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Hedge-Fund Love Affair Is Ending for U.S. Pensions, Endowments

  • State retirement plans for workers fed up with fees, returns
  • University endowments also redeeming, negotiating better terms

About five years ago, Kentucky started investing some of its public-employee pension money with hedge funds. Sure, fees were high but the funds came with the lure of high returns and could serve as a buffer if the market tanked.

By early November, Kentucky officials had had enough. They voted to start yanking $800 million from hedge funds including Pine River Capital Management and Knighthead Capital Management.

Disappointing returns were certainly a factor. But another reason was the public’s perception of hedge funds as highly risky and run by guys with penthouses and yachts, said David Peden, chief investment officer for Kentucky’s $16 billion portfolio. That was poison at a time when taxpayers were being asked to fork over more to close a 60 percent gap in pension liabilities.

“We’re in a situation where there’s a lot of eyeballs on what we’re doing because we are so poorly funded,” Peden said.

Kentucky is one of the latest among America’s biggest investors -- pensions, endowments and foundations -- that are souring on hedge funds after a 15-year romance.

Unhappy with mediocre results and high fees, pensions in states like Illinois, New York and Rhode Island are slashing their allocations to hedge funds. More than one in four endowments and foundations, from colleges to museums to hospitals, are doing the same or considering it, according to a survey by consultant NEPC. Many are demanding lower fees and better terms to stick around, and usually getting it.

All told, redemptions hit a 2016 peak in the third quarter when investors pulled a net $28 billion from hedge funds, the most since early 2009, according to Hedge Fund Research Inc.

Read more: a QuickTake on Endowment Tax-Exempt Status

The backlash is part of a broader rebellion that has seen an avalanche of money move from actively-managed funds to low-cost passive products like index funds. The $3 trillion hedge fund industry, however, has become the poster child for the sins of active management because it charges among the highest fees even as performance lags. That doesn’t sit well in the political world of public pensions and endowments. They face pressure to boost returns as an aging workforce enters retirement and tuitions rise.

Foregone Returns

“Hedge fund managers continue to reap hundreds of millions of dollars in fees, regardless of their performance, which is a rip-off at the expense of pensioners,” said Maria T. Vullo, who as superintendent of the New York Department of Financial Services is the state’s top financial regulator. She has estimated hedge funds cost her state’s retirement system $3.8 billion in fees and foregone returns over the last eight years.

It was a different picture after the 2008 financial crisis. Pensions began pouring more money into hedge funds, hoping they’d be better prepared for the next downturn.

Read more on hedge funds in Bloomberg Briefs

By June of this year, pension allocations to those funds more than doubled to about $180 billion from 2008, according to Keith Brainard, research director of the National Association of State Retirement Administrators. That accounted for about 5 percent of pensions’ total assets.

Yet on average hedge funds have failed to outperform stocks since 2008, returning only 3.6 percent a year, while traditionally commanding fees of 2 percent of assets and 20 percent or more of the fund’s annual profit.

Citing high costs and complexity, the California Public Employees’ Retirement System, the largest U.S. pension fund, kicked off the exodus two years ago, when it voted to shed its $4 billion hedge fund stake.

‘Honey Pot’

Momentum picked up this year as performance continued to lag. The $16.1 billion Illinois State Board of Investment said last month that it has moved two-thirds of its assets to passive management and away from the "honey pot" of high fees, said Chairman Marc Levine.

In coming months, Rhode Island’s $7.7 billion pension fund is redeeming an estimated $585 million from hedge funds -- including Och-Ziff Capital Management Group LLC and Brevan Howard Asset Management -- and reallocating it to low-fee index funds.

Among colleges, Berea College is unwinding about $42 million in hedge fund commitments this year from its $1.1 billion endowment. For the year ended June 30, the endowment’s hedge fund allocation lost 2.5 percent, which didn’t help the school’s overall investment decline of 1.1 percent.

“The performance net of fees wasn’t paying off,” said Jeff Amburgey, vice president for finance for the private college in Kentucky, which doesn’t charge tuition.

Fee Leverage

While the redemptions represent only about 1 percent of hedge funds’ total assets, the threat of withdrawals has given investors leverage on fees.

Firms from Brevan Howard to Caxton Associates and Tudor Investment Corp. have trimmed fees amid lackluster performance.

William Ackman’s Pershing Square Capital Management last month offered a new fee option that includes a performance hurdle: It keeps 30 percent of returns but only if it gains at least 5 percent, according to a person familiar with the matter.

The offer came after Pershing Square’s worst annual performance, a net loss of 20.5 percent in 2015. Pershing Square spokesman Fran McGill declined to comment.

“They had a terrible year and they have to be extremely worried about a loss of assets under management,” said Tom Byrne, chairman of the New Jersey State Investment Council, which had about $200 million with Pershing Square as of July 31. “You’re losing clients because your prices are too high? Lower your price. That’s capitalism.”

New Jersey Cuts

In August, the $73.8 billion New Jersey pension voted to halve its $9 billion hedge fund allocation.

Cambridge Associates, which invests for endowments and foundations, has negotiated lower fees and improved terms with about 80 hedge funds, according to Noel O’Neill, head of global investment research.

Of course, as the stock market continues a seven-year rally, now may be the wrong time to abandon hedge funds because of their traditional role of smoothing out returns. That’s why some investors are only reducing their exposure to the asset class.

“People are forgetting about risk,” said Karl Scheer, chief investment officer at the University of Cincinnati. “Hedge funds are a good risk-mitigation tool. They didn’t remember how it felt in 2008.”

Cincinnati’s $1.2 billion fund negotiated fee reductions with four hedge funds while maintaining its investment.

But others aren’t convinced. “Is it worth that fee?” said David Eager, interim executive director of Kentucky’s retirement system. “The answer with hedge funds is no.”

— With assistance by Martin Z Braun, Michael McDonald, and Melissa Karsh

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