Hedge funds: California calls time

By Miles Johnson and Dan McCrum. This article originally appeared on the Financial Times website, FT.com on September 19th, 2014

Few of the local workers who pay into the London borough of Camden pension scheme each month would have heard of Alan Howard.

But while he is not a household name, Mr Howard is managing a sizeable chunk of the money for Camden’s retired public workers. As founder of Brevan Howard, one of the world’s largest hedge funds, Mr Howard has become one of Britain’s richest men in little more than a decade, in part through charging pension funds such as Camden large fees to manage their money.

Pension funds across the world have embraced hedge funds over the past decade, hoping that the industry would live up to its reputation for delivering high-octane returns. This departure from the traditional, conservative approach typically taken by retirement funds became a necessity as many of them had big gaps between the assets they held and the amount they owed pensioners.

Once the preserve of members of the super rich with an appetite for risk, hedge funds have been transformed by this rush of money, with pensioners now making up 36 per cent of the $3.1tn invested in hedge funds globally, according to Towers Watson, a consultant.

“The hedge fund industry has evolved significantly since its beginnings,” says David Barenborg, a managing director at BlackRock, one of the world’s largest allocators to hedge funds. “What was a cottage industry, opaque and secretive and dominated by high net worth capital, has become much more institutionalised”.

But this love affair may be drawing to an end. This week the California Public Employees’ Retirement System, the largest public sector pension fund in the US, said it was eliminating its entire $4bn of investments in hedge funds, citing concerns over their expense and complexity. The withdrawal by Calpers comes at a time when hedge funds are coming under greater scrutiny over the high fees they charge investors after several years of underwhelming performance.

Hedge funds – small private investment managers that can make bets across multiple markets – have historically promised their investors outsized returns in exchange for a fixed management fee of 2 per cent of their investment a year, and 20 per cent charged on any profits they make.

While this fee structure has fallen in recent years, hedge fund managers still earn big money from it. Last year the world’s 25 best-paid hedge fund managers made an estimated $21.1bn, equivalent to the entire economy of Jamaica

At the same time, from 2008 to 2013 the average hedge fund managed to increase the savings in its care by only 3.6 per cent each year, according to HFR, significantly less than a simple collection of stocks and bonds. In 2011, a year when markets were roiled by the European debt crisis, most hedge funds lost money for their investors.

A Financial Times analysis of industry data from HFR and Preqin found that at the start of 2008 public pension plans had invested about $380bn with hedge funds. Over the following six-and-a-half years the data indicate that they committed another $70bn in capital to the industry’s care, and received about $95bn in investment gains, based on the performance of the average hedge fund. For such money management the hedge funds took about $68bn in fees.

To put it another way, since the start of 2008 public sector pension plans paid about 72 cents for every dollar of investment gain they got back from hedge funds, according to the FT calculations.

At the heart of Calpers’ decision lies a debate over what role – if any – hedge funds should play in safeguarding the retirement money for public employees. For hedge funds, there are questions about whether the strategy of growing bigger by taking on public pension fund money may in fact destroy the model that made them successful in the first place. Once they were unshackled, investors were free to make billion-dollar bets at their fancy. Today they resemble public sector contractors.

Denizens of London’s well-heeled Mayfair district and leafy Greenwich, Connecticut – hubs of the hedge fund world – are quick to dispel the idea that others would follow Calpers’ lead, arguing that this was merely one client among many. Yet others in the industry argue that their job is to focus on long-term performance, and that they should not have to be distracted by the shorter- term concerns of their investors.

I am perfectly happy for anyone who is not happy to fire me,” says one of the world’s highest-profile hedge fund managers. “I have made my investors money in the past and will continue to do so”.

Managers such as this one argue that the hedge fund industry has become a victim of its own success by attracting more risk-averse money, such as pension funds. In the heyday of the industry, savvy hedge fund managers could sniff out “market asymmetries and anomalies” and take advantage of them quickly. But today thousands of traders and investors are competing to gain an edge. Profits fade away too quickly in niches where an alert manager may have had little competition two decades ago.

While the correlation may be misleading, the performance of the $25bn Brevan Howard Master Fund has suffered as it has grown. After making low single-digit returns in 2012 and 2013, it is on track to lose money this year for the first time.

In the 1990s, when most hedge funds were small and managed savings for the rich, the promise was that they could make money irrespective of economic conditions or market movements. So-called “absolute returns” was the defining term, used to contrast the approach of risk-taking hedge fund managers such as George Soros, left, or Luis Bacon with humdrum managers of mutual funds, who measured their investment skill against an index of stocks or bonds.

After the financial crisis, the sales pitch for hedge funds changed. Many high-profile funds collapsed, lost large amounts of money or refused requests to hand back cash to investors. They reassured their clients by arguing that they had lost less money than the overall stock market. According to HFR, the average hedge fund lost only a fifth of its investors’ money. Investing in hedge funds, they explained, was a way to limit risks. Pension funds that had suffered big losses were encouraged to turn to hedge funds to survive the next crisis.

They may well have to hone their sales pitch once again. Calpers’ decisions are watched carefully in the pension fund world. It was a pioneer in investing in hedge funds when it launched its Absolute Return Programme in 2002. Now that it has turned its back on hedge funds, others may follow suit, dealing a huge blow to the industry.Edmund Truell, chairman of the £4.5bn London Pensions Fund Authority and a critic of hedge fund charges, said that the industry’s high fees were no longer acceptable. Mr Truell, who took over the fund in 2012, redeemed an investment it held with Brevan Howard after the fund failed to comply with the level of transparency he had requested.

“In a low interest rate environment you cannot justify the traditional hedge fund fee structure, and as a steward of public money we cannot pay those fees,” Mr Truell said.

Pension funds are also negotiating ever harder on fees, pushing down hedge fund manager’s margins at a time when their operating costs have risen.

“We are willing to pay good rates for higher returns but when returns are low, we need to ensure that fees are also lower,” says Luke Dixon, co-head of Public Market Manager Selection for the UK’s £44.7bn Universities Superannuation Scheme.

Defenders of hedge funds argue that their job is not simply to mimic the returns of stocks and bonds, of which pension funds already hold large amounts. Instead the role of shrewd managers is to provide protection from large market drops and to deliver investment performance that does not correlate to the wider market. Investors face a quandary over where to place their money after big rallies in both stocks and bonds. Hedge funds, their supporters argue, will be the beneficiaries when volatility returns to the markets.

“Investors like pension funds are now facing a dilemma as stock markets have risen very sharply, and bonds yields are very low,” says Max von Bismark, chief executive Europe for SkyBridge, a $10bn investor in hedge funds on behalf of its clients. “The question is, where do they go? Hedge funds will provide a balance to their overall portfolio, providing returns that are less correlated to the wider market and are better positioned to cope with volatile markets than regular investment managers”.

Investors may well continue to trust the sharp-suited traders to help them navigate the uncertainty hanging over the market as the US Federal Reserve edges closer to unwinding its crisis-fighting measures.

But if hedge funds fail to shine come the next market crisis, they could find that faith will have disappeared for ever.

Additional reporting by Josephine Cumbo

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