Hurdles For Hedge Funds?
Hedge fund investors are catching up with their private equity peers. Five years after clients of leveraged buyout firms released a set of best practices for the industry, hedge fund clients are following suit.
The Teacher Retirement System of Texas and MetLife Inc. are among those that yesterday called on managers to produce “alpha,” or gains above market benchmarks before charging incentive fees in a range of proposals that address investing terms. Funds should also impose minimum return levels known as hurdle rates before levying the charges, said the Alignment of Interests Association, a group that represents some investors in the $2.8 trillion hedge fund industry.
“Some managers are abiding by the principals to some extent but we are hoping to move everyone toward industry best practices,” Trent Webster, senior investment officer for strategic investments and private equity at the State Board of Administration in Florida, said in a telephone interview. The pension plan, a member of the association, oversees $180 billion, of which $2.5 billion is invested in hedge funds.
Hedge fund managers, who are among the highest paid on Wall Street, have come under pressure from clients to adjust agreements since the 2008 financial crisis led to record losses for the industry. Traditionally, the firms have charged investors 2 percent of assets as a management fee along with 20 percent of profits as an incentive.
$75 Billion
As funds trail the Standard & Poor’s 500 Index for the sixth straight year, some clients have complained that managers still provide little information about their holdings and tie up their investors’ cash while lagging behind benchmarks. The California Public Employees’ Retirement System said in September it would divest its $4 billion from hedge funds after officials concluded the program couldn’t be expanded enough to justify the costs.
The investor group, known as AOI, was started in 2009 and more than 250 hedge fund clients, including foundations, insurance companies and firms that oversee money for the wealthy, have taken part in its meetings. The New York-based group’s steering committee, which includes Siemens Financial Services GmbH and the South Carolina Retirement Systems’ Investment Commission, has a combined $75 billion invested in the industry.
The Institutional Limited Partners Association, which represents private equity investors, released its original set of best practices in 2009. Typically, private equity firms comply with their guidelines, which include communication with clients and valuations.
Internal Funds
In addition to fees, the AOI principles address subjects including internal employee funds, hard-to-sell assets and governance. Some hedge fund managers and investors have contacted the group to endorse the principals since they were released yesterday, said Melissa Santaniello, a founding board member of the AOI.
“Over time, we expect dialogues between both parties to become more efficient,” she said.
The lawyer for billionaire investor Stan Druckenmiller in January wrote a paper pushing for changes in partnership agreements covering areas such as legal fees and the suspension of client withdrawals.
Druckenmiller, who produced annual profits averaging 30 percent for more than two decades, last year described the industry’s returns as a “tragedy” and questioned why investors pay hedge-fund fees for annual gains closer to 8 percent.
Linking Compensation
To better link compensation to longer-term performance, the AOI recommended funds implement repayments known as clawbacks, a system in which incentive money can be returned to clients in the event of losses or performance that lags behind benchmarks. The group said performance fees should be paid no more frequently than once a year, rather than on a monthly or quarterly basis as they are at many firms.
Management fees, which are based on a fund’s assets, should decline as firms amass more capital, the investor group said.
“We need good managers, not asset gatherers,” Florida’s Webster said. “The incentives are currently skewed.”
Hedge fund fees in the second quarter averaged 1.5 percent of assets managed and 18 percent of profits generated, according to the latest data from research firm Hedge Fund Research Inc. Some firms stick to the “2 and 20” model, while management fees of 4 percent and a 27 percent cut of profits are among the highest charged.
Lower Fees
“The industry continues to progress toward lower fees, and not just for large investors who lock up their capital for longer periods,” Webster said.
Firms should disclose their operating expenses to investors so they can assess the appropriateness of management fee levels, the group said.
“Management fees should not function to generate profits but rather should be set at a level to cover reasonable operating expenses of a hedge fund manager’s business and investment process,” the AOI said.
Fees should fall or be eliminated if a manager prevents clients from withdrawing money, according to the group.
After investors pulled several hundreds of billions of dollars from hedge funds in 2008 and 2009 because of losses, the discovery that managers had invested in illiquid assets and news of conman Bernard Madoff’s pyramid scheme, funds made efforts to appease investors. Many started providing increased information about holdings, created segregated accounts so clients could monitor trades and implemented easier terms when they want to exit funds.
Internal FundsI applaud the initiatives of the Alignment of Interests Association and recommend you all take the time to read the range of proposals they're recommending.
The AOI said in its proposals yesterday that managers should disclose employee-only funds that aren’t available to outside investors. This year BlueCrest Capital Management LLP, run by billionaire Michael Platt, had its ratings on its funds reduced by two industry consultants for not providing sufficient information about a proprietary fund.
The AOI said that funds should notify clients of non-routine inquiries by legal or regulatory bodies. It also proposed that fund employees should in most circumstances face the same withdrawal restrictions as outside investors and that managers should tell clients of any “pending material redemptions by insiders with sufficient time for outside investors to redeem on the same date.”
Hedge fund boards should be made up of a majority of independent directors, with at least one primarily representing the interests of outside investors, according to the group. Managers should allocate hard-to-sell investments to segregated accounts at the time the assets are purchased, and clients should have the choice to opt out of them, the AOI said.
Hedge funds returned an annual average of 3.5 percent in the five years through Oct. 31, as measured by the Bloomberg Global Aggregate Hedge Fund Index, compared with almost 17 percent for the S&P 500 Index of large U.S. stocks and 4.2 percent for the Barclays U.S. Aggregate Index for bonds.
