Hedge funds cut fees to win big investors

Last updated: December 12, 2013 7:00 pm

Hedge funds cut fees to win big investors

By Stephen Foley in New York

Do you know what your hedge fund manager is up to?

It is a question that haunts the institutional investors who have piled into hedge funds in increasing numbers in recent years, brandishing increasingly large cheques. Mindful of the historic opacity of the industry, and the wide latitude given to hedge fund managers to invest as they see fit, institutional money has demanded such an array of new transparency and compliance procedures that hedge fund managers often grumble the job is no fun any more.It seems, though, that the sides have found their way to an accommodation.

Investors are expecting less in the way of returns, but have judged that hedge funds will provide a cushion against any correction in the stock market or downturn in the bond market when interest rates rise. Hedge fund managers, meanwhile, are dropping fees for big investors and offering a much wider array of customised investment options.

“The challenges for managers have never been greater, but the appetite of investors has never been greater either, so managers are feeding off that investor buzz,” says Cary Stier, head of the asset management sector at consulting firm Deloitte.

The sustained enthusiasm for hedge funds among institutional investors, particularly mid-tier corporate and state pension funds that were not in the first wave of investors to add alternatives to their portfolios, might seem surprising given the more modest expecations for returns.

A survey of investors conducted annually by Preqin, the data provider, shows that expectations for hedge fund returns have fallen from 7.7 per cent in 2011 to 7.0 per cent in the most recent poll, full details of which will be published in its 2014 Global Hedge Fund Report in January.

Sovereign wealth funds, public pension schemes, insurance companies and university endowments have cut the returns they seek particularly sharply.

In a recent paper, Goldman Sachs assessed overall returns from the past five years and concluded that, adjusting for the drag on performance from lower interest rates, the amount of “alpha” – returns over and above those from the broad stock and bond markets – generated by hedge funds was broadly the same as in the previous 10 years.

Hedge funds are designed, of course, to hedge against the risk that markets will cool and to provide uncorrelated, absolute returns. Or, in layman’s terms, to not lose money when everyone else does.

Investors have sometimes lost sight of that when equity markets are soaring, and complained about hedge fund underperformance, but that seems not to be the case this time, says Jeff Majit, a member of the fund of hedge funds investment committee at Neuberger Berman, the asset manager.

“2008 was a sufficiently traumatic event that memories will be longer-lived than after previous crises,” he says. “Investors’ commitment to preserving capital is as strong today as it was in the wake of the crisis.”

Consultants say the challenge now, given that investors are using hedge funds to hedge the risks of their equity portfolios, is to make sure fund managers are not simply chasing returns in the stock market.

“If you hired someone to your orchestra to play the trumpet, you don’t want them switching to the violin half way through the performance,” says Jon Hansen at Cambridge Associates. “There may be periods when they are sitting with the trumpet on their knee, but that’s okay.”

With a record 66 per cent of hedge fund assets under management now coming from institutions, according to Preqin, “the tables have turned and there is a greater leverage on the part of investors”, says Mr Majit.

That means two things for investors: lower fees and more choice.

Newer funds, in particular, are extending the dollar amount and the time period for which specially discounted “founder share class” terms are available. Investors are also pressing for fee structures where the annual management fee scales down as assets under management grow.

Meanwhile, it is on choice where both hedge fund managers and big investors are seeing most closely eye to eye. Managers see big opportunities from offering bespoke products, akin to separately managed accounts, for their biggest clients.

In addition, one quarter are planning to launch new hedge funds in 2014, according to the Preqin survey, and many are also considering launching new mutual fund-style products that can bring in retail investors through defined benefit pension plans.

Deloitte’s Mr Stier describes the harmonious new mood. “The managers that have been most successful in gathering assets do not go in and say, ‘let me tell you about me’,” he says. “The best ones are listening first and then developing products.”