Dec. 18 (Bloomberg) -- Pennsylvania's 200,000 public employees are paying Morgan Stanley some of the money-management industry's steepest fees to get returns that aren't much better than yields on U.S. Treasury bills.

For the privilege of investing in the $2.6 billion Institutional Fund of Hedge Funds, the Pennsylvania State Employees' Retirement System gives up about 2 percent of assets and 20 percent of any profits to Morgan Stanley and the management firms it hires. The so-called fund of funds is supposed to reduce the risk of investing in hedge funds while beating stock or bond returns. Instead, Pennsylvania made 5.1 percent through September when it could have earned 3.6 percent on T-bills, the world's safest investment.

Securities firms will collect more than $1 billion in fees this year to keep clients such as the New Jersey and Philadelphia pension plans invested in funds of funds. Those who assumed that Goldman Sachs Group Inc.'s Global Tactical Trading LLC would provide the best returns for the lowest risk in the hedge fund industry were mistaken. They got 1.7 percent through October -- a situation all too common on Wall Street, where every firm selling funds of funds is a winner even when their customers aren't.

``For these large institutions gathering assets is the name of the game, not performance,'' said Edward Bowman, a partner at Veritable LP, the Newtown Square, Pennsylvania-based consulting firm that oversees $8 billion for wealthy families.

Another of Goldman's funds of funds, Hedge Fund Partners LLC, made 5.6 percent for investors in the first 10 months of this year, compared with an industry average of 6.5 percent, according to Chicago-based Hedge Fund Research Inc. The $681 million fund, which is registered with the U.S. Securities and Exchange Commission, has trailed the industry by between one and three percentage points for each of the past three years.

Not Enough for Goldman

Sarah Gardner doesn't make enough as an associate director at the Center for Environmental Studies at Williams College in Williamstown, Massachusetts, to be an individual investor in Goldman's funds of funds. Most of her retirement money is in a stock fund run by New York-based TIAA-CREF, which charges a 0.48 percent management fee and doesn't keep a slice of the profits. It's up almost 18 percent this year.

The Vanguard 500 Index Fund, which levies a 0.16 percent fee to track the Standard & Poor's 500 benchmark index of U.S. stocks, has returned 16.3 percent through Dec. 15.

Goldman spokeswoman Andrea Raphael said Hedge Fund Partners has underperformed other funds of funds because it invests with managers who trade futures contracts and others who employ so- called macro strategies, which bet on global stocks, bonds, currencies and commodities.

Better Fund Closed

``This fund is one of a large number of Hedge Fund Strategies funds of funds and represents less than 5 percent of our overall business, which manages over $17 billion,'' she said. ``By contrast, Goldman Sachs West Street Partners LLC is a larger fund that has returned 17.5 percent over the same time period, year-to-date. West Street is closed to new investors.''

Employees at Goldman aren't paying a price for poor returns. The average compensation at the New York-based firm rose 19 percent to $622,000 in the year ended Nov. 24. Chief Executive Officer Lloyd Blankfein, 52, may get a 32 percent raise to $50 million, said Jeanne Branthover, head of the financial-services group at Boyden Executive Search in New York.

Goldman on Dec. 15 appointed Marc Spilker, 42, to take charge of the alternative-investments unit that includes funds of hedge funds. He reports to Eric Schwartz, 44, and Peter Kraus, 54, who run Goldman's money-management division.

`Mixed' Returns

Jeffrey Slocum & Associates Inc., a Minneapolis-based consultant to pension plans, doesn't recommend any Wall Street- managed funds of funds because they tend to underperform, said Sean Goodrich, the firm's director of alternative investment strategy research.

``Their returns have been mixed,'' he said.

Goldman's clients would have done better investing in the firm instead of its funds of funds. Goldman shares have gained 56 percent this year, after rising 23 percent in 2005.

Most funds of funds returns aren't publicly disclosed. Some funds, including Goldman's Global Tactical Trading and Hedge Fund Partners, are SEC-registered and so report their performance.

Deutsche Bank AG, which owns Europe's largest securities firm, has about $4 billion in fund of fund assets. Its Topiary Fund for Benefit Plan Investors has returned an average 5.39 percent a year since opening in October 2004, compared with 8.6 percent for the Hedge Fund Research fund of funds index.

$140 Billion

This year, the Topiary Fund gained 5.97 percent through October, excluding a maximum sales fee of 2.5 percent. Deutsche Bank's earnings this year may rise 38 percent, according to a Bloomberg survey of analysts, putting CEO Josef Ackermann in line for a raise similar to the 18 percent boost to 11.9 million euros ($15.6 million) he received last year.

The Frankfurt-based bank's head of asset management is Kevin Parker, 47. Spokeswoman Mayura Hooper declined to comment.

All told, nine of the world's biggest banks and securities firms -- Goldman, Morgan Stanley, JPMorgan Chase & Co., Citigroup Inc., UBS AG, Societe Generale SA, Credit Suisse Group, Credit Agricole SA and Royal Bank of Scotland Group Plc -- rank among the 50 largest operators of funds of funds, managing a collective $140 billion, according to a survey by Institutional Investor's Alpha magazine.

