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A Hedge Fund Adviser’s Open Letter to Pension Trustees

It’s hard to pick up a financial newspaper these days without seeing some sort of piece on a purported hedge fund disaster. There are a number of reasons, I surmise, that this is the case:

The “rich guy gets hammered” trope sells papers. For every fund down 20 percent, a different one is up 20 percent. There’s a cottage industry of people who run around trying to find the next calamity.

High fees — justifiably — lead to high expectations. When you pay 2-and-20, you should expect magic. Reveal the wizard as human, and disappointment and anger inevitably follow.

Zero-interest rates make high-fee strategies look terrible. Cash plus 4 percent with bondlike volatility and low correlation to traditional assets is a valuable diversifier. The problem is that today cash plus 4 percent is only 4 percent. That seems pretty paltry after you’ve paid 3 percent or more in fees.

Bull market equity returns are a terrible point of comparison. The next 30 percent-plus drawdown in equities will be a great equalizer across strategies. Procrastination has paid off handsomely.

Many articles miss the point. CalPERS pulled out from hedge funds because $4 billion didn’t move the needle on $325 billion in assets. MetLife cut back on its hedge fund allocation because it prefers private equity — whose fees are higher than hedge funds’ — where it doesn’t have to mark the portfolio to market. The ballyhooed $15 billion pulled from hedge funds during the first quarter of this year was half of 1 percent of the industry’s $3 trillion in assets — hardly a flood of redemptions.

Let’s do a reality check. Hedge funds have set themselves a difficult task: to generate equitylike returns with bondlike risk. In simple terms equities have a 5 to 6 percent return over cash over time, with 15 to 18 percent volatility. For statistics aficionados, this is a Sharpe ratio of around 0.3. Bonds have returned cash plus 2 to 3 percent with half the volatility — again, a Sharpe ratio of about 0.3. Hedge funds are trying to do cash plus 5 to 6 percent with volatility of 6 to 8 percent — or double the Sharpe ratio. If they can do that consistently, then any associated headaches such as illiquidity, high fees or opacity are worth it.

Now let’s turn to a set of well-founded criticisms:

Hedge funds have underperformed their own expectations. Over the past ten years, the HFRI Fund Weighted Composite Index has returned 2.6 percent over Libor. Decent, but hardly worthy of a victory lap. Funds of funds, with another layer of fees, have done much worse.

Hedge fund fees are probably double what they should be. Before fees, funds typically hit their target of Libor plus 5 percent with a Sharpe ratio of 0.8. The problem is that virtually all that value-add goes to the managers.

The allocation process is broken. All the money goes to the largest managers to cover themselves rather than for investment reasons. The story line of “a fund puts up great numbers when small, then pulls in a ton of money and can’t repeat it” is played out day in and day out across the industry.

Some strategies are worth the fees, and others aren’t. The decline of market-beating returns in equity long-short strategies means investors regularly overpay. For other tactics, such as illiquid or esoteric strategies, it’s a different story, however.

Some populism is warranted. Persistent overpayment by pension funds comes off as unseemly. On big dollars, saving a percentage point or two in fees makes a real difference to retirees.

Instead of throwing out the baby with the bathwater, pension fund trustees should demand that their advisers provide a clear justification of when high-cost strategies are warranted and when they’re not. Hope isn’t an excuse anymore. They should be attuned to the fact that advisers almost invariably allocate to managers who have done well — which garners few complaints. This is simple selection bias, and it’s pervasive throughout the industry.

Advisers should also be required to explain why high-fee asset classes are preferable to lower-cost ones, such as multiasset strategies that, like hedge funds, seek to return Libor plus 5 percent with controlled risk but charge a quarter of the fees.

Advisers should be held to the same alignment and performance standards that are applied to active managers. Examine their picks from three years ago: Did they meet the assumptions established at the time? If not, why? It’s too easy to move the goalposts or blame the markets.

The tools are there; investors just need to use them.

Andrew Beer is managing partner and co–portfolio manager at Beachhead Capital Management, a hedge fund advisory firm, in New York.

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