Hedge Fund Fees Shrink as U.S. Pensions Make Direct Investments

Date: Friday, May 2, 2008
Author: Katherine Burton, Bloomberg

U.S. hedge-fund investors are paring the roughly $80 billion they pay in annual fees by cutting out the middlemen.

New York State's $155 billion retirement system has shifted a portion of its $5.3 billion in hedge-fund assets away from the intermediaries, known as funds of funds. ITT Corp.'s pension fund and Baylor University's endowment have already made the move.

``We didn't want to pay the extra layer of fees,'' said Scott Pittman, investments director for the $1.1 billion Baylor fund in Waco, Texas. The university, which began using funds of funds five years ago, now has direct investments with 15 managers.

For the first time, more than half of the hedge-fund assets of the 200 largest U.S. pension plans were invested with individual managers last year, data compiled by Pensions & Investments show. The proportion of pension assets overseen by funds of funds fell to 49 percent on Sept. 30 from 57 percent in 2002, when the magazine started collecting the information.

The change reflects the growing confidence of pension funds, endowments and foundations in choosing their own managers after gaining experience through funds of funds, said Stewart Massey, founding partner of investment consulting firm Massey, Quick & Co. in Morristown, New Jersey. New hedge-fund investors mostly depend on middlemen to guide them through the process.

Fees Atop Fees

A fund of funds generally charges 1 percent of assets and 10 percent of any investment profits for selecting managers. That comes on top of the 2 percent of assets and 20 percent of profits the underlying managers collect. Hedge funds are private, largely unregulated pools of capital that can buy or sell any assets, betting on falling as well as rising prices.

The industry manages $1.9 trillion worldwide, including $800 billion in funds of funds, according to data compiled by Hedge Fund Research Inc. in Chicago.

Defense-systems supplier ITT has been steering money from its $5.1 billion pension fund directly to individual managers since 2003. The amount has risen to about 40 percent of the $1 billion it has placed with hedge funds.

``We weren't satisfied we were getting the best performance,'' said Donald E. Foley, treasurer of White Plains, New York-based ITT's pension fund. Foley said most funds of funds seek out managers with steady performance, which usually means lower returns than he wants. The pension fund rose 12.7 percent in 2007, more than twice the Standard & Poor's 500 Index.

New York State

Foley plans to put money in funds this year that buy distressed mortgages, leveraged loans and corporate bonds. He said he'll use the fund's consultant, St. Louis, Missouri-based Summit Strategies Group, as a sounding board.

The New York State Common Retirement Fund is transferring a portion of the $4.2 billion that was invested in seven funds of funds to individual managers, said two people with knowledge of the decision.

New York State had $114 million to $1 billion in funds of funds as of March 2007, including Consulting Services Group LLC in Memphis, Tennessee; Paris-based Olympia Capital Management SA; and Coast Asset Management LLC in Santa Monica, California, according to the pension system's most recent annual report.

Robert Whalen, a spokesman for the fund, declined to comment, saying a review of the funds-of-funds investments was still under way. Executives at the funds of funds either declined to comment or didn't return calls seeking comment.

Worst Start

It's a tough time for investors to forgo the expertise associated with funds of funds in choosing a manager, said James McKee, head of hedge-fund research at industry consulting firm Callan Associates Inc. San Francisco-based Callan has been advocating the use of funds of funds since 2002.

``There has been a lot of turmoil in the underlying funds,'' McKee said.

Hedge funds declined by an average 3 percent in the first quarter, according to Hedge Fund Research, the worst start for a year since the group began tracking performance in 1990. The funds then advanced about 1.5 percent in April.

Many institutions still go through a middleman because they don't have the staff to oversee investments or a big enough pool of capital to be adequately diversified. Even funds that tend to invest directly use funds of funds for certain investments.

Wake Forest University in Winston-Salem, North Carolina, has about $250 million of its endowment in hedge funds, primarily with individual managers. Louis Morrell, the school's head of investments, put money into an emerging-markets fund of funds late last year because tracking down managers located overseas was too time-consuming, he said.

Funds `At Risk'

``Funds of funds have clearly been successful and popular,'' said Aymeric Poizot, Fitch Ratings Ltd.'s hedge-fund analyst in Paris, who covers Europe, the Middle East and Asia. ``The question is: Are funds of funds really smart money?''

Poizot said some funds of funds, which he didn't identify, dropped as much as 15 percent this year, losses that may cause investors to pull money. Fitch estimates $50 billion invested in funds of hedge funds could be ``at risk.''

``You have some hedge funds where 80 percent of the investor base is funds of funds,'' he said. ``That creates a risk of simultaneous massive redemptions.''

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