Hedge funds face investor war on fees

Date: Wednesday, November 4, 2009
Author: Laurence Fletcher, Reuters.com

Institutional investors are going to gang up on "arrogant" hedge funds, a pension fund chairman warned, as investors increasingly press for changes that would link lucrative fees more closely to genuine outperformance.

A key complaint of investors has been that while many of them lost money during the financial crisis, hedge fund managers were still able to rake in millions of dollars in fees. Last year, average hedge fund returns were a minus 19 percent.

"If they want money from us they will have to offer ... alignment of interests. If hedge funds remain arrogant and not humble, I think money will go elsewhere," Philip Read, chairman of the British Coal Staff Superannuation Scheme, said on Tuesday.

"We're increasingly going to gang up against you... Institutional investors are totally disillusioned with funds not delivering what was on the tin," he told the the Hedge 2009 conference in London. Hedge funds typically charge a management fee of 2 percent or sometimes more on assets -- well above the cost of mutual funds -- plus a 20 percent fee on performance, which is often levied on any positive returns not just those that fall above a "hurdle rate", or target agreed with the investor.

Institutional investors at the conference said they favoured skewing fees further towards performance and away from rewarding firms for the amount of assets gathered.

They also said managers should be rewarded when they deliver returns due to their skill -- known as alpha -- and not due to rising markets -- or beta -- as very cheap exchange-traded funds also offer investors beta. "We're essentially trying to minimise non-performance-related fees. We want managers to make money when we make money," said Mike Powell, head of alternative investments at Universities Superannuation Scheme, Britain's second largest pension scheme.

"Management fees can cover costs and not much else, and you should introduce proper hurdles for managers to beat before they start taking performance fees," he said.

The focus on performance fees extends beyond the hedge fund industry. The BT pension scheme in its 2008 annual report said it had agreed performance fees and targets with some of its mainstream active managers to encourage outperformance.

CLAWBACKS

Hedge funds have also come in for criticism from investors and regulators for charging performance fees on an annual basis and not offering cash back to investors in down years.

For instance, a fund gaining 40 percent in year one but falling 40 percent in year two would reward the manager with lucrative performance fees in year one, while the investor would have lost money over the two-year period.

Niels Oostenbrug, head of alternative investments at Netherlands-based pension fund administrator and manager Mn Services, said this could be remedied if hedge funds move to a private equity model, where performance fees are allocated over a longer period and fees awarded in early years can be reduced in later years.

"What I like about private equity is that a clawback is possible -- the investor doesn't pay a performance fee if no performance is made over a number of years," Oostenbrug said. "Hedge funds could learn something from their private equity brothers."

A small number of funds, including RAB Capital's Special Situations fund, have reduced fees for investors, but investors said they were seeing other evidence of charges falling.

Omar Kodmani, who runs fund of hedge funds firm Permal's London office, said better fees could be negotiated if investors opted for segregated accounts rather than traditional fund investments, while Gina Sanchez, director of public investments at the Ford Foundation, said she had seen lower fees agreed with smaller, up-and-coming hedge funds. (Additional reporting by Raji Menon; editing by Karen Foster) (To read the Reuters Hedge Fund Blog click on blogs.reuters.com/hedgehub; for the Global Investing Blog click here)