Investors Pay Twice

Investors pay twice to invest in funds of funds. The charges by the firms come on top of fees levied by the hedge fund managers themselves, typically 1.5 percent of assets and 20 percent of investment gains.

``The layering of fees makes it difficult to produce the type of returns that investors are hoping for,'' said Geoff Bobroff, an industry consultant in East Greenwich, Rhode Island. ``With the underlying fund fees, and the fund of funds fees, you nail investors.''

It's no surprise that Wall Street has its eye on funds of funds. Not only do they require fewer investment professionals to run than a traditional hedge fund, institutional investors are flocking to them. Of the $7.6 billion that U.S. pension funds farmed out to hedge fund managers this year, 62 percent went to fund of funds, according to Louisville, Kentucky-based Eager, Davis & Holmes LLC.

The fees for overseeing hedge fund assets are so lucrative that Goldman's money-management unit reported a 19 percent increase in fourth-quarter revenue. Goldman's so-called incentive fees, the slice of investment gains it keeps, plunged 78 percent in the quarter as some its own hedge funds, such as Global Alpha, declined.

Buoyed by Management Fees

David Viniar, Goldman's chief financial officer, said in a Dec. 12 interview that incentive fees will show a ``significant decline'' in the first quarter. He also expects the firm to attract enough new assets from clients to make up for the difference with management fees over the course of the year.

Goldman managed $15.8 billion in funds of funds as of June 30, an 11.6 percent increase over the 12 previous months, according to a survey by Alpha magazine.

The City of Philadelphia Municipal Pension Fund is one Goldman client. It has $30 million invested in the firm's Global Equity Long/Short fund, a fund of funds that returned 7.8 percent this year through October. Christopher McDonough, chief investment officer for the Philadelphia fund, didn't respond to a request for comment on his choice of Goldman.

`Great Business'

``This is a great business for brokerage companies,'' said James Ellman, president of Seacliff Capital LLC in San Francisco, which manages more than $100 million in financial-services stocks. ``The market likes asset management more than investment banking because the booms and busts are much less pronounced and the more that brokers can make their earnings stable, the higher their stock price multiples will be.''

While funds of funds spread the risk of investing in hedge funds, they aren't immune to the industry's periodic blowups. Returns at funds managed by Goldman, Morgan Stanley and Deutsche Bank were hurt this year by the implosion of Amaranth Advisors LP, the Greenwich, Connecticut-based hedge fund manager that lost 70 percent of its $9.6 billion in assets in September because of wrong-way bets on natural gas.

Morgan Stanley's Institutional Fund of Hedge Funds had 5.5 percent of its capital invested in Amaranth as of the end of June, according to SEC filings. By the end of September, after Amaranth's collapse, the fund returned 5.1 percent for the year, according to a person familiar with its performance.

Pennsylvania's Stake

Pennsylvania has $1.3 billion invested in Morgan Stanley's Institutional Fund of Hedge Funds, according to Robert Gentzel, a spokesman for the state employees' Harrisburg, Pennsylvania-based pension plan. He declined to comment on Morgan Stanley's performance. Andrea Slattery, a spokeswoman for Morgan Stanley in New York, declined to comment.

The fund, which levies lower fees than some of its competitors, charges clients 0.55 percent of assets. It takes 10 percent of any investment gains above the three-month T-bill rate plus five percentage points. The Institutional Fund of Hedge Funds has lagged behind the average industry return in each of the last three years, SEC filings show.

New York-based Morgan Stanley had $6 billion in fund of funds assets as of June 30, according to data compiled by Alpha magazine. Owen Thomas, 45, runs Morgan Stanley's asset-management division.

Morgan Stanley CEO John Mack, who has made five hedge fund acquisitions this year to close a $80 billion gap in so-called alternative assets with Goldman, was awarded a $40 million bonus for 2006 -- the biggest in Wall Street history -- after putting the firm on track for record earnings.

Lack of Scrutiny

Bowman, the money manager for wealthy families at Veritable, said funds of funds run by investment banks often don't spend enough time scrutinizing the hedge funds they pick as investments.

``Some firms have decided it's hard to add value choosing underlying funds, so they don't bother picking,'' he said. ``They just hire a whole bunch of managers.''

Deutsche Bank's Topiary Fund invests in 48 separate hedge funds, according to the bank's Web site.

Some investors aren't as concerned that Wall Street-managed funds of funds are dragging down returns for pensioners. New Jersey entrusted Goldman to invest some of the state's $79 billion in public savings in a customized fund of funds three months ago.

``I have an extremely high regard for the quality of service at Goldman,'' said Orin Kramer, chairman of the New Jersey State Investment Council.

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net; Katherine Burton in New York at kburton@bloomberg.net.

Last Updated: December 18, 2006 00:06 EST