Public plans must demand a fair shake from hedge funds

In 2009, I was a hedge fund consultant helping institutional investors build hedge fund allocations. At that time, institutions were seeking to abandon allocations in hedge funds of funds to eliminate the extra layer of fees. It was my job to attend public pension board meetings and present funds to board trustees who worked hard to deliver services to their communities.

I'll never forget the day I presented the “manager du jour” at a meeting. The presentation was going swimmingly until we got to fee structure: the customary and oft quoted “2 and 20.”

A trustee asked: “How can you ask us to pay these high fees to managers? This is absurd!” His question elevated my defensive instincts. I immediately pleaded that hedge funds:

  • were necessary to lowering the plan's volatility by preserving capital during market dislocations;
  • had low correlation to traditional asset classes; and
  • would allow the board to expect equity-like returns with bond-like volatility.

I was successful in my pitch; the manager was approved. And while I'm almost certain the hedge fund manager did not keep pace with the S&P 500 and contribute half its volatility, a decade later I still believe there's value in adding hedge funds to institutional portfolios — albeit, assuming they're priced fairly and investors keep an appropriate amount of the profits generated on their capital.

Today, public pension funds are in a state of crisis, with funding levels well below expected liabilities or benefit payments. State pension funding ratios stood at 95% in 2007, according to Wilshire Consulting. Then, along came a recession, market deleveraging and stock market correction followed by a 10-year bull market. The net result: state pension funds have yet to recover since the recession and funding ratios are currently less than 75%. Some plans are below 50% funded. Adding insult to injury, Forbes magazine recently published its “25 Highest Earning Hedge Funds and Traders” ranking, illustrating annual compensation for stewards of public fund capital ranging from about $150 million to $1.5 billion.

Some trustees argue the anemic performance of hedge fund portfolios has cost state pension systems an opportunity to reduce the funding gap after the recession. From 2008 until now, hedge fund returns have almost halved as compared to returns from the prior decade. Albourne Partners reported the HFRI Fund Weighted Composite index, a proxy for the hedge fund industry, returned 14.6% from Jan. 1, 1998, to Dec. 31, 2007, as compared to returns of only 8.6% from Jan. 1, 2009, to Dec. 31, 2016. Notably, despite these decade-over-decade declining returns, manager fees have remained relatively unchanged.

Investors must understand the inconvenient truth about hedge fund fees: The oversimplification of the fee structure as “2 and 20” has hidden the fact that the real percentage of profits taken by the manager varies year to year. It has been much higher than 20% recently.

Investors would be better served ignoring the “sticker price” and focusing on the “split” or actual percentage of profits paid to the manager.

A 10% gross return is respectable for a hedge fund and above the assumed rate of return of the 7% required annually for most pension plans. A 10% gross return becomes a 6.4% net return when a “2 and 20” fee structure is applied and the manager's “split” of profits is 36%. In other words, the manager keeps 36 cents of every dollar of profit.

Let's take 2016 as an example. The HFRI index returned 5.6%. Apply the “2 and 20” fee structure and the manager split is 49% — very different from the “20% of profits” quoted to investors. Thus, it is only logical that trustees negotiate fees more in line with current performance levels — such as a “1 and 10” structure — whereby they are getting half the performance of the prior decade.

Hedge fund and other alternative strategies have valuable portfolio benefits to pension funds' portfolios, and eliminating or reducing them as equity markets hit new highs might prove to be ill-timed. Trustees have a fiduciary responsibility to protect the plan assets from market dislocations by diversifying assets and including strategies such as hedge funds. Just as important is their duty to not “overpay” these managers.

As the most meaningful investors in hedge funds and other alternative strategies today, public pension plans must demand a more equitable split of profits. After all, it is their money on which wealth is being generated.

As the proverb states: “A fool and his money are soon parted.” It is time for our public pension plans to fight for what is right.

Jacob Walthour Jr. is CEO of Blueprint Capital Advisors LLC, New York.

This article originally appeared in the May 29, 2017 print issue as, "Public plans must demand a fair shake from hedge funds".