One major concern around the growing use of hedge funds is that the universe is proliferating so fast that finding opportunities to generate alpha are diminishing and many managers are on a band wagon of charging exorbitant fees for beta returns rather than the alpha they purport to be chasing.
The average annual base fee for hedge funds is between 1 per cent and 2 per cent of the capital committed plus a 20 per cent performance fee. If the investor chooses to use a fund of hedge funds then an additional layer of 1 per cent annual base and 10 per cent performance fee is added.
A recent study by Watson Wyatt revealed that pension funds are paying on average 50 per cent more in fees than they were five years ago, with average fees around 110 basis points compared with around 65 basis points in 2002. Hedge funds were named as one of the big culprits contributing to these rising fees.
“We strongly believe that managers should be compensated for a job well done, but fees are too high for the value they currently represent, particularly if we are moving to an environment in which market returns are lower,” the report says, adding that “under this scenario 95 per cent of the alpha is paid away in fees”.
Traditionally, hedge funds have been able to charge extremely high fees because in the early days of hedge fund investing those fees came on the back of 15-20 per cent per annum returns. The cut is more painful now that hedge fund returns routinely come in at around 6-7 per cent per annum.
“Many funds of hedge funds are marketed at 2 per cent plus performance fees, but this then produces only a marginal return over cash, and this is just not worth it,” says Andrew Wilson, head of investments at Towry Law. “As a rule, we’re not happy to pay a performance fee for funds of hedge funds, unless it is offset by a reduction in the AMC [annual management charge].”
In recent years investors assumed they were paying these fat fees to reward manager skill, but in many cases they were mistaken, and the main driver of returns was the strength of the equity markets.
Some consultants suggest that fund managers should set ‘hurdle rates’, such as Libor or Treasury bill rates, that fairly closely reflect long-term beta exposure so that managers would collect fees only on performance above a pre-determined benchmark.
“Performance-related fees are increasingly common across all management areas and I’m comfortable with the concept but one solution is that first the fund should make Libor or even outperform it before performance fees cut in,” says Robert Howie, head of European funds of hedge funds research at Mercer Investment Consulting. “Funds of hedge funds are expensive – the best ones are justified and add value but performance fees can be 10 per cent, which is too high.”
Managers might also consider different fee structures depending on the investment strategy, largely basing the level on whether the strategy is targeted at beta or alpha. Investors are now beginning to be much more aware of alpha and beta in their portfolios and often run a range of strategies within their overall portfolios that explicitly focus on one or the other.
Direct investing
A more reactive response to the issue of exorbitant fees has been direct investing. “I still see the fund of hedge funds as the pricing conduit for most clients and the best ones have track records that prove value for money but increasingly there is a place for direct investing,” says Mr Howie. “Hedge fund investing is now mainstream and the bigger and more sophisticated clients are looking to supplement it with direct investing because so many hedge funds are now of institutional quality and there is not a lot of difference between these funds and top quality names.”
But the funds of hedge funds argue that what they add to the process is very important, and never more so than in the current market uncertainty.
 | “Pre-investment due diligence is labour intensive,” says Graham Martin, managing director (Europe) of Optima, a fund of hedge funds with a 20-year track record, and he stresses the importance of the background checks and due diligence, right down to checking where the fund’s assets are located and which prime brokers it uses. |
As an example, Mr Martin cites a report Optima clients can currently see on request that shows the consolidated cash exposure of the funds to any of the big banks. He says that there have been instances where assets have not been where they’ve been told they would be, or for a hedge fund to claim it has been audited by a certain accountant when it has not. More often Optima will decline to invest owing to less deliberate attempts to mislead, however, such as a fund that calls itself multi-strategy which in reality has all its investments in one area.
“Investors shouldn’t take anything at face value,” Mr Martin says. “If factors don’t stack up, then we don’t invest. Our job is to understand how managers are making their money and to try and avoid the Amaranths of this world.”
