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With most hedge funds substantially underperforming the major stock market indices year after year since the 2008 financial crisis, it is only natural for hedge fund investors to expect some concession on the fees they pay to hedge funds. However, despite reports of some hedge funds offering to lower asset management fees, it appears that there are a lot of hedge fund investors who feel like they are paying too much for too little with their hedge fund investments. Bloomberg is quoting a large hedge fund investor as saying that 90 percent of hedge fund managers are overpaid relative to their true talent.

Unigestion Holding SA

Unigestion is a large hedge fund investor. The Switzerland-based asset management firm has approximately $16 billion in assets and invests $2 billion of them in about 60 hedge funds. Nicolas Rousselet, who is the head of hedge fund investments at Unigestion says nine out of 10 hedge fund managers are overpaid. He adds that management fees at hedge funds don’t reflect lower interest rates and fund returns.

Hedge funds typically charge 2 percent of assets as management fees irrespective of whether a fund makes or loses money in a financial year. During years of positive returns, hedge funds pocket 20 percent of the profit. For a large hedge fund investor such as Unigestion which has $2 billion in hedge funds, a 2 percent management fee would equate to payout of $40 million every year.

Explaining his frustration with the current fee structure Rousselet says, “The philosophy of the hedge-fund industry, as it should be, is to remunerate true talent. Fund managers should be remunerated when they perform. They should not be remunerated for doing nothing.” Rousselet adds that he prefers a different structure in which the hedge fund industry should either abandon the management fee or combine it with a hurdle rate that must be achieved before collecting incentive fees.

Investor Dissatisfaction With Fees Common

Unigestion invests in 60 hedge funds which gives a lot of credibility to its view that most hedge fund managers are paid more than they deserve. Such dissatisfaction has been felt among other large long term hedge fund investors also.  The largest US public pension fund, the California Public Employees’ Retirement System or Calpers is a well-known example of a firm disappointed with their hedge fund investments. It decided to make a significant cut of about 40 percent to its hedge fund allocation this year after weaker than anticipated returns on its hedge fund investments over several years forced a review of its costs associated with investing in hedge funds.

There are many portfolio advisers who share Unigestion’s view. Simon Lack, founder and portfolio manager of investment firm SL Advisors, says that across the hedge fund industry a lot of funds charge fees they don’t deserve. According to Michael Smith, who is the managing director at Global Endowment Management LP, most hedge funds aren’t worth paying 2 percent management fees and 20 percent performance fees.

Relevance to Job Market

This latest example of investor frustration with high fees adds to the thesis that hedge funds no longer enjoy the kind of clout they once had with investors. Even the continued increase in hedge fund assets is a result of a handful of large hedge funds capturing most of the money. With more and more hedge fund investors pressuring for changes to the traditional 2 and 20 fee structure, the net result is likely to be lower operating capital for many hedge funds. This will likely have a negative impact on the job market especially since many hedge funds are finding it difficult to meet targeted returns in the current market.

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Patience is wearing thin among some large public pension funds with regard to their hedge fund investment returns. Years of weak returns combined with high investment fees have forced a few prominent pension funds to consider reducing allocation to hedge funds. Among the pension funds planning cuts in hedge fund allocation include the largest US public pension fund, the California Public Employees’ Retirement System or Calpers, the School Employees Retirement System of Ohio and New Jersey’s State Investment Council. In addition, another pension fund that sought the advice of Warren Buffett on allocating large capital to hedge funds was told in no uncertain terms to choose index funds over hedge funds.

Calpers Mulling 40 Percent Cut

Calpers is a widely followed pension fund as it is the largest pension fund in the US. It had assets of approximately $301 billion at the end of its fiscal year ending June 30. Its return from hedge fund portfolio during the fiscal year was the lowest among all of its asset classes at 7.1 percent, well below the 25 percent return on its public equity investments.

As of June 30, Calpers had $4.5 billion representing 1.5 percent of its portfolio invested in hedge funds. Compared to a few other pension funds, this proportion of hedge fund allocation is quite small. Pension funds such as the School Employees Retirement System of Ohio and New Jersey’s State Investment Council have a much larger proportion of their assets invested in hedge funds. But smaller than anticipated returns on hedge fund investments over the last 10 years is prompting Calpers to consider cutting its hedge fund allocation by 40 percent. Calpers says it will make a formal recommendation to its Board in the fall.

Other pension funds cutting hedge fund allocation are the School Employees Retirement System of Ohio, which will reduce hedge fund investments to 10 percent of its assets in 2015 from its current 15 percent and New Jersey’s State Investment Council which is lowering its hedge fund investment limit to 12 percent from 12.25 percent of its overall portfolio.

Last year, the Los Angeles Fire and Police Pensions fund got out of hedge funds entirely after an annual investment return of only 2 percent over seven years. The fund had approximately 4 percent of its assets, amounting to $500 million, invested in hedge funds but fees paid to hedge fund managers accounted for 17 percent of its total fees.

Buffett Advises Against HF Investments

Another pension fund, the $20 billion San Francisco City & County Employees’ Retirement System is currently debating whether to allocate any capital to hedge funds. Its chief investment officer is making a pitch to allocate as much as 15 percent of the pension fund’s assets to hedge funds. One of the pension fund’s board members had his reservations about the significant hedge fund allocation plan and sought to get the advice of Warren Buffett on the matter. Buffett responded with a hand written note that read, “I would not go with hedge funds — would prefer index funds.”

David Kotok, the chief investment officer at Cumberland Advisors has deep expertise on advising public pension funds on their investments. He says that many pension funds that pump a large portion of their assets to hedge funds are underfunded and are on shaky financial footing.  Kotok adds that such funds are taking on more risks to improve their returns.

Relevance to Job Market

During the recent financial crisis in 2008, many hedge funds reported smaller losses than the overall market and some funds such as Pershing Square Capital Management and Paulson & Co even reported big gains. Such an outperformance during a time of market weakness prompted many pension funds to up their allocation to hedge funds.

But since 2009, hedge funds have consistently, and by a large margin, underperformed the market. As a result, it is not a complete surprise to see some pension funds lowering their hedge fund allocation. Verne Sedlacek, CEO of Commonfund which manages money for pension funds and endowments, says “We are seeing a little moving away from hedge funds, but so far it’s just on the margin.”

Recent data from BarclayHedge and TrimTabs Investment Research shows that hedge funds attracted approximately $83 billion in new capital during the first half of this year, the most since 2007. This suggests that despite concerns from certain investor classes, there is still interest among the broader investor community for hedge funds. And as such this planned pullback by a few pension funds likely will not negatively impact the job market.

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CalPERS Mulling Steep Cuts to Hedge Fund Investments

May 19, 2014

At a time when allocations to hedge funds are surging to record levels, one of the largest and widely followed pension funds is contemplating a significant reduction in its allocation to hedge funds.  According to a report by the newspaper Pensions & Investments, The California Public Employees Retirement System, commonly known as CalPERS, is planning […]

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