Sunday, July 16, 2017

Using hedge pricing as a weapon - the firms with scale will squeeze smaller firms


The idea that hedge funds are getting 2/20 for management fees is becoming a myth. Dynamic pricing is being used more aggressively by hedge funds with a wide range of management and incentive fee options. For example, in the managed futures space, there seems to be a willingness to offer beta products as low-cost alternatives as well as traditional alpha plus beta products. The low cost products are being marketed as trend-following beta at low cost while higher priced products are being offered as alpha generators relative to trend-following beta. Of course, there is not a clear definition for what is trend-following beta so there is something more going on with this pricing. (The beta may be associated with a peer index, so the beta firms offer a low cost product to match a bundle of competitors.) This approach is being used by a number of larger firms.  

Since smaller firms have been shown to perform better than larger firms, lower fees by large firms help to cut the return edge associated with smaller firm. Secondly, lower fees after fixed costs are covered will create a barrier to entry for new firms who have to grow to break-even. Lower fees will mean a higher breakeven AUM is necessary to turn a profit. As the break-even level of AUM is raised, marginal firms are forced out of business unless they can consistently generate incentive fees to cover fixed costs. Additionally, it will harder for smaller firms to charge premium prices if the market fees are moving lower. This approach is extremely disruptive to the market structure as we believe that this pricing is being used more and more as a weapon to stop entrants and create barriers to entry. Now some of this pricing is not conscious action since for large allocations the investor sets the price, but changing the product mix, a willingness to negotiate prices, and lower posted prices all have impact on competitors. 

While any marginal dollar is valuable for smaller firms, the profit for firms will fall if the costs of marketing does not decline but the market price for management services is lowered. None of this should be news or surprising, but the economics of scale and pricing is becoming more relevant as returns from hedge funds move lower and the dispersion of returns compress. As the hedge fund industry moves from high new growth to taking market share from other firms, pricing as a tool for firm growth will become more sensitive to the impact of others. This is good news for investors, but bad news for the upstart firm who may thing that a good investment idea and hard work by itself will lead to success.

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