In particular, a minimum hurdle rate similar to that of private equity but not as high (T-bills + 300 basis points?) because hedge funds are more liquid alternative investments, should be mandatory. Also, as I've discussed plenty of times on this blog, it's ludicrous paying 2% or even 1% management fee to a multi billion dollar hedge funds because it incentivizes these funds to focus on asset gathering, not performance.
In my comment on oversized hedge fund egos, I referred to Ray Dalio at Bridgewater and wrote:
There is something else that irks me a lot. All these overpaid hedge fund gurus collecting huge fees on the billions they manage have catapulted into the Forbes' list of billionaires. Dalio is now the richest person in Connecticut with an estimated net worth of $14.3 billion (do the math...when managing over $100 billion, that 2% management fee really kicks in, making Dalio obscenely rich). Kudos to him, he's come a long way since starting his fund in a small Manhattan apartment in the mid-70s.And it's not just Ray Dalio. I can list a lot of managers, including the fallen bond king, who have become über wealthy not just on their performance but mostly on their uncanny ability to raise assets. In the case of hedge funds managing billions, it's simply indefensible to pay them management fees for turning on the lights. Institutional investors should scrutinize their operational costs and set the management fee accordingly.
But when a hedge fund manager's net worth is roughly 10% of the assets he manages, I start worrying that his ego will get the better part of him and whether he's spreading enough of his enormous wealth to all his employees. What else worries me? As I've stated before, that 2% management fee should be scrapped for alternative investment funds managing billions because it turns most funds into large, lazy asset gatherers (not the case for Bridgewater but this is a legitimate concern).
In fact, to make things simple, I would set a flat nominal management fee of 25 basis points (performance fee once they clear the hurdle rate) for all funds managing over a billion dollars. That would be my recommendation for hedge funds and private equity funds and it would ensure real alignment of interests. As far as clawbacks, they should be standard at all funds, including pension and mutual funds.
In this historic low rate environment, institutions invest in hedge funds as an alternative to bonds, so in theory these funds should be delivering uncorrelated alpha. In layman's terms, this simply means hedge funds should be delivering absolute returns that don't swing with equity and bond markets.
In practice, the majority of hedge funds stink and are full of beta. This is why they're closing like it's 2009 and why many investors are giving up, in many cases wrongly comparing their performance to the S&P 500 and coming to the conclusion that it's better indexing their money than invest in underperforming hedge funds delivering sub-beta returns.
When CalPERS dropped a bomb back in September, divesting from hedge funds, they received a lot of flack for this decision. I defended this decision based on their rationale and think that program was never well managed and it became too complex, too costly and not worth the effort to maintain. CalPERS also cited the small percentage of hedge funds in their portfolio as a reason to divest.
Other pension funds that have invested a small percentage of their assets in hedge funds maintain their allocation. In my comment on the Caisse souring on debt, I embedded a clip where Michael Sabia, the Caisse's CEO, explained why even though hedge funds make up roughly 1% of assets, they still invest in them to gain insights from the top money managers in the world (knowledge leverage).
But the difference with the Caisse and Ontario Teachers is they have a group of dedicated professionals that have been investing in hedge funds for a very long time. And at Ontario Teachers, Ron Mock has learned quite a few harsh lessons over the years, which is why after the crisis, most of their hedge fund investments are now on a managed account platform set up at Innocap. This means they receive real time information on where their managers are investing and what risks they're taking and can pull the plug at any time.
One thing that struck me in the AOI proposals was that both the Caisse and Ontario Teachers are not part of the Steering Committee:
- Afred P. Sloan Foundation
- Employees’ Retirement System of Rhode Island
- Employees Retirement System of Texas
- Fire & Police Pension Association of Colorado
- MetLife
- OMERS Capital Markets
- San Bernardino County Employees’ Retirement Association
- Siemens Financial Services GmbH
- South Carolina Retirement Systems' Investment Commission
- State Board of Administration of Florida
- Teacher Retirement System of Texas
- The University of Texas Investment Management Company
- University of Toronto Asset Management
Let me end by stating that I'm not against hedge funds and think that it absolutely makes sense to invest with the best alpha managers around the word, even if it's a marginal investment. But to do this properly, you need a dedicated team that knows how to perform operational, investment and risk management due diligence and you need a process to share valuable insights on a timely basis with internal pension fund managers (this was part of my job when I was investing in directional hedge funds at the Caisse before joining PSP).
And if you don't invest in hedge funds, take the time to read my quarterly comments on top funds' activity going over what they bought and sold in the previous quarter. It's far from perfect but it provides you with a glimpse of where top managers are taking equity risks (tread carefully, even the best of the best get clobbered in these crazy markets).
Once more, I welcome your feedback either here or on Seeking Alpha and kindly remind all the institutions paying 2 & 20 to big, swinging hedge funds that you should subscribe to this blog at the top right-hand side and support my efforts in providing you truly independent advice.
I can say the same thing to a lot of hedge funds that are also gaining valuable insights reading my blog. If you need help bolstering your lousy performance, read my comments on preparing for a deflationary boom and whether central banks are panicking. And for Pete's sake, don't be cheap bastards, I can't stand cheap people!
Below, a discussion on whether Carl Icahn caused a private equity bubble. I don't blame Icahn for any PE bubble as there are plenty of dumb public pensions chasing deals at all cost, but there's no doubt activist funds are getting more active and this is pushing valuations higher and making it harder to find good deals.
And Bloomberg’s Mike Regan discusses why it's been a tough year for hedge funds with Julie Hyman on "Street Smart." I'm sick and tired of poor, lame excuses. The real reason why hedge funds are underperforming is most of them stink and they keep reading the macro environment wrong!
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