Are hedge funds a luxury schemes could do without?

However, recently the average investor in hedge funds has experienced meagre returns, indeed Hedge Fund Research’s diversified fund of funds index annualised 3.6 per cent in the five years to end August 2014 compared with an annualised return of 14.5 per cent for the S&P 500 over the same period. 

Investors have also faced little improvement in other aspects of the asset class important to pension funds such as liquidity terms, transparency and costs. 

It is the latter consideration – costs – that has particularly placed hedge funds in the firing line among critics and contributed to recent decisions by the London Pensions Fund Authority and the California Public Employees’ Retirement System in the US to pull out from hedge funds altogether.

The increasing popularity, prevalence and performance of new product concepts such as diversified growth funds and smart beta strategies, available at significantly lower costs, have also compounded this sentiment.   

Do hedge funds offer pension funds good value for money? Or are they just an expensive luxury that pension funds can do without? The answer lies somewhere in between.

We believe there are a small number that are worth it as they can consistently generate the potential for growth and provide true diversification to traditional sources of return. These investments can play an important role for pension funds if allocated appropriately. However, the vast majority of hedge funds do not warrant the fees they levy, and the fact that high fees have become ubiquitous in the industry is a troubling case of the Emperor’s new clothes.

We highlight three criteria pension funds should use to determine whether or not a particular hedge fund strategy presents good value:

1. Is the strategy just beta dressed as alpha? 

A key justification often cited for high fees is to reward hedge funds for the alpha, or manager skill, they produce. However, historically most hedge funds have relied on beta to generate at least some of their returns. If hedge funds charge fees for alpha they should be able to prove they have delivered alpha.

2. How big is their piece of the pie?

Given typical management fees of 1.5-2 per cent each year and the existence of performance fees, normally levied for the generation of a positive return over a year, the proportion of returns that hedge funds take away for themselves can end up being significant. For example, on a standard ‘2 and 20’ fee structure, a 5 per cent gross return translates to a 2 per cent net return for investors, meaning the manager takes away 60 per cent of the return.

There have also been historical instances where hedge funds have put through costs such as private jets as additional expenses that investors are required to pay, above and beyond management and performance fees. Investors should assess the impact of all fees on returns and insist on mechanisms such as performance fee ‘hurdles’ –  the minimum level of return that the manager must achieve before levying a performance fee and high watermarks.

3. What are the benefits of an illiquid diet?

Hedge funds often point to the so-called illiquidity premium – the reward that comes from investing in illiquid assets – as justification for the infrequent subscription and redemption cycles on offer. The presence of this premium varies considerably across markets and over time, and it is not always evident that hedge funds access it. Is your money locked away for a good reason? 

The above considerations mainly apply to defined benefit pension funds, but as the pension landscape continues its evolution towards defined contribution, hedge funds will need to change their whole charging model in order to adapt to a world of fee caps and pricing transparency. If they will not do this, they will be of no value to pension funds.

Atul Shinh is an investment specialist in the multi-asset team at Investec Asset Management