Pension funds and other institutional hedge fund investors must demand greater disclosure from hedge funds, not just of their investment strategies, but also of their administrative practices.
That's the clear implication of the revelation that many hedge funds have been charging operational expenses — from legal and auditing to office gyms and even fine art — to their clients in addition to their management fees and performance fees.
The practice has been characterized as a "dirty little secret" because of the lack of disclosure.
Executives overseeing pension funds, endowments and foundations ought to insist they receive itemized disclosure of all expenses charged to their funds. It is their fiduciary duty.
That duty requires trustees and other fiduciaries to know how the money they oversee is spent, and to approve of the expenditures as justified. In the case of pension funds, the expenditures must be justified as in the long-term best interests of the participants.
The hidden nature of such charges at some hedge funds raises issues of potential conflicts of interest in the use of the money, and also of the efficiency of hedge fund management.
If hedge fund managers had to pay their own administrative costs, or at least had to justify them to clients, the money would certainly be spent more carefully. No doubt the managers would find ways to minimize costs without jeopardizing the effectiveness of their investment management.
The practice of passing on administrative costs to clients in a sense puts no cap on fees. What is a management fee for, if not to cover the manager's expenses, including salaries, office expenses, legal and auditing expenses, gymnasium expenses for employees, if the hedge fund manager so desires? Isn't that what the typical 2% management fee is for?
Without detailed disclosure, administration costs should not be charged back to the clients as additional expenses.
Pension funds, in particular, should not invest if these expenses are not disclosed and itemized. To do so would seem to breach fiduciary duty under the Employee Retirement Income Security Act.
In a sense the hedge fund practice is reminiscent of the use of soft dollars by money managers, which often don't itemize for clients how this money is spent. This soft-dollar practice has promoted conflict-of-interest abuses that have been assailed by the Securities and Exchange Commission.
The increasing popularity of hedge funds because of the appeal of their potential outperformance might induce prospective and existing clients to accept such charges without question for fear of being kept out of promising lucrative strategies if they demand disclosure.
But that's not acceptable for fiduciaries, especially pension fund fiduciaries subject to ERISA.
To its credit, one fund, Citadel Investment Group Inc., fully discloses charges for expenses. However, Citadel does not charge a management fee. With such information, investors can evaluate whether the expense charges are justified, whether to accept such opened-ended fee arrangements, and ultimately whether to invest with a hedge fund.
Lack of disclosure and, worse, lack of interest in disclosure, of such charges go in tandem with a lack of scrutiny by some pension fund investors of the investment strategies of hedge funds, and the failure to seek adequate detail on investments and risks.
This kind of complacency would never stand in traditional investment strategies. But a desperate search for alpha in a market of generally declining or lackluster returns has made some investors lose sight of due diligence.
Pension funds need to fully vet hedge funds, as they should any other kind of investment strategy. They need to ask the right questions and insist on answers. They should not compromise on disclosure. As fiduciaries, pension fund trustees need to be held accountable for fully understanding and approving how pension money is invested, whether in hedge funds or other investments, and what fees are charged.