When the California Public Employees’ Retirement System made its first-ever hedge fund investment, in 2002, institutional investors around the U.S. sat up and took notice. CalPERS, then and now the nation’s largest public pension plan and widely viewed as an investment trendsetter among its peers, was the first such fund of significant size to invest in what was a burgeoning corner of the alternative-investment industry. Other public plans followed: Hedge fund assets swelled from $626 billion in 2002 to, by some estimates, nearly $3 trillion today, with the bulk of that growth coming from institutional investors.
So when CalPERs, which now manages $298 billion, announced last month that it was slashing its exposure to hedge funds to zero, institutional investors once again scrutinized the California plan’s action and the reasons behind it. For its part, CalPERS cited the costs and complexity of maintaining its $4 billion hedge fund program. Given the modest size of that allocation, hedge funds weren’t likely to make much of a difference in the performance of the California plan’s overall portfolio. But critics pointed out that the program’s returns were less than stellar: It had earned 4.8 percent annually, on average, for the past ten years. Last year CalPERS reported gaining 7.1 percent on its hedge fund investments, compared with 18.4 percent for the plan overall; it paid out some $135 million in hedge fund fees, however. Media outlets including the New York Times and Bloomberg pounced on CalPERS’s decision to pull back, declaring that pensions were finally facing the truth about hedge funds: They’re too expensive, and their results are not nearly strong enough to justify the costs.
The complaints have merit. From 1990 to 2000, hedge funds routinely posted gains north of 20 percent and in aggregate did not have a down year, according to Chicago-based Hedge Fund Research. Compare that with returns over the past five years, an unusual period defined by the Federal Reserve’s quantitative easing policies and geopolitical instability. The average hedge fund produced an annualized return of 7.78 percent from 2009 to 2013, according to the HFR Fund Weighted Composite Index. By contrast, a low-fee index fund with a 60-40 allocation of stocks and bonds had an annualized return of 13.17 percent over the same period. What’s worse, hedge funds delivered these returns after charging between 1 and 2 percent of assets under management and a staggering 20 percent of performance gains.
Institutional investors — university endowments, sovereign wealth funds and public and private pension plans — now make up 63 percent of hedge fund assets, reports London-based Preqin, so the impact would be large if they retreated. To be clear, there are no signs that institutions plan to cut hedge funds en masse any time soon. A recent Preqin survey of more than 100 institutional investors collectively managing $13 trillion found that 87 percent intend to maintain or boost hedge fund allocations in the next 12 months.
But the CalPERS move does suggest that institutional investors are growing restive, and some contend that either performance must improve or fees are going to have to come down — or both.
“The growth that the hedge fund industry has received over the past four or five years has not been earned,” says Thomas Britton (Britt) Harris IV, chief investment officer of the Teacher Retirement System of Texas, the $130 billion pension fund for the state’s public school teachers. “Returns have been too low. If you look at returns of the typical hedge fund over the past five years, it’s going to be below equity and fixed-income markets. The saving grace has been that nobody has needed hedge fund performance.”
Even if CalPERS’s exit does turn out to be an anomaly, the hedge fund world is nevertheless changing in fundamental ways. The onslaught of institutional capital has created megafirms that bear little resemblance to the owner-operator boutiques that dominated the industry in its early days — and has created a bifurcation between fast-growing institutional complexes and family-office-style operations. Increased regulation since the 2008 financial crisis has made it more costly for firms to operate, and generating alpha, or excess returns above a benchmark, has grown more difficult.
The wild card is the imminent end of the Fed’s quantitative easing program and the cascade of consequences, on everything from fixed-income portfolios to emerging markets to the stock market, that could ensue, particularly when rates rise. It is impossible to predict any single future for hedge funds, but in a constantly evolving industry the greatest certainty is that the business will look very different from what it is today.
Change has been component of hedge funds since their infancy. The funds gained traction in the 1960s. They were designed to protect portfolios from sharp stock market declines — hence the name. But the industry became famous for sky-high performance. Star managers, including Paul Tudor Jones II, George Soros and Michael Steinhardt, delivered huge gains in the 1980s, sometimes hitting triple digits. In the 1990s hedge funds produced an annualized return of 18.26 percent, according to HFR. Wealthy individuals and family offices flocked to hedge funds and remained their primary investors for years, along with so-called funds of hedge funds, which built portfolios of hedge fund stakes for their own clients.