“To pick hedge funds directly is dangerous unless you have an absolutely huge governance budget and a large number of staff to monitor the sub-funds,” says Chris Erwin, investment principal at Aon Consulting. “The average hedge fund has outperformed shares by a considerable margin both this year and last so to that extent there is a case for them. But with 25,000 hedge funds, while most are in positive territory this year, it is difficult to generalise.”
“The average fund of hedge funds will contain eight different strategies and we believe this will diversify the risk,” adds Mr Erwin. “It is worth paying a premium for that.”
“Hedge funds often use sophisticated instruments and funds of hedge funds usually have models that deconstruct what the fund manager is doing. Further, in normal markets, new strategies come along on a regular basis, and by the time everyone gets to know about them they no longer work.” A fund of hedge funds will pick up that intelligence sooner than the non-specialist.
“These are the sort of times, when funds are changing their composition almost daily, and the additional fees should justify themselves in keeping out the funds that go wrong. A particular effect that has impacted all liquid asset types is that the diversification between different strategies has less impact in a bear market, but as we come out of this climate these differences will get bigger again.”
Disappearing funds
Hedge funds have been disappearing if not quite dropping like flies in the last few months. Carlyle Capital Corporation failed in March, unable to put up the extra collateral required when its mortgage investments lost value, while credit market fund Peloton Partners collapsed despite winning recent awards for best newcomer of last year.
“What we can be sure of is that the next risk in the market will be different to the last risk in the market, and so its important to keep as broad a perspective as we can,” says Mr Martin. “When things look at their worst, then that of course is the opportunity and we are picking managers with the experience to see the wood for the trees as the situation plays out.”
Another major factor in favour of funds of hedge funds is that they have the muscle to buy into the best managers. “There are funds of hedge funds out there that underperform the average hedge fund,” says Mr Wilson. “However if you can access the best fund of hedge funds, maybe two thirds of which is in funds closed to new business, then for clients the extra layer of fees will be small compared with the gains.”
“If a fund of hedge funds has done a good job, then he will have earned his fees, but it is very difficult to identify these managers,” says Nathan Gelber, chief investment officer at Stamford Associates . “The really successful hedge funds are closed, so the managers have to demonstrate their ability to fish in the pond of newer hedge fund propositions and there the choices are difficult. Like everyone else they are attracted to good recent numbers but these funds may not be able to repeat those numbers because they outgrow their founding entrepreneurial spirit and it is harder to deploy a large asset base.”
Greater risk control and transparency are also arguments that support the managed account structure. However, it is not always easy to persuade hedge fund managers to reveal their positions to the platform for the sake of transparency, which severely limits the universe of funds available to product structurers.
Like investable hedge fund indexes, managed accounts tend to underperform the general hedge fund universe because they are not representative of the very best the industry has to offer. The managers prepared to run parallel funds and meet their conditions will be those who most need the business. Further, the returns of managed accounts are often lower owing to the performance trade-off that comes with greater liquidity; they can’t mirror the underlying hedge fund’s ability to take illiquid positions and often have to trade more frequently, bumping up dealing costs.
Research from Cass Business School in London has shown that it is possible to replicate and even surpass hedge funds using mechanical futures trading strategies. In a study involving almost 2,500 funds of hedge funds, Professor Harry Kat showed that over the previous 15 years, synthetic funds would have outperformed real funds of hedge funds 82 per cent of the time.
These purely mechanical futures trading strategies can also be designed to generate returns with the same risk characteristics as funds of hedge funds, yet avoiding typical drawbacks of alternative investments, such as extensive due diligence, liquidity, capacity, transparency and style drift problems and possible regulatory problems – all without excessive management charges.
Professor Kat is one of many academics predicting a shift away from active management in alternatives over the next 10 years towards a passive approach, in the same way that indexing has captured perhaps 40 per cent of equity investing. On other hand, consultants and manager of managers say there is genuine and deep expertise out there in the hedge fund community, and that managers are swift to respond to market events.
Robert Howie, for example, says researchers at Mercer are having lots of conversations with fund of hedge fund managers and finding their insights into the market and their decisions to switch around their portfolios are perceptive and intelligent. “The top tier is impressive in their ability to respond quickly and in their resources to do research as the market evolves,” he says.
