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Alternatives

Investors see innovation as way out of limbo

New thinking could counter low-return/high-fee problem

Stanford University researcher Ashby Monk
Ashby Monk believes high fees make it tougher for investors to achieve their investment agenda.

Asset owners looking for high returns without paying high prices are being forced to innovate.

Institutional investors are not only seeking strategies such as alternatives, global macro and absolute return but also are engaging in co-investments and partnering with emerging managers to get more bang for their buck.

"As you get fee transparency, it does become harder to allocate to the extremely high-cost asset managers such as hedge funds and private funds," Stanford University researcher Ashby Monk said in an email.

"Fee and cost transparency is a catalyst for innovation within plans, as boards begin to realize that there must be another way to achieve their returns without paying so much to Wall Street," he added.

Mr. Monk said he is seeing three innovations within the institutional investment industry: better use of technology; collaborative models among asset owners; and creating platforms to seed new managers.

As the demand for fee transparency ​ increases and many hedge funds struggle to produce high returns, several pension plans have either been steadily moving away from or reducing allocations to the asset class.

In July, trustees of the $17.2 billion Illinois State Board of Investment, Chicago, eliminated hedge funds as an asset class. That followed ISBI's decision in February 2016 to reduce its hedge fund allocation to 3% from 10%.

In March, the $27.5 billion Pennsylvania State Employees' Retirement System, Harrisburg, replaced a dedicated hedge fund allocation with a multistrategy allocation that includes hedge funds among other strategies.

PennSERS spokeswoman Pamela Hile said in an email that the new multistrategy structure opens the door for more investment opportunities.

"While in the past, if staff and consultants identified a promising opportunity that didn't fit squarely within our existing asset class structure, we would have to pass on the opportunity," she said.

Ms. Hile added: "While hedge funds and private equity managers generally charge fees based on committed capital, managers in other strategies charge fees on invested capital only. Paying a fee on invested capital only is more desirable to the board than paying fees on committed capital."

Rhode Island reduces

In September, the Rhode Island State Investment Commission, approved a significantly reduced target allocation to hedge funds and an increased allocation to private equity for the $8 billion pension fund.

Evan England, spokesman for Rhode Island state Treasurer Seth Magaziner, who oversees the investment commission, said the commission reviewed its hedge fund investment for the past three years and concluded that more money had stayed with managers in fees and expenses than had been earned for the fund. "There was too much downside correlation," he said.

This move followed Rhode Island adopting the "Transparent Treasury" initiative in June 2015, requiring managers wishing to do business with the commonwealth to publicly disclose information about performance, fees, expenses and liquidity.

In April 2016, the $56.2 billion New York City Employees' Retirement System decided to stop hedge fund investing and liquidate its 2.8% allocation after a review by its consultant, Callan Associates, "demonstrated that hedge funds can be removed from the NYCERS asset mix to achieve targeted levels of return and maintain consistent levels of volatility," according to the resolution adopted by system's trustees.

"Fees are something we've been focused on across all five funds," said Jack Sterne, spokesman for New York City Comptroller Scott M. Stringer, fiduciary for the $169.8 billion New York City Retirement Systems. "We've been putting pressure on all our managers to provide better fee disclosure, so that we have transparency and fairness."

Mr. Stringer said in 2015 that a restructuring of the city's public pension system was necessary because high fees and disappointing performance cost an estimated $2.5 billion in lost value during the 10 years ended Dec. 31, 2014.

The revamping includes improving selection of outside investment managers and better linking management fees to investment manager performance.

Lacking fee concessions

Although institutional investors are still interested in alternative strategies such as private equity, private credit and real assets, not much in the way of fee concessions are offered in those asset classes.

"Real estate and private equity managers have seen fee pressures, but they've been less pronounced than what we've seen in the public markets and hedge fund space, maybe because many of these firms have been able to produce alpha," said Russell K. Ivinjack, a senior partner at Aon Hewitt, Chicago.

So the higher return/lower fee search creates opportunities for traditional investment managers.

Susan M. Brengle, managing director, institutional, at Eaton Vance (EV) Management (EV), Boston, said investors disappointed by their hedge fund investments "are interested in other strategies that offer higher returns at a more cost-effective price point along with being already liquid."

One option is Eaton Vance's global macro absolute-return and global macro absolute-return advantage strategies. Ms. Brengle added that institutional clients are "seeking liquidity, downside protection with strong absolute-return focus with proven track record and much more reasonably aligned pricing structure, such as a flat fee as opposed to a one-and-20."

At BlackRock (BLK) Inc. (BLK), Josh Levine, managing director and head of the alternative investment strategy group for the Americas, New York, said that investors looking to avoid high fees for high returns have been increasingly turning to co-investments and what he described as "evergreen deals."

"Co-investments tend to be much less expensive for investors to implement and have an outstanding track record in private equity and real assets," Mr. Levine said. The evergreen private equity structure, which is more like a separate account than a commingled fund, "allows for one conversation where (both parties) agree on the business terms at the outset."

"The guarantee of long-term capital brings down all sorts of costs," he added.

Mr. Levine also warned that although the traditional commingled fund structure "is alive and well," managers "cannot be cemented in yesterday's fund terms" and need to "listen to the investors and find out the terms that work best for them."

One investment consultant also noted that co-investments are being used as an innovative avenue to high returns.

Splitting up commitments

Andrea Auerbach, managing director and global head of private investment research at Cambridge Associates LLC, San Francisco, noted that instead of committing to a private equity fund wherein the manager charges two-and-20, an investor puts 50% in a co-investment and pays one-and-10. "So, you've just reduced your cost of access," she said.

However, one private equity executive warned that although co-investments can be a good idea if done methodically and with managers that the investors trust, they can reduce diversification and therefore increase volatility.

Another way investors can reduce their cost of access is by investing with emerging managers. With several experienced money management executives looking to spin off and form their own firms or funds, many are trying new fee models.

The Cambridge Associates director said most fee innovation tends to occur in new fund formation and in the middle market. "Investors have a wider menu of options to consider. There are many different approaches being taken today," Ms. Auerbach said.