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How Hedge Funds Keep Winning Clients Despite Prolonged Slump

The average hedge fund has returned 5.1 percent annually over the last 10 years, according to HFR, a hedge fund data firm.

The investment vehicle has even been outperformed by many “balanced” mutual funds. But the flow of clients to hedge funds isn’t slowing down, which begs the question: how do hedge funds keep winning clients when performance is so paltry?

Gregory Zuckerman dives into that question and comes up with some interesting answers:

How to explain the paradox of a superhot investment vehicle producing ice-cold returns for clients more smitten than ever?

Part of the reason for the lackluster returns: Hedge funds don’t have the same incentive to hit home runs they once did. They can charge management fees of close to 2% of assets. As the industry swells, many managers can get rich just keeping their funds afloat. A decent performance and no huge loss will do just fine.

The head of one of the world’s largest funds recently told me his challenge is to get his traders to embrace more risk, not less. Hedge-fund traders are more conservative because it’s in their self-interest to be more conservative.

There are similar ways to explain why hedge-fund clients aren’t up in arms. Some see an expensive market and want to be in a vehicle that should do better in a downturn.

But others simply want to keep their jobs. Recommending low-cost balanced mutual funds can be hard to justify if one has a well-paid job at a big pension fund or endowment. Properly allocating money to hedge funds is seen as a bigger challenge. Investing in brand-name hedge funds instead of big stocks once might have put an institutional investor’s career on thin ice. Today, avoiding popular hedge funds to wager on the market is seen as a risky career move.

Preqin: Hedge Funds Grew More Than Any Alternative in 2014

Hedge funds experienced the most asset growth of any alternative asset class in 2014, according to a Preqin report.

Despite scrutiny over low returns and high expenses, investors put more money into hedge funds in 2014 than private equity, infrastructure or venture capital.

Chart: Negotiating Hedge Fund Expenses

A recent survey asked investors: have you negotiated a cap on direct expenses with your hedge funds managers? This chart, above, displays the results.

The 2013 version of the same survey found that fees were the biggest obstacle for institutional investors looking to put money in hedge funds:

1st chart credit: Ernst & Young 2014 survey

2nd chart credit: Ernst & Young 2013 survey

Newspaper: Kentucky Pension Officials Have “Forgotten Whom They Work For”

Pension360 has covered the push in recent weeks by several Kentucky lawmakers to make the state’s pension system more transparent.

The secrecy surrounding Kentucky’s pension investments is well documented, and the issue has even spurred a lawsuit.

One Kentucky newspaper wrote Tuesday that pension officials have “forgotten whom they work for” – the public.

The Herald-Dispatch editorial board writes:

Apparently, [pension officials] are in sore need of a reminder that they are employed to serve the public and, as such, how they conduct their business should be open to scrutiny by the public.

[…]

Some want to know more about how the pension funds operate. As of now, Kentucky law allows the systems to operate partly shielded from the public. For example, the public is not allowed to know how much is paid out to individual retirees, nor does the systems have to reveal how much they pay out in fees to individual hedge fund managers who are investing the pension money and other external investment advisers. But we do know they are paying out hefty sums, to the tune of $55 million last year to investment management firms.

The public has a right to know both of those aspects of the pension system.

[…]

Private investment companies doing business with governments also must realize who’s paying their fees and that accountability comes with gaining contracts with government-run pension systems. The excuse put forth by Kentucky officials and others about how revealing the investment companies’ contracts would reveal “trade secrets” doesn’t hold up. That argument simply is not sufficient to conceal how much money they are making from taxpayers and the public employees who contribute to the systems. Until that information is revealed, the public has no way to know whether it’s getting its money’s worth from those companies.

A couple of Kentucky lawmakers plan to introduce bills next month that would require the pension systems to use the state’s competitive bidding process, disclosing terms of the deals and the proposed management fees, as well as shed more light on the pension payouts to the state’s lawmakers. All of those requirements would be steps in the right direction and should be put into law.

Read the full piece here.

Pennsylvania Not Cutting Hedge Funds Despite State Auditor’s Skepticism

CalPERS’ decision to pull out of hedge funds is having a ripple effect across the country.

