Hedge Funds Urged to Beat Benchmarks Before Charging Fees

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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.

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.

“Some managers are abiding by the principals to some extent but we are hoping to move everyone toward industry best practices,” Trent Webster, senior investment officer for strategic investments and private equity at the State Board of Administration in Florida, said in a telephone interview. The pension plan, a member of the association, oversees $180 billion, of which $2.5 billion is invested in hedge funds.

Hedge fund managers, who are among the highest paid on Wall Street, have come under pressure from clients to adjust agreements since the 2008 financial crisis led to record losses for the industry. Traditionally, the firms have charged investors 2 percent of assets as a management fee along with 20 percent of profits as an incentive.

$75 Billion

As funds trail the Standard & Poor’s 500 Index for the sixth straight year, some clients have complained that managers still provide little information about their holdings and tie up their investors’ cash while lagging behind benchmarks. The California Public Employees’ Retirement System said in September it would divest its $4 billion from hedge funds after officials concluded the program couldn’t be expanded enough to justify the costs.

The investor group, known as AOI, was started in 2009 and more than 250 hedge fund clients, including foundations, insurance companies and firms that oversee money for the wealthy, have taken part in its meetings. The New York-based group’s steering committee, which includes Siemens Financial Services GmbH and the South Carolina Retirement Systems’ Investment Commission, has a combined $75 billion invested in the industry.

The Institutional Limited Partners Association, which represents private equity investors, released its original set of best practices in 2009. Typically, private equity firms comply with their guidelines, which include communication with clients and valuations.

Internal Funds

In addition to fees, the AOI principles address subjects including internal employee funds, hard-to-sell assets and governance. Some hedge fund managers and investors have contacted the group to endorse the principals since they were released yesterday, said Melissa Santaniello, a founding board member of the AOI.

“Over time, we expect dialogues between both parties to become more efficient,” she said.

The lawyer for billionaire investor Stan Druckenmiller in January wrote a paper pushing for changes in partnership agreements covering areas such as legal fees and the suspension of client withdrawals.

Druckenmiller, who produced annual profits averaging 30 percent for more than two decades, last year described the industry’s returns as a “tragedy” and questioned why investors pay hedge-fund fees for annual gains closer to 8 percent.

Linking Compensation

To better link compensation to longer-term performance, the AOI recommended funds implement repayments known as clawbacks, a system in which incentive money can be returned to clients in the event of losses or performance that lags behind benchmarks. The group said performance fees should be paid no more frequently than once a year, rather than on a monthly or quarterly basis as they are at many firms.

Management fees, which are based on a fund’s assets, should decline as firms amass more capital, the investor group said.

“We need good managers, not asset gatherers,” Florida’s Webster said. “The incentives are currently skewed.”

Hedge fund fees in the second quarter averaged 1.5 percent of assets managed and 18 percent of profits generated, according to the latest data from research firm Hedge Fund Research Inc. Some firms stick to the “2 and 20” model, while management fees of 4 percent and a 27 percent cut of profits are among the highest charged.

Lower Fees

“The industry continues to progress toward lower fees, and not just for large investors who lock up their capital for longer periods,” Webster said.

Firms should disclose their operating expenses to investors so they can assess the appropriateness of management fee levels, the group said.

“Management fees should not function to generate profits but rather should be set at a level to cover reasonable operating expenses of a hedge fund manager’s business and investment process,” the AOI said.

Fees should fall or be eliminated if a manager prevents clients from withdrawing money, according to the group.

After investors pulled several hundreds of billions of dollars from hedge funds in 2008 and 2009 because of losses, the discovery that managers had invested in illiquid assets and news of conman Bernard Madoff’s pyramid scheme, funds made efforts to appease investors. Many started providing increased information about holdings, created segregated accounts so clients could monitor trades and implemented easier terms when they want to exit funds.

Internal Funds

The AOI said in its proposals yesterday that managers should disclose employee-only funds that aren’t available to outside investors. This year BlueCrest Capital Management LLP, run by billionaire Michael Platt, had its ratings on its funds reduced by two industry consultants for not providing sufficient information about a proprietary fund.

The AOI said that funds should notify clients of non-routine inquiries by legal or regulatory bodies. It also proposed that fund employees should in most circumstances face the same withdrawal restrictions as outside investors and that managers should tell clients of any “pending material redemptions by insiders with sufficient time for outside investors to redeem on the same date.”

Hedge fund boards should be made up of a majority of independent directors, with at least one primarily representing the interests of outside investors, according to the group. Managers should allocate hard-to-sell investments to segregated accounts at the time the assets are purchased, and clients should have the choice to opt out of them, the AOI said.

Hedge funds returned an annual average of 3.5 percent in the five years through Oct. 31, as measured by the Bloomberg Global Aggregate Hedge Fund Index, compared with almost 17 percent for the S&P 500 Index of large U.S. stocks and 4.2 percent for the Barclays U.S. Aggregate Index for bonds.

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