund and will help manage it as chief investment officer of Glocap Partners LLC in New York.

According to his calculations, on a 10% annual return, the Belstar fund's total fees would be nearly 3 percentage points less than those charged by most funds of hedge funds.

The fee structure is as revolutionary as it is controversial, according to hedge fund manager and Yale University professor Scott Johnston.

"The fund-of-funds model, as it exists today, is untenable," said Mr. Johnston, chief executive of Peconic Management Co. Inc., a $60 million hedge fund operation based in Mount Kisco, N.Y.

"The [Belstar fund model] has dramatically cut down on fees, and I think they'll do tremendously well, provided they can pick the right managers," he said.

Mr. Johnston added that the Belstar fee structure could offer a glimpse of the future.

"The fund-of-funds industry will work for a flat [0.75 percentage points] within five years," he predicted.

Belstar Group is in the process of establishing an insurance contract with a commercial bank to cover the performance fees as they are triggered by underlying funds. In the meantime, the general partners have set aside $1 million to handle such expenses.

In addition to the fee reductions earned through the so-called netting risk strategy of making the fund-of-funds manager responsible for underlying performance fees, the Belstar fund has also shunned the idea of adding its own layer of performance fees.

According to Morningstar Inc. of Chicago, only about 12% of all funds of hedge funds operate without charging a performance fee.

The performance fee at the fund-of-funds level ranges typically from 5% to 30%, with 59% of the funds opting for a 10% performance fee.

"It seems that hedge funds are always trying to find some new way to be on the cutting edge, whether it's investment strategies, or compliance, or structuring fees," said Ryan Tagal, Morningstar's product manager in charge of hedge fund research.

"We've seen an explosion in the number of funds of funds, and a lot of them are trying to figure out what makes them different."

Even before the Belstar fund gets officially off the ground, there are corners of the $1 trillion hedge fund industry that have either downplayed the idea of reduced fees or focused on the apparent conflicts of interest.

"If I were investing in this [Belstar fund], I'd want to first run some scenarios to see how it's supposed to work," said John Van, chief financial officer of Van Hedge Fund Advisors International Inc. in Nashville, Tenn. "I don't really want to call it a gimmick, because it could work out."

Focus on performance

As high as fees are across the hedge fund industry, they have never been the main focus of veteran financial adviser and hedge fund investor Robert Levitt, president at Levitt Capital Management LLC in Boca Raton, Fla.

"The primary determinant of investing in a hedge fund should be returns, not fees," said Mr. Levitt, who oversees $325 million in client assets.

He has seen individual hedge fund managers charge performance fees as high as 50%.

"Those top managers can charge high fees, because they make money," Mr. Levitt added.

That said, however, he admitted that he plans to liquidate all his firm's fund-of-hedge-fund investments by the end of the year because of poor performance.

"There has been a massive amount of money going into hedge funds, and there's no way managers can take on that much money and still make money," he said.

Belstar Group representatives declined to identify any of Belstar Multi-Advisor's underlying hedge funds, citing competitive reasons.

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