Hedge Funds: Overpriced, underperforming

 25 May 2016

The hedge fund industry, which promised stellar returns in exchange for hefty fees, has ballooned over the past decade thanks to pension funds. Now institutional investors are taking a second look at the costs. By John Authers and Mary Childs

It was the shot heard around the hedge fund world. After the New York City Employees’ Retirement System decided to cash all its investments inhedge funds, Letitia James, the city’s public advocate, delivered a message to the industry straight out of Occupy Wall Street: “Let them sell their summer homes and jets and return those fees to their investors.”

Hedge funds, she said last month, “believe they can do no wrong, even as they are losing money”. If they truly cared about New York’s pensioners, “they would never charge large fees for failing to deliver on their promises”.

New York City’s investment in hedge funds - $1.5bn in well-known firms such as DE Shaw and Brevan Howard - does not matter much for an industry that manages $3tn of assets. But worryingly for hedge funds, Nycers’ decision appears to be part of a trend. According to Chicago-based Hedge Fund Research, pension funds and other big institutions now account for only 43.1 per cent of hedge funds’ assets, from 47 per cent three years ago. The reasons for moving their money mix populist politics - many are enraged by the fortunes that hedge fund managers can amass on the back of high fees - with disappointment in their performance.

“Let’s face it: if you go back to the 1990s, hedge funds delivered something very special: high returns or very differentiated returns that you could not get elsewhere, and that is what hedge fund investors have been looking for,” said Neil Chriss, founder of Hutchin Hill Capital, a fund with more than $4bn in assets that caters for big institutions. “The problem is, since the crisis, a lot of hedge funds have not been delivering. Returns have been mediocre,” he told the Milken Conference this month.

Flows of money from big institutions have transformed hedge funds, which were once primarily a vehicle for rich families. Today, large pension funds account for about a quarter of the money managed by hedge funds. Since the market hit its post-crisis bottom in March 2009, passive, low-cost equity fund investors have thrived while hedge fund returns have underperformed the S&P 500 by 51 percentage points.

The first of the big institutions to openly split with hedge funds was the California Public Employees’ Retirement System, the world’s largest public pension scheme. Calpers announced 20 months ago that it was scrapping hedge funds from its portfolio to reduce costs and complexity. At the time, many thought it would trigger a wave of redemptions, but with public boards tending to be deliberative, it is only now that the wave seems ready to break, hedge fund managers say.

In New Jersey, legislators are considering a proposal to withdraw all alternative investments from the state pension fund. Massachusetts is cutting back its pension fund holdings in alternative investments, which include hedge funds, private equity and venture capital, and pressing hedge funds to reduce their fees. Illinois is preparing to take similar action. Even big insurers like AIG and MetLife have cut back on hedge funds, as have some of Europe’s biggest pension funds.

“The hedge fund community has had reduced and in some cases negative returns, and with high fees you are seeing a re-evaluation of how you’re going to allocate your money,” Larry Fink, chief executive of BlackRock, recently told CNBC.

The famous flame-outs

Should this continue, it will mark the reversal of a decade-long investment trend. Hedge funds’ success in generating gains during the 2000-02 dotcom crashlured many institutions to invest in them for the first time. The success of university endowments - led by Yale, which used investments in hedge funds and other alternatives to generate returns of 13.9 per cent annually for two decades - prompted many institutions to dive into the sector.

“In 2005, the number of times Yale and Harvard were mentioned [as a model for other institutional investors] was incredible,” says Amin Rajan, chief executive of Create-Research, and an expert on the fund management industry. “But they had the governance and the skills to go after risky asset classes. Big pension plans didn’t.”

More recently, hedge funds started to look attractive after US markets rebounded from their post-crisis lows in 2009. With bonds and equities, the traditional staples of pension fund port- folios, both looking expensive, hedge funds appeared to be one of the few viable options. The hope was that hedge funds would generate strong returns while also helping to manage risks by using strategies that were not correlated with the stock or bond markets.

The effect has been transformative for the hedge fund industry. Entering 2000, there were 3,102 hedge funds managing $456bn, mostly for wealthy families, according to HFR. This year, it counted 8,474 funds managing $2.89tn, mostly for institutions.

Against such growth, the exit looks like more of a trickle than a flood. Investors withdrew $1.5bn in the fourth quarter of last year, accelerating this year to $15bn, according to HFR. High-profile flame-outs in companies championed by hedge funds, including Valeant, Allergan and SunEdison, have not helped their reputations.

But many fear that worse is to follow. Daniel Loeb of Third Point, one of the most powerful hedge fund managers, says the first quarter was “one of the most catastrophic periods of hedge fund performance that we can remember since the inception of this fund”.

He says: “There is no doubt that we are in the first innings of a washout in hedge funds and certain strategies.”.

The hedge fund market is more crowded than when industry pioneers such as George Soros, Julian Robertson and Paul Tudor Jones made their names. With so many assets and so many funds, beating the market becomes harder. Exploiting a market anomaly or scouting out a stock poised for a bounce makes less difference to the performance of a big institution than a hedge fund with a handful of wealthy clients. And inevitably the skill and quality of the people involved in hedge funds has been diluted.

As Mr Rajan puts it, there is a Darwinian process at work. Hedge funds that lack the skill to add value are being slowly forced out of business.

“Maybe 20 years ago, projects involving leveraged buyout funds did much better than the general stock market, but all the excess returns have been competed out,” says Jeff Hooke,a consultant to the New Jersey Public Pension Coalition attempting to force the state to divest from all alternatives. “There’s just too much competition.”

