Bloomberg reported on Wednesday that hedge fund investors are finally getting serious about reining in hefty fees when investment performance is underwhelming, particularly since that has been the case for the industry as a whole in recent years. But regular readers of this blog can tell how serious this initiative really is from the very first paragraph of the article:
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.
If the deferential attitude of limited partners towards private equity general partners is the model for toughness, hedge funds have nothing to worry about.
The very fact that this proposal has been so slow in coming is another big tell about how willing investors are to demand a better deal. Consider the next paragraph in the story:
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.
It is hardly a secret that most hedge funds don’t generate alpha, or manager outperformance. CalPERS acknowledged that in 2006, pointing out that hedge funds had underperformed the stock market for the preceding three years. The giant California pension fund nevertheless rationalized staying with hedge funds because their return profile differed from that of other asset classes, offering useful diversification. But the fact that the most the industry really produces was not alpha but “alternative beta” had been recognized by 2005, if not earlier. And it took CalPERS nearly eight years after its admission that hedge funds didn’t outperform (and thus their fees were not justified) to pull the plug on the strategy.
We’ve written about this issue from the very inception of this blog. For instance, from a March 2007 post:
Supposedly, the reason that sophisticated investors like pension funds and endowments pay 2% management fees and 20% upside fees (and sometimes more) to hedge funds and private equity funds (and higher-than-index-fund fees for long equity managers) is that they are buying “alpha,” which is the manager’s ability to beat the relevant market. (To be more precise, it’s the risk-adjusted return over a benchmark, also referred to as “excess return.”)
As we have discussed, the problem is that a lot of fees are being paid, but not a lot of alpha exists. In fact, the gap between expectations of hedge fund performance and actual performance has grown so large that the salesmen have come up with a new rationale: “synthetic beta.” You are not paying for alpha, you are paying for a very particular combination of market exposures.
The problem with that is there is no reason to pay a 2/20 fee structure for that. A customized exposure, no matter how exotic, could be designed and implemented more cheaply.
An article in the current Economist, “What’s it all about, alpha?” covers some of the same territory, namely the seeming lack of real alpha, the claims made for the virtues of specialized profiles (the article doesn’t use the term “alternative beta”) and the rise of hedge fund clones based on the view that a lot of hedge funds are charging a lot of money for strategies that can be replicated more cheaply.
The piece is more than a bit distressing, because it serves up arguments that are bunk. The first is that even if hedge fund’s attractive (or seemingly attractive) is simply making the right mix and match of market returns (or betas) that’s worth paying for.
Uh,no. Any investor in a hedge fund has other investments (unless he is a fool). Institutional investors like pension funds hire fund consultants to help them determine asset allocation (as in what markets to be in, meaning what combination of betas to buy, as in how much in domestic stocks, foreign stocks, domestic bonds, etc.). So any “beta mix” decision by a hedge fund could run counter to other investments being made. Put it another way: the hedge fund isn’t being hired to choose which betas to invest in. That’s someone else’s job.
Put it this way: when the Economist feels compelled to run interference for hedge funds, the matter at hand is hardly a state secret.
And it’s also clear long been clear that hedge funds have cost structures that are out of whack with the performance they could deliver. This from a February 2007 post, quoting FT Alphaville:
Transaction costs run to 4 per cent of the $1,300bn of hedge fund assets under management. Manager salaries and performance fees take another 4-5 per cent, meaning hedge funds need to generate average annual returns of close to 20 per cent to keep everyone (including their investors) happy. Yet the strategies employed to produce these returns are not necessarily sustainable.
Notice despite this fundamental problem, the assets under management in Hedgistan have grown, per the Bloomberg story, to $2.8 trillion. More money pouring into existing strategies is not a formula for better returns.
So given years of inaction in the face of a widely-recognized problem, what are we to make of the supposed show of resolve by this investor group known as AOI, which has $75 billion of hedge fund assets among its 250 members?
Admittedly, some of its ideas sound promising, such as requiring funds to disclose if they have in-house pools not open to outside investors, or if they are subject to non-routine regulatory inquiries. But their key proposals are around fees. As readers probably know from private equity, the devil for this sort of thing lies in the details.
One of this group’s Big Ideas is requiring funds to meet benchmarks before profit shares are paid out, meaning the famed prototypical 20% upside fees. And they do sensibly want those fees to be based on annual rather than monthly or quarterly performance (with more frequent fees, an investor could have a lot of performance fees paid out in the good periods more than offset by underperformance or losses in the bad ones, and not see a settling up until he exited the fund or it was wound up. Longer performance periods reduce the odds of overpayment for blips of impressive results). But private equity funds have long had clawbacks. Yet as we’ve discussed at length, those clawbacks are virtually never paid out in practice. One big reason is the way the clawbacks intersect with tax provisions that serve to vitiate the clawback. It would be perfectly reasonable for hedge funds to ask for provisions similar to those used by private equity funds, with those clever tax attorneys modifying them to the degree possible to make them work just as well, from the perspective of the hedgies, as they do for private equity funds.
Hedge fund investors also want management fees to scale more with the size of fund. Again, that exists now to some degree in private equity funds, with megafunds charging much lower management fees. But it isn’t clear how much the hedge funds investors will gain. Bloomberg reports that the average management fee in the second quarter of this year was 1.5% of assets. That’s lower than typical private equity fees, which according to Eileen Appelbaum’s and Rosemary Batt’s Private Equity at Work still averaged 2%, and for funds over $1 billion, 1.71%. And of course, the fact that hedge fund agreements are treated as confidential, just as private equity agreements are, impedes fee comparisons and tougher bargaining. If this group really wanted to drive a tougher bargain, they’d insist on having the contracts be transparent. That proposal is notably absent.
In keeping, the AOI also calls for better governance. We’ve seen how well that works from private equity land. “Governance” in private equity consists of an advisory board which is chosen by the general partner from among its limited partners. You can bet that the general partners choose the most loyal and clueless investors. The only way one might take oversight arrangements seriously is if these funds had far more independent boards, as is the case with mutual funds.
So while I would be delighted to be proven wrong, history says that there isn’t much reason to expect this effort to get tougher with hedge funds to live up to its billing. And with new investment dollars continuing to pour in despite mediocre performance (assets under management rose 13% in the last year, with roughly half the increase coming from new contributions/a>. As long as investors are putting more money into hedge funds despite dubious performance, there isn’t sufficient negotiating leverage to push for more than token reforms.