On Wednesday, Pennsylvania Auditor General Eugene DePasquale released this skeptical statement on the state pension system’s hedge fund investments:

“Hedge fund investments may be an appropriate strategy for certain investors and I trust that SERS and PSERS weigh investment options carefully,” DePasquale said in a statement. “But, SERS and PSERS are dealing with public pension funds that are already stressed and high fees cost state taxpayers more each year. I support full disclosure of hedge fund fees paid by our public pension funds and we owe it to taxpayers to ensure that those fees do not outweigh the returns.”

Spokespeople for both the State Employees Retirement System (SERS) and the Public School Employee Retirement System (PSERS) have now responded. The consensus: the pension funds will not be cutting their hedge fund allocations.

From Philly.com:

SERS has no plans to cut hedge funds further. “Hedge funds play a role in our current board-approved strategic investment plan, which was designed to structure a well-diversified portfolio,” SERS spokeswoman Pamela Hile told me. With many more workers set to retire, hedge funds (or “diversifying assets,” as SERS prefers to call them) combine relatively steady returns with low volatility “over varying capital market environments.” By SERS’s count “difersifying assets” are now down to $1.7 billion, or 6% of the $28 billion fund and returning 10.7% after fees for the year ending June 30, up from a 10-year average of 7.4%.

Says PSERS spokeswoman Evelyn Williams: “We agree with the Auditor General that hedge funds are appropriate for certain investors. Not all investors can or should invest in hedge funds. Clearly CALPERS reviewed their hedge fund allocation and acted in their own fund’s best interests.

“PSERS also sets our asset allocation based on our own unique goals and issues. We do not have any immediate plans to change our hedge fund asset allocation at this time… PSERS’ hedge fund allocation provides diversification for our asset allocation and is specifically structured so it does not correlate with traditional equity markets…PSERS hedge fund allocation has performed as expected and provided positive investment returns over the past fiscal year, one, three, and five years.”

SERS allocates 7 percent of its assets, or $1.9 billion, towards hedge funds. PSERS, meanwhile, allocates 12.5 percent of its assets, or $5.7 billion, towards hedge funds.

Photo by TaxRebate.org.uk

CalPERS To Ditch Hedge Funds Entirely

CalPERS has been reviewing its hedge fund strategy for months, and that review initially led to a 40 percent pullback from hedge funds.

But now the California pension fund has announced plans to cut the cord from hedge funds entirely, pulling out $4 billion from 30 hedge funds. From Reuters:

Calpers, the largest U.S. pension system, said on Monday it has scrapped its hedge fund program and will pull about $4 billion in its investments from 30 such funds.

The $300 billion California Public Employees’ Retirement System said it would exit the program, known internally at Calpers as the Absolute Return Strategies (ARS) program, to reduce “complexity and costs.”

“Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale … the ARS program doesn’t merit a continued role,” Ted Eliopoulos, Calpers interim chief investment officer, said in a statement.

Calpers said it will spend the next year exiting 24 hedge funds and six hedge fund-of-funds, “in a manner that best serves the interests of the portfolio”.

The decision to exit the hedge fund program culminates a search, Calpers says, that began after the 2008 financial crisis to ensure it was “less susceptible to future large drawdowns.”

Calpers has signaled waning enthusiasm for the asset class for some time. It started a review of its hedge fund program this year and has said for months it would cuts its allocation to hedge funds.

CalPERS overall portfolio returned 18.4 percent last year. But it’s hedge fund portfolio earned only 7.1 percent, while racking up $135 million in fees and expenses.

Video: The Evolution of Allocating to Hedge Funds

Bloomberg TV sat down with Agecroft Partners founder Don Steinbrugge to talk about pension fund investments in hedge funds and what it means for both sides.

Other topics touched: hedge funds facing the reality of having to settle for less fees and more transparency to play ball with pension funds, and paying pension fund staff market rates. Watch the video here:

Pension360 has also covered the recent counter-evolution of hedge fund allocation, a trend in which many pension funds across the country are pulling back their hedge fund investments.

CalPERS, for instance, plans to pull back 40 percent of their hedge fund investments in the near future.

Photo by Simon Cunningham via Flickr CC License