The rapid ascent of the federal funds rate from near 0% in 2022 to a 15-year high of 5.25% in July 2023 presents both an opportunity for hedge funds’ expected returns and a silent increase in the price of alpha.
Indeed, given the interest rate trajectory, the alpha captured by those who invested with a good manager with an equity beta of 1 may have fallen by 36%.
So, how can hedge fund investors optimize the price they pay for alpha?
The Alpha Capture Ratio
The alpha capture ratio metric gauges the cost of alpha. To calculate it, we first apply the capital asset pricing model (CAPM) to measure the net alpha return for managers with varying equity betas in different interest rate environments under a given equity risk premium.
Net Alpha = Net Returns – Risk-Free Rate – (Equity Risk Premium * Equity Beta)
Since managers should not charge active rates for beta, we treat all management fees as the cost of generating alpha and define gross alpha as follows:
Gross Alpha = Net Alpha + Management Fees + Performance Fees
With the resulting alpha capture ratio, we can compare managers with different equity betas in different interest rate environments.
Alpha Capture = Net Alpha / Gross Alpha
How Do Different Manager Risk Profiles Impact the Alpha Capture Ratio?
To answer this question, we created two hypothetical managers: a Good Manager and a Bad Manager who achieve a gross alpha of 7% and 3%, respectively. Assuming a 2 and 20 fee structure of 2% management and 20% performance fees with no risk-free rate performance fee hurdle, 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 across equity beta levels of 0.2, 0.5, and 1. As the risk-free rate rises to 5%, however, the rate of alpha capture declines by between 27% and 36%, indicating a substantial spike in the price of alpha.
This leads to two observations: First, the rate of alpha capture diminishes the higher the equity beta levels because the returns generated by equity beta drive up the absolute performance fee charged by the fund and consequently reduce net alpha. Second, the rise in the risk-free rate has a more pronounced negative effect on the price of alpha for managers with higher equity beta levels.
Alpha Capture: Good Manager with 2 and 20 Fee Structure
In the case of our Bad Manager with an equity beta of 0.2, when the gross alpha drops from 7% to 3%, alpha capture falls from 54% to 19%. This downward trend in the alpha capture rate persists as the equity beta increases. Such a steep decline reflects the importance of manager selection.
Alpha Capture: Bad Manager with 2 and 20 Fee Structure
In both scenarios, as the risk-free rate rises, so does the price of alpha, assuming the expected return of alpha and the equity risk premium remain unchanged.
Alpha Capture with Different Fee Structures and Risk-Free Rates
Alpha capture rates vary depending on the fee structure and the risk-free rate. To illustrate this phenomenon, we compare the performance of three different pricing structures: one with a 1% management and 20% performance fee, another with a 2% management and 10% performance fee, and a third with a 2% management and 20% performance fee as well as a performance fee hurdle.
Under the lower fee structures — our 1 and 20 and 2 and 10 scenarios — the alpha capture rate rises. But the rate of alpha capture declines roughly twice as much — between 22% and 28% — when the management fee drops from 2% to 1% than when the performance fee is lowered to 10% from 20%. In the latter scenario, the alpha capture rate falls by between and 11% and 13%. This discrepancy underscores the influence of performance fees on alpha capture rates amid a higher 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 influence of rising interest rates and performance fees on alpha capture, investors should engage with managers to implement a risk-free rate performance fee hurdle.
The charts below explore the rate of alpha capture under the different fee structures during both a 0% and 5% risk-free rate environment and compare the base case 2 and 20 fee structure with three alternatives: one with a 1% management fee reduction, a second with a 10% performance fee reduction, and another with a risk-free rate performance fee hurdle that assumes the investor has a positive conviction about the manager.
These scenarios raise two important points. First, there is no ideal fee structure across the scenarios. With a low 0.2 beta manager in a 0% risk-free rate environment, the 1 and 20 fee structure would be optimal for an investor, delivering the highest alpha retention of 65%. But if the risk-free rate climbs to 5%, a lower performance fee structure — our 2 and 10 scenario — would work better. Conversely, with higher beta managers — 0.5 and 1 beta — the 2 and 10 structure would also be preferable.
Second, if investors cannot negotiate management or performance fee discounts, a risk-free rate performance fee hurdle could be an acceptable compromise. When the risk-free rate increases to 5%, the alpha capture rate falls somewhere between the rate observed with lower management fees and that with lower performance fees.
Looking Ahead
In the current high interest rate environment, investors should try to maximize alpha capture by negotiating a discount on performance fees rather than management fees. Failing that, they should try to implement a risk-free rate performance fee hurdle.
All told, investors should consider the impact of a performance fee hurdle when inferring a manager’s future performance. In the past, since the risk-free rate was practically zero, there was little to no track record distortion due to the potential performance fee hurdle. With the rise in rates, however, investors would pay more for the same level of skill (alpha).
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Talaj
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