Hedge Funds Buckling Under Fee Pressure, LP Apathy

A greater portion of hedge funds (78%) say they’re open to cutting fees than investors report even asking for better terms (63%), according to a major BNY Mellon survey.

Private equity once again came out as the favored alternatives strategy, accounting for 37% of unlisted allocations to hedge funds’ 14%. Appetite for future investments wasn’t any stronger.

To lure back apathetic allocators, the vast majority of hedge fund respondents said they want to meet investors at the negotiating table. Whether institutions will take them up on that offer remained an open question.

“It feels as though 1.5% is the new 2% in fees,” said Robert Chambers, BNY Mellon’s head of global product management. “As new ways of accessing the market, such as liquid alternatives, gain traction, there is increasing compression on fee levels.”

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The ‘black box’ days have ended too, with three-quarters of general partners considering increased portfolio transparency to render themselves more attractive.

BNY Mellon Hedge Funds Source: BNY Mellon, “Split Decisions”Investors broadly reported satisfaction with the client service and returns they have received from hedge funds, despite years of relatively weak performance by the sector. Only 6% of the respondents told BNY they were unhappy with either category.

The results painted a challenging picture for hedge funds looking to raise capital.

Three-quarters of investors said they plan to retain or shrink their average 14% allocation to hedge funds over the next year, making it the least popular alternatives category.

Private equity firms, in contrast, could expect ever more inflows, with 51% of investors planning to grow their average 37% allocations. While hedge funds were willing to bend over backwards to attract limited partners, investors said they want that flexibility more from their private equity partners.

“The private equity industry has huge growth potential,” said one investment director, “but this is dampened due to unreasonable fees.”

Hedge funds may have been getting a lot of criticisms lately—but the investment vehicle still has at least one supporter.

A new report from consultant Cambridge Associates has argued that hedge funds remain “integral” to pension investment strategies, especially as plan sponsors struggle with mounting funding deficits.

“For some pension sponsors, the hedge fund solution may sound counter-intuitive, based upon their earlier experiences with hedge funds,” said Managing Director Joseph Marenda. “Many sponsors went into hedge funds that had done well during the crisis—but they were essentially too late. They were chasing what had worked in the last cycle, but they were actually in a different cycle.”

As a result, he added, these pension funds saw poor risk-adjusted returns.

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But according to Cambridge Associates, hedge funds can still offer a source of alpha and risk reduction for plans in need of bigger investment returns to counter rising liabilities.

“A carefully selected group of hedge funds, diversified across different strategies, may produce alpha and play a key role in risk reduction and return enhancement—not just in bull markets but across all market cycles,” Marenda said.

Cambridge Associates clients’ hedge fund programs have outpaced global equities by 48 percentage points cumulatively over the last 15 years after fees, with one-third of the volatility of public markets. According to the report, a hypothetical 10% market correction would set a traditional portfolio back 5.9%, while a similar portfolio including hedge funds would lose a more modest 4.4%.

The key, Marenda said, is choosing the right managers. Of the 11,000 hedge funds on the market, less than 5% actually merit institutional capital, according to Cambridge Associates. Pension funds should therefore carefully consider hedge fund investments—both as individual allocations and within the context of the total portfolio.

“Choosing managers and creating a program that truly benefits a pension portfolio is as much art as science,” he said. “If you know the people running the investments, how they think and how they manage their risk profiles, there is a much greater likelihood that you will be successful in building a winning portfolio.”

cambridge associates hedge funds report Source: Cambridge Associates’ “Hedge Fund-ing the Pension Deficit”