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Pension Funds Need To Stay Out of the “Bargain Bin” When Shopping For Hedge Funds


More than ever, pension funds are negotiating fees with hedge funds in an effort to lower the expenses associated with those investments.

That sounds like a wise course of action. But a new column in the Financial Times argues that pension funds need to stop shopping in the “bargain bin” for hedge funds—because the hedge funds that are willing to negotiate fees are also the ones who deliver lackluster returns.

From the Financial Times:

With many pension funds facing deficits, and needing investments that will generate high returns, the promise of hedge funds has an obvious appeal.

The problem is, like the star chef, the small number of hedge funds that have made staggering amounts of money for their investors over several decades already have too many clients and are closed for business.

Among these are Renaissance Technologies’ Medallion Fund, founded by the mathematician James Simons, which has long been all but shut to new money, and Seth Klarman’s Baupost Group, which last year returned $4bn to clients and has a highly select number of investors.

At the same time investors in hedge funds, such as pension managers, are loath to pay high fees for their services, and must enter into tough negotiations to bring these fees down. This makes sense.

But few of the handful of truly top tier hedge funds have any need to lower their fees for new investors and tend to politely show such requests to the door.

Mediocre hedge fund managers on the other hand cannot afford to be so dismissive, and are more than happy to gather more assets to play with.

The outcome is that many pension funds end up forcing themselves to shop in the hedge fund equivalent of the reduced aisle in a supermarket. They should stop. At the root of this problem is the flawed thinking that a large number of investors have been either seduced into, or institutionally obliged to believe in: the idea that hedge funds constitute an “asset class” all of their own, distinct from other types of active fund management.


Wholesale shopping for hedge funds is a bad idea. Instead of deciding to bulk invest in hedge funds as a questionable means of diversification (the HFR index shows the majority of hedge funds have underperformed the S&P 500 while being correlated to it), investors should only seek out the select few.

And if the best are closed to new investment they must find something else to do with their money.

The author puts the situation in context by comparing hiring a hedge fund to hiring a caterer. From the column:

You are planning a party and have decided to hire a caterer. A trusted friend has recommended two of the best in the city. One is a famous chef who has won numerous awards for his cooking, and another is a younger caterer who previously worked for one of the best restaurants in the world.

You call them both, only to have second thoughts. The first, the famous chef, is simply too busy with existing work to help you.

The other is unbelievably expensive, costing at least double what a regular caterer would charge. But you need your guests to be fed, so you look for an alternative option. You find a cheaper company on the internet and book them.

Come the party the food arrives late. When you taste it, the hors d’oeuvres are stale and the wine tastes like biro ink. Embarrassed and enraged, you mutter under your breath about the money you have wasted, vowing to never hire a caterer ever again.

This flawed thinking resembles the way too many institutional investors select hedge fund managers.

Pension360 has previously covered studies that suggest problems with the way pension funds select managers.


Photo by Gioia De Antoniis via Flickr CC License

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