Fees fall along with performance; how much is hard to tell, exactly

Stephen L. Nesbitt
Cliffwater's Stephen L. Nesbitt: 'For an industry that insists that it's all for transparency, it's very difficult to get a hedge fund manager to give you information about what they're charging. What you do get tends to be very poor and inconsistent.'

The good news is that some large institutional investors didn't pay high fees for hedge fund investments in 2016.

The bad news is that incentive fees were low because of poor hedge fund performance.

For fans of transparency, another bad news story is that few public pension funds report all the fees they pay for their hedge fund portfolios.

In fact, it's often impossible to discern how much a pension fund pays in total hedge fund fees because most report only the hedge fund management fee in their comprehensive annual financial reports, noting — occasionally — that incentive fees are netted out of final hedge fund returns.

Pensions & Investments analyzed hedge fund fee information reported in CAFRs for 18 hedge fund portfolios of 17 large U.S. public pension plans for the fiscal year ended June 30 and found that:

  • Total fees averaged 1.72% in 2016 for 10 hedge fund portfolios that include incentive fees in their reports, with management fees averaging 1.33%, incentive fees, 0.35%, and other fees (primarily pass-through fees), 0.12%.
  • Nine hedge fund portfolios reporting only management fees paid an average fee of 1.46%.

In P&I's analysis, three of the pension funds had different 2016 fiscal year-ends — March 31, Aug. 31 and Dec. 31.

Fuzzy comparisons

The unevenness of investment reporting for hedge funds by retirement systems makes fair comparison of hedge fund fees impossible, sources said.

The investment staff of the $39 billion Missouri Public School and Education Employee Retirement Systems of Missouri, Jefferson City, reports all fees for all investments, Craig Husting, chief investment officer.

“We want to be completely transparent in our reporting. We know every single fee we pay and we are committed to showing them,” Mr. Husting said.

PSRS/PEERS reports fees separately for its two hedge fund portfolios.

Fees for the Missouri system's $5.1 billion hedge fund portfolio totaled 1.47% as of the fiscal year ended June 30, comprising a 1.29% management fee and 0.18% in incentive fees. Total fees for the $2.7 billion alpha overlay portfolio were 1.18% comprising management fees of 1.25% and incentive fees of -0.07%. The combined portfolios account for 20% of total fund assets and 22% of total fund fees.

“It's all about classification. U.S. pension funds are all in the same funds but we account for them differently,” said Anita M. Brand, the systems' chief financial officer.

Ms. Brand said alternative investment firms managing strategies that include hedge funds, private equity, real estate and infrastructure deduct incentive fees from the return, and many pension funds don't account for those fees in their public reporting.

“It's a lot of work to calculate these fees by hand from managers' financial statements, but we think it's very important to know what we are paying for investment management,” Ms. Brand said.

Other U.S. funds that provided complete hedge fund fee information on request or in their CAFR include:

(See accompanying chart for more detail.)

P&I's data about hedge fund management fees gleaned from U.S. pension plan annual reports are roughly in line with the results of a Deutsche Bank AG survey conducted in December that found 63% of global hedge fund allocators said they pay between 1.3% and 1.8%.

But results from each analysis differ regarding incentive fees. Deutsche Bank's survey revealed 66% of respondents pay between 15% and 19.9% in performance fees. Deutsche Bank's much-larger universe of 460 hedge fund investors includes a large number of non-institutional respondents, including family offices, private banks, wealth managers and hedge funds of funds.

“The balance of power has shifted to institutional investors when it comes to fees,” said Marlin Naidoo, managing director in Deutsche Bank's New York-based hedge fund capital group and hedge fund consulting group.

Mr. Naidoo noted the bank's survey found 78% of all investors surveyed demand that hedge fund managers institute a hurdle — a set performance return — before they assess incentive fees and 71% demand lower management fees.

Performance clips fees

What's evident from the full hedge fund fee information provided by a handful of U.S. public pension plans is that management fees are coming down. But it's not clear from fiscal year 2016 data whether percentages specified in contracts — 10%, 20% or 30% of profits, for example — for incentive fees are really down or not.

Still, the pension funds paid significantly less — or nothing — in incentive fees for P&I's study period because hedge fund performance was so poor, investors and hedge fund managers stressed.

Only one of the 16 hedge fund portfolios P&I reviewed for which return information was available produced a positive return during the fiscal year. Returns ranged from 0.6% to -9.1%, with an average return of -3.4% for the year.

An investment officer of a pension plan who asked not to be identified said revealing fees paid to hedge fund managers gives institutional investors overall more influence over those managers.

“If you don't calculate, report and display hedge fund fees, you're not really cognizant of the magnitude of the fees you are paying and you can't put pressure on managers for lower fees. (Pension fund investors) have got to come together and all report fees in order to bring hedge fund costs down.”

The sheer difficulty of getting hedge fund managers to provide accurate fee information in a timely, efficient manner likely is deterring many U.S. public pension plan chief investment officers from trying.

“It is an arduous task,” said Stephen L. Nesbitt, CEO of hedge fund consultant Cliffwater LLC, Marina del Rey, Calif., noting that “for an industry that insists that it's all for transparency, it's very difficult to get a hedge fund manager to give you information about what they're charging. What you do get tends to be very poor and inconsistent. It's just a mess.”

For the most part, public pension funds didn't even try to calculate their fees because “they just assumed performance was netted from the return. Historically, pension funds didn't even know what they paid,” Mr. Nesbitt said.

Even with the recent clamor for information, Mr. Nesbitt said, “whether you get fee information depends on the whim of a given manager and even then, there's usually a huge lag time. We just got fee information from a manager for a client that we requested nine months ago.”

Hedge fund managers and investors could create a standardized reporting template like the one developed for private equity reporting by the Institutional Limited Partner Association, Washington, and introduced in January 2016.

The template is getting “great traction,” said Jennifer Choi, a managing director in ILPA's industry affairs department, because having a single standardized reporting form is much easier for private equity managers to implement and provide to all of their investors.

Ms. Choi said 100 organizations, including more than 60 institutional investor limited partners and 16 private equity general partners have formally endorsed the template so far. More than 160 other private equity companies are using the template for client reporting but are waiting to make an endorsement, she said.

This article originally appeared in the April 17, 2017 print issue as, "Fees fall along with performance; how much is hard to tell, exactly".