Crystallization: A Hidden Dimension of CTA Fees

The authors investigated the impact on fee load of variations in the frequency with which commodity trading advisers update their high-water mark. They documented crystallization frequencies used in practice, analyzed the effect on fee load, and found that the crystallization frequency set by the manager significantly affects fee load and should thus be a relevant consideration for investors. We investigated the impact on fees paid by investors of variations in the frequency with which commodity trading advisers (CTAs) or managed futures update their high-water mark (HWM). Although this aspect of hedge funds’ fee structure might be neglected in fee negotiations, the “crystallization” frequency has a material impact on the fee level that investors pay. Therefore, the issue is of high relevance for investors that are invested in or wish to allocate to CTAs or other hedge fund categories. The crystallization frequency is an important element of any performance-based fee structure that includes a high-water-mark provision. In our study, we first documented the crystallization frequency commonly used by managed futures. We found that in the majority of cases, the high-water mark is updated quarterly. This finding contrasts with the view expressed in prior academic research that hedge funds commonly charge the incentive fee annually, at the end of the year. Furthermore, using data on managed futures from BarclayHedge for 1994–2012, we studied the impact of crystallization frequency on the average annual fee load that investors pay. We first estimated CTAs’ gross returns by using the funds’ headline fee levels and assuming quarterly crystallization. We then used gross returns as inputs for a block bootstrap approach to simulate the track record of CTA funds. The final step consisted of applying a standard 2/20 fee structure but varying the crystallization frequency. In this way, we were able to quantify the average annual fee load for different crystallization frequencies under realistic conditions. The results that we report in the article provide investors with a number of useful insights. We found that the expected total fee load charged by the hedge fund manager increases with the crystallization frequency. In the case of CTAs and assuming a 2/20 fee structure, shifting from annual to quarterly crystallization leads to a 49 bp increase in the average annual fee load (as a percentage of assets under management). These results imply that funds with different (identical) headline fee levels can have remarkably similar (different) fee loads. We quantified the trade-off between crystallization frequency and performance fee level. Specifically, our results suggest that an incentive fee of 15% under monthly crystallization leads to the same total fee load as an incentive fee of 20% under annual crystallization. Our results imply that the effect of crystallization frequency on fees is important for investors evaluating and comparing different fund investments. Headline fee levels do not tell the whole story when a high-water-mark provision is used. Considering the crystallization frequency should allow a more informed choice when investing in CTAs or other investment vehicles with a high-water-mark provision.