Negotiating fees

The trend is not all in one direction, however. US endowments, which are hugely influential because their long-time horizons allow them to experiment, slightly increased their allocations to hedge fund managers last year. So did the similarly influential sovereign wealth funds. According to Preqin, a research group, the proportion of SWFs investing in hedge funds has held steady at 32 per cent, while the proportion investing in private equity - another alternative asset class under fire over fees - has risen from 47 per cent last year to 55 per cent this year.

Indeed, several big investors have boosted their exposure to hedge funds. Finland’s state pension scheme plans to invest another $500m this year, and the State Universities Retirement System of Illinois is jumping in with $500m for its first hedge fund allocation.

The actuarial consultants, who wield huge influence over how pension funds deploy their money, continue to recommend enthusiastically buying into hedge funds. “The key is that they are structured to protect capital,” says Deb Clarke, Mercer’s global head of investment research. “The danger is that pension funds move into beta [passive funds that track equity indices] at the wrong time and miss the point where idiosyncratic hedge funds should deliver returns.”

The critical factor keeping institutional money in hedge funds may be the sheer lack of anything else in which to invest. As Ms Clarke puts it: “Plainly people want something different from equities and bonds - bonds are expensive, and equities are not cheap.”

Yogesh Dewan of Hassium Asset Management, which advises family offices on investments and is strongly critical of hedge funds, says they have benefited from quantitative easing and other tactics employed by central banks.

“I suspect hedge funds are doing OK because interest rates are so low,” he says. “What would usually go into fixed income assets doesn’t really want to go into fixed income. And everyone thinks they can find that brilliant manager.”

Then there is the emotive issue of fees, which are typically referred to as “2 and 20” - a 2 per cent fee levied on assets, regardless of any performance, plus 20 per cent of fund profits. Such fees are far higher than those charged by mutual funds or other options open to large pension managers.

With returns coming down, such fees look ever harder to justify. Many institutions are losing patience.

“I see the herd mentality among hedge funds every day,” said Roslyn Zhang, managing director of fixed income and alternatives at one of China’s SWFs, China Investment Corporation, at SkyBridge Capital’s annual meeting in Nevada this month. She cited the popular idea to short the Chinese currency. “They spend two seconds on this theme, and they put on the trade. We pay two and 20 for treatment like this. I am reflecting [that] maybe we are not making the right decision.”

While hedge funds do not advertise this, their fees are generally negotiable. This is particularly true if the client is a large institution with plenty of money to invest, or if the investor is willing to commit their capital for a longer period of time. Ray Nolte, chief investment officer of SkyBridge, which manages a fund of funds, says paying less in fees is their “job on behalf of investors”. It has negotiated the average fees it pays to about 1.3 per cent for management and an incentive fee of less than 15 per cent.

“Performance numbers on an absolute basis are coming down, so fees on a percentage have actually gone up,” he says, and “managers are waking up” to the fact that the days of 20 per cent returns are over.

However, Mr Rajan of Create- Research suggests that cutting fees may not resolve hedge funds’ problems.

“The immediate cause, fees, is appealing and grabs attention,” he says. “It means you didn’t make a bad choice, you got ripped off. But the main reason is that the hedge funds failed to deliver what it said on the tin.”

New Jersey

Criticism grows over asset allocations in $79bn pot

Should New Jersey keep 35 per cent of its $79bn pension fund in hedge funds and private equity, or sell up and return to a traditional model of only stocks and bonds, as a coalition led by unions wants?

The critics’ main argument: hedge funds are not worth the money. “The costs are exorbitant,” said Philip Murphy, a former head of Goldman Sachs’ Frankfurt office and a Democrat who is in the running to be New Jersey’s next governor . He has complained that “fees and performance bonuses paid to alternative managers have totalled roughly $1.3bn” over the past two years, while it costs “roughly 30 times as much to manage the 35 per cent of the portfolio that is invested in alternatives as it does to manage the 65 per cent in traditional investments”.

New Jersey’s alternative assets programme involves investments in 53 separate hedge funds, according to its official report as of the end of January, and more than 100 separate private equity funds. New Jersey’s treasury says it has enjoyed good performance. Since 2000, it has managed an annualised return of 5.45 per cent, compared with 4.85 per cent in its benchmark of 60 per cent in global equities and 40 per cent in bonds.

Its performance is also slightly ahead of the average for large public pension funds. The state’s investment council contends that “a diverse portfolio, including hedge fund investments, mitigates risk and produces the best returns for beneficiaries over a substantial period of time”.

But Jeff Hooke, an investment banker with Focus who is working on the case for the New Jersey Public Pension Coalition, pointed to the state’s analysis of the returns that would have been generated over the past 10 years by the new asset allocation proposed by the critics, all indexed, which would include US and non-US stocks and bonds, and some US real estate investment trusts. Over the 10 years to the end of December, this formula would have made 6.25 per cent a year - albeit with noticeably higher volatility - against the 6.08 per cent that the pension fund realised.

“They burnt through those fees to achieve nothing except less transparency and liquidity,” Mr Hooke says. John Authers

Speed read

Rich on retirement Pension funds account for about 25 per cent of the total money managed by hedge funds

Too pricey Calpers, the world’s largest public pension, exited hedge funds in 2014 due to complexity and costs

A trend? Now others, including in New Jersey, Massachusetts and Illinois, are considering ditching hedge funds

Copyright The Financial Times Limited 2016

(c) 2016 The Financial Times Limited