Ganging Up on Hedge Funds?

Reuters reports that according to BNY Mellon, the stock market decline in October trimmed the funding status of U.S. pensions.

Funny how after the 2008 debacle, U.S. pensions are reducing risk and rediscovering liability-driven investing strategies. FinAlternatives reports that the New York State Common Retirement Fund plans big increases in hedge fund investments:

Having all but liquidated its fund of hedge funds portfolio in the wake of a pay-to-play scandal, New York’s state pension fund plans to pour more than $1 billion into single-manager hedge funds by the end of the year.

The $116 billion New York State Common Retirement Fund is in talks with several potential managers, already awarding a $50 million mandate to Stamford, Conn.-based Diamondback Capital, Crain’s New York Business reports.

The pension has just $2.9 billion currently invested with single-manager funds. Amidst a scandal which implicated several of his predecessors’ top advisors for allegedly taking kickbacks in exchange for arranging mandates, state Comptroller Thomas DiNapoli fired just about all of the pension’s fund of funds managers, reducing their share of its hedge fund portfolio from 80% to less than 5%.

Mr. DiNapoli better approach hedge fund investments carefully, making sure they're not paying 2 & 20 for disguised beta. Lucky for him, he can visit Ray Dalio and the folks over at Bridegwater right in his backyard to explain all this to him in detail (I highly recommend it).

By the way, Reuters reports that hedge funds face investor war on fees:

Institutional investors are going to gang up on "arrogant" hedge funds, a pension fund chairman warned, as investors increasingly press for changes that would link lucrative fees more closely to genuine outperformance.

A key complaint of investors has been that while many of them lost money during the financial crisis, hedge fund managers were still able to rake in millions of dollars in fees. Last year, average hedge fund returns were a minus 19 percent.

"If they want money from us they will have to offer ... alignment of interests. If hedge funds remain arrogant and not humble, I think money will go elsewhere," Philip Read, chairman of the British Coal Staff Superannuation Scheme, said on Tuesday.

"We're increasingly going to gang up against you... Institutional investors are totally disillusioned with funds not delivering what was on the tin," he told the the Hedge 2009 conference in London. Hedge funds typically charge a management fee of 2 percent or sometimes more on assets -- well above the cost of mutual funds -- plus a 20 percent fee on performance, which is often levied on any positive returns not just those that fall above a "hurdle rate", or target agreed with the investor.

Institutional investors at the conference said they favoured skewing fees further towards performance and away from rewarding firms for the amount of assets gathered.

They also said managers should be rewarded when they deliver returns due to their skill -- known as alpha -- and not due to rising markets -- or beta -- as very cheap exchange-traded funds also offer investors beta. "We're essentially trying to minimise non-performance-related fees. We want managers to make money when we make money," said Mike Powell, head of alternative investments at Universities Superannuation Scheme, Britain's second largest pension scheme.

"Management fees can cover costs and not much else, and you should introduce proper hurdles for managers to beat before they start taking performance fees," he said.

The focus on performance fees extends beyond the hedge fund industry. The BT pension scheme in its 2008 annual report said it had agreed performance fees and targets with some of its mainstream active managers to encourage outperformance.

CLAWBACKS

Hedge funds have also come in for criticism from investors and regulators for charging performance fees on an annual basis and not offering cash back to investors in down years.

For instance, a fund gaining 40 percent in year one but falling 40 percent in year two would reward the manager with lucrative performance fees in year one, while the investor would have lost money over the two-year period.

Niels Oostenbrug, head of alternative investments at Netherlands-based pension fund administrator and manager Mn Services, said this could be remedied if hedge funds move to a private equity model, where performance fees are allocated over a longer period and fees awarded in early years can be reduced in later years.

"What I like about private equity is that a clawback is possible -- the investor doesn't pay a performance fee if no performance is made over a number of years," Oostenbrug said. "Hedge funds could learn something from their private equity brothers."

A small number of funds, including RAB Capital's Special Situations fund, have reduced fees for investors, but investors said they were seeing other evidence of charges falling.

Omar Kodmani, who runs fund of hedge funds firm Permal's London office, said better fees could be negotiated if investors opted for segregated accounts rather than traditional fund investments, while Gina Sanchez, director of public investments at the Ford Foundation, said she had seen lower fees agreed with smaller, up-and-coming hedge funds.

Ok, here is my take on this. Yes, hedge funds are charging management fees. They say they need it to pay the "best and the brightest" to deliver "alpha". To a certain degree, I accept that argument but what typically happens is that as hedge funds' assets under management grow, their performance dwindles. Many big hedge funds (and private equity funds) become asset gatherers, collecting 2% on huge assets. When you see more marketing personnel than investment professionals visiting you, pull the plug fast!

Moreover, as I have stated above, most hedge funds are charging alpha fees for leveraged beta. You would be surprised to find out how easy it is to replicate most hedge fund strategies using a few futures contracts. A buddy of mine in Montreal has successfully done so and his replication is better than anything I've seen from the big investment banks or academic "gurus". He uses this to gauge external managers, making sure they're delivering true alpha. He has traded many of these strategies so he knows the kinks of replicating them.

As for the "war on fees", I highly doubt the top multi-strategy and single strategy hedge funds will lower their fees but if enough pressure comes from institutions, they might consider it. And clawbacks should be imposed on managers who experience huge drawdowns, wiping out previous years' performance. The same goes for pension fund managers who make reckless bets with other people's money and then fall back on four-year rolling returns when it comes time to get their big bonus!

Finally, I like what the Ford Foundation is doing, focusing on smaller, up-and-coming hedge funds. I've said it before, in the new era of investing, small is beautiful. Far too many pension funds go with "brand name funds" because they worry about reputation risk. Do your due diligence, but don't be afraid to take a chance on smaller hedge funds that are managed by bright people with experience. If you need some help, I'll be glad to point you to the right direction.