In the early 1990s the first wave of institutions discovered hedge funds and the industry exploded, from $39 billion in assets in 1990 to $491 billion a decade later. The arrival of pension plans drove assets to $1.9 trillion by 2007.
A cottage industry mushroomed into a nearly $3 trillion business, with capital driving evolution and funding different strategies, from activism to macro players to quant-driven funds. More important, institutions, particularly pensions, had different performance objectives from earlier investors. They required a certain level of performance to meet financial obligations, but they needed to earn that with low volatility and low correlation to other portfolio assets.
“No question, return demands and the risk appetite has come down from the early days of the industry,” says Gideon Berger, head of the investment team for the hedge fund solutions division of Blackstone Group, the alternative-asset giant that is the world’s largest investor in hedge funds, with $64 billion invested in them. Pension fund investment officers, he says, look to hedge funds for better risk-adjusted returns than equity managers can provide. “Pension funds, which are typically trying to make 7 or 8 percent, find large equity allocations to be a huge headache because the associated volatility can quickly swing them from overfunded to underfunded even if they achieve their return objectives,” he says.
In hopes of finding steadier, less volatile returns, pensions and other institutions have sought a performance profile that the earliest hedge fund investors undoubtedly would have rejected. Preqin’s survey found that only 7 percent of institutions consider high returns a priority. Two thirds say they are looking for annual returns between 4 and 6 percent.
Some hedge fund firms adapted their businesses to meet the performance requirements of these institutions, and this turned out to be a savvy business move. In fact, Institutional Investor’s Alpha’s annual Hedge Fund 100 ranking of the world’s top hedge funds is now dominated by institutionally oriented firms. In 2004 the largest hedge fund firm in the ranking was New York–based Caxton Associates, at $11.5 billion; today it’s Westport, Connecticut–based Bridgewater Associates, with $160 billion in total assets, $92.7 billion of it in hedge funds.
Still, some observers argue that capital from institutions seeking steadier, more modest returns has dampened the mystique that made hedge funds so appealing: managers’ ability to generate alpha. “Hedge funds have become an asset class themselves, and it is quite possible they are creating inefficiencies instead of exploiting them,” notes Rael Gorelick, co-founder of Charlotte, North Carolina–based Gorelick Brothers Capital, a private-wealth investment adviser that invests in hedge funds and other alternative assets. Gorelick thinks returns have come down because too much money is chasing too few opportunities. “It’s not their own fault; it’s just the fact that their pool of capital is too large,” he says. “It’s a meta-problem. You were created by an inefficiency, and you have become part of the problem.”
Other critics contend that if the industry provides the modest performance standards that, say, pension investors require, its fees are no longer appropriate. “When you tell people, ‘You pay me 2 and 20 and I’ll always make money,’ you’re kind of implying you have magic, and you’re charging fees commensurate with magic,” says Clifford Asness, founder of Greenwich, Connecticut–based AQR Capital Management, which oversees $115 billion in assets, including $62 billion in alternative assets including hedge funds.
Asness has long been critical of hedge fund fees, asserting that many managers charge alphalike fees for returns that rarely come entirely from alpha. And many people, including legislators, have grown increasingly irate about public pension plans paying high fees, even after they’ve negotiated special deals. Although the most elite, best-performing managers will likely be able to charge whatever they want, there are signs that fees are edging down and that investors are growing more sophisticated about what they pay for and the types of returns managers deliver.
Some industry observers say the largest hedge fund firms have already accepted that the bulk of future earnings will not come from supercharged performance fees and have begun diversifying into more-mainstream offerings. Others say that as rates rise, institutional investors may no longer be as dominant, which could further alter the dynamics of the business. In any case, hedge funds are facing a watershed moment.
Alfred Winslow Jones — a former Foreign Service officer stationed in Europe who dabbled in Marxism before moving to New York and writing for Fortune magazine — gets credit for creating the first hedge fund, in 1949. Jones fashioned an investment vehicle that used borrowed money to buy stocks while simultaneously selling other stocks short to reduce his overall exposure to market swings. He also helped create the modern hedge fund fee structure. Never a particularly talented stock picker himself, Jones hired men to run a portion of partners’ capital internally and gave the biggest payouts to those who generated the greatest returns. By tying compensation to performance, Jones fostered a Darwinian, kill-or-be-killed culture in which managers were richly rewarded for delivering big gains (for more, see our 1968 feature, “The Mystique of the Hedge Funds”).
