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CalPERS Chief Assails Hedge Fund Fees That Outperform Results

The International Herald Tribune has reprinted a Bloomberg News story written by David Clarke summarizing a recent Institutional Fund Management Conference held in Geneva. At that conference, Russell Reed, the chief investment officer of California Public Employees Retirement System ("CalPERS", the largest pension plan in the United States), said hedge funds charge too much in fees for performance that frequently mimics major stock indexes.

Mr. Reed's point is that pension plans and endowments can get average market risk (and returns) very cheaply through index products popularized by investment firms like Barclays Global Investors and The Vanguard Group. Typically, these index funds own securities in proportion to the composition of the underlying index, which can be something well known like the S&P 500 stock index or the Lehman Brothers Intermediate Government Corporate (bond) index. Alternatively, the index can be customized (or tilted) by over-weighting some sub-sectors and under-weighting others. Depending upon whom gets the benefits of the fees that result from securities lending, the asset management fees can be just a few basis points (or hundredths of one percent).

Contrast these index asset management fees with those charged by the "typical" hedge fund: two percent management fee plus twenty percent of profitable performance. (In fact, hedge fund fees vary considerably from this two and twenty model, especially for larger investors in funds run by a hedge fund management team. Nonetheless, they are considerably more than a few basis points.) The IHT article reveals that CalPERS paid $500 million in asset management fees to external managers. It is not clear though what percentage of CalPERS' assets were managed by external managers. However, clearly ERISA plans like CalPERS have a vested interest in increasing their investment returns while minimizing the fees to produce those returns, and comments from such officials may reflect this bias.

The issue that Mr. Reed's comment points to is "What does an investor get for paying such large fees?" Does the hedge fund manager produce superior returns that justify these fees? Or put in other terms, how much Alpha return (especially on a risk-adjusted basis) do hedge fund managers actually produce and what fees are appropriate for that superior performance?

As TCM has previously noted, the 8,000 plus hedge funds in existence produced an average return in 2006 of approximately 13%. By comparison, the S&P 500 stock index had a higher return (13.6% in this IHT article and 15.8% in other Bloomberg News reports with cash dividends reinvested). The IHT article continues:

Eight of every 10 hedge funds do not provide the returns to justify the fees they charge, according to Harry Kat, a professor at the Cass Business School in London. After surveying as many as 2,500 hedge funds since 1995, he concluded that in 80 percent of cases the investors would have been better off putting their money elsewhere.

"The bottom line is, it's like a charity where you give these people lots of money, they make a really good living out of it, and they provide you with returns that are substandard," he said during an interview at the conference.

Read said that the fee system for hedge funds might eventually evolve to allow those who outperformed markets to get paid more than those who rode market returns. "We have no problem paying high performance fees for a manager's selection, but we find taking on average market risk inherently unsatisfying," he said. …

Figuring out how much of a fund's returns are the result of risks the manager is taking and how much reflects rising markets is almost impossible, Carol Verkoeyen, who works on allocation and research at Stichting Pensioenfonds, the largest pension fund in Europe, said at the Geneva conference.

"Hedge funds are like black boxes," Verkoeyen said. "They charge these high fees, and we don't actually know if their returns are coming" from manager skill or market gains.

Investing with money managers who provide returns similar to the stock market "is one of the biggest dangers when investing in hedge funds," said Hasse Joergensen, who oversees the €40 billion, or $52 billion, Sampension in Denmark.

2006 was a year of substantial appreciation for United State equity securities. Equity indicies substantially outperformed fixed-income assets in which numerous hedge funds pursue investment strategies. Hence, one would expect average hedge fund returns to be less than a pure equity index return.

The key to determining whether hedge fund manager fees are excessive is to determine how well the "average" hedge fund does over the investment cycle. Since hedge funds generally also "short" securities, they have tended to out-perform during periods when the stock (or other market) sectors decline and "long-only" strategies produce negative results. Hence, hedge funds generally tend to produce more Alpha return.

How much Alpha return (especially on a risk-adjusted basis) does the "average" hedge fund manager actually produce and how much should they be paid for that return? This is the challenging question that many institutional investors are grappling with as they consider upping their portfolio allocations to the hedge fund sector. Toomre Capital Markets LLC welcomes the reader's comments and thoughts.