Though the original purpose of hedge funds was to insure against market declines, the funds became best known for spectacular performance. Soros earned his investors — and himself — huge returns by placing outsize wagers like his bet against the British pound, which netted a stunning $1 billion in 1992. Julian Robertson Jr. grew his New York–based stable of stock pickers, Tiger Management Corp., to a peak of $23 billion from $8 million. generating annualized returns of 25 percent, net of fees. Hedge funds were a rough playground for financial geniuses who could deliver high-double-digit returns.
The 1990s ushered in an era of rapid growth. In the early part of the decade, a smattering of institutional investors — most notably, the Yale University endowment, whose portfolio was managed by David Swensen — jumped on board, looking to smooth out volatility after the early-’90s recession. Then, when the dot-com bubble burst in 2000, stock market investors lost staggering amounts. Hedge funds, by contrast, acquitted themselves well, and institutions noticed. The trickle of money turned into a flood.
“The dot-com bubble was probably the greatest time in the history of investing for being able to produce alpha in a down market,” says Texas Teachers’ Harris. Massive overvaluation in technology and telecommunications, coupled with undervaluation nearly everywhere else, meant easy pickings for fundamental long-short stock investors. Adds Harris: “When it was all over, people saw that the typical equity fund went down 35 percent and the typical hedge fund went up 12 percent. People looked at it and said, ‘What’s going on over here?’”
Mark Anson, CIO of the Robert M. Bass family office, Acadia Capital, in Fort Worth, Texas, was CIO of CalPERS at the time. The pension plan had gone from being overfunded to the tune of 110 percent to underfunded after dot-com-era market losses. Anson invested $50 million of CalPERS’s money into five different hedge fund firms — the first part of a $1 billion allocation. Other institutions followed. As pension assets rushed in at a breakneck pace, hedge funds grew more “institutional” — investor-speak for more mature. Unlike the wealthy individuals who once backed hedge funds, many institutions were not looking for hedge fund managers to shoot the lights out; lower returns suited them fine.
Those expectations have not changed. “I’m no longer looking for huge double-digit gains from hedge funds,” Anson says. “If I can get above 10 percent a year, that’s fine and dandy, but what I distinctly look for is lower volatility than the broad stock market.”
If anything, appetite for low returns with low volatility grew after the financial crisis. Central banks intervened in markets, cut interest rates and introduced stimulus measures. Marc Lasry, co-founder and chief executive of $14.1 billion hedge fund firm Avenue Capital Group, says that when the risk-free rate essentially moved to zero, institutions had no choice but to move into alternative assets to meet return objectives. He contends that delivering the performance institutions want with levels of risk they’ll tolerate is easier said than done. “Today pensions say, ‘Hit my bogey of 8 percent’ — that’s 32 times the risk-free rate,” he says. He points out that when Treasury bills yielded 5 to 6 percent, institutional investors didn’t need hedge funds. “Until the risk-free rate changes, the industry is moving toward people being happy with 6 to 8 percent.”
Ashbel Williams Jr., executive director and CIO of the Florida State Board of Administration, concurs. “Today people like us look at hedge funds as downside protection,” he says. “Investors like us are not trying to get the highest returns we can. We are investing over the long term to meet a set of liabilities that are coming due in 20, 30, 40 and 50 years. Protecting capital in down markets will, over the fullness of time, help us compound capital.” He says that since inception his hedge fund portfolio has exceeded its benchmark by 40 percent, with almost half its volatility.
But not all investors are happy with how the average hedge fund return has slipped over the years. Some assert that institutionalization has created tension among different investors. One executive for a prime brokerage firm describes a kind of class system. The common perception, this executive says, is that institutions don’t want to invest alongside funds of hedge funds, which they consider more fickle because they have their own investors to answer to — and which have gained a reputation for yanking money out at the first sign of trouble. But today the executive sees a different issue. Funds of funds no longer want to be invested alongside institutional investors that are happy with single-digit returns with low volatility.
A similar schism is dividing managers. Some of the largest, most visible hedge fund firms have matured into huge quasi–asset management firms and created lower-risk, lower-return funds to cater to pension plans. They have branched out into long-only investments, so-called smart beta products (which track a customized index or give investors exposure to specific style factors) and other offerings that don’t fit the hedge fund mold. A few have even moved into mutual funds, offering liquid alternative funds to mass-affluent and retail investors. Other managers, who formed hedge funds to flee what they thought of as the establishment, remain committed to the traditional hedge fund model. They are focused on generating the highest possible returns, within acceptable risk parameters, at the expense of growing assets, and they have no intention of reducing fees to lure investors.
“I would view the hedge fund industry as two groups. You have institutional asset gatherers, and you have your owner-operator hedge funds,” says Lawrence (Larry) Robbins, founder of $9.8 billion, New York–based hedge fund firm Glenview Capital Management. “The institutional asset gatherers will attract more pension money, they will attract money at scale, and since their size and structure hamper investment returns, they need to charge lower fees.”
To be fair, some institutional investors would be thrilled with high-performing funds as long as returns were strong on a risk-adjusted basis. But managers who can consistently produce these returns are rare, have a line of investors waiting to sign up and are not interested in cutting fees. And even if pension CIOs could get their boards to approve investing in such managers, there is the reality that those fees can be political lightning rods.
Just ask Rhode Island General Treasurer Gina Raimondo. She boosted the state’s investment in hedge funds as part of a larger plan to reform Rhode Island’s pension funds; critics attacked her for steering public workers’ retirement plans into investments they said were too expensive and operated in secrecy. (Despite the attacks, Raimondo recently won the Democratic primary for governor. She’s expected to come out on top in November’s general election.) It’s an argument that people in Raimondo’s position should expect to hear, says Lawrence Schloss, president of Angelo, Gordon & Co., a New York–based hedge fund and investment management firm. Schloss, a veteran of Donaldson, Lufkin & Jenrette, should know: For nearly four years he served as CIO of New York City’s five public employee retirement plans. “When I was at the city, we negotiated everything down to the basis point as hard as we could and threw our weight around as much as possible and did a great job getting fees down,” he says. “But as an industry it advertises 2 and 20, so you have to take the heat for that, even if you got a special deal. At the end of the day, it’s the net return that really matters, as well as the specific manager performance.”
Glenview’s Robbins says a pension fund once fired his firm over fees — just in time to miss huge gains the following year. He defends his refusal to budge on fees that allow him to invest in the high-quality portfolio managers and analysts necessary to achieve high returns. “Hedge funds are asked to do something unnatural, which is to produce above-average performance with below-average risk. That’s hard to do,” he says. “In our case we’ve delivered to investors six to seven times the profit dollars with two thirds of the volatility of the S&P 500. The owner-operators are really where the performance has been and will continue to be. So investors should be willing to pay higher fees to get predictably higher returns and a better alignment of interests.” Robbins takes issue with firms that don’t deliver strong performance but still charge high fees. “Adding even a 100-basis-point management fee to a 4 or 5 percent return is offensive if you add an incentive fee on top of that,” he says. Still, the 2-and-20 fee has proved to be astonishingly resilient.
In the 1990s and early 2000s, hedge funds could easily defend giant fees. But, says AQR’s Asness, few firms deliver the kind of performance to justify those fees anymore. Asness, in fact, contends that hedge funds deliver a lot less alpha than their investors are paying for. True alpha, he says, is extremely scarce and difficult to generate, and most hedge funds charge hefty fees despite the fact that at least some of their returns come from market exposure or from strategies that, though not as simple as buying an index fund, are not that complicated, either. “If I have a beef with the hedge fund industry, it’s that they put together this portfolio of three things that we like as a firm, but they charge fees as if it’s all alpha,” he says. “We have naturally gravitated to calling the few things we think are really unique alpha and then being honest about the rest of it.”
At AQR different products get different fees. For index-type strategies the firm charges indexlike fees. For pure alpha strategies the fees are closer to standard hedge fund fees. And for strategies that are more complex than an index fund but not as arcane as a hedge fund — the smart beta strategies — the fees fall in the middle. Asness thinks that smart investors will differentiate among sources of fees, though he admits this is taking longer than he expected.
Others say the trend is gaining momentum. Trey Beck, head of investor relations at D.E. Shaw & Co., a New York–based, $34 billion asset management firm with $24 billion in hedge funds, observes that institutions have grown more sophisticated on fees. Beck says fee discussions are changing, with managers becoming “more thoughtful and more rigorous about disentangling the different sources of return and charging accordingly.”
Institutions are not as concerned with returns as with returns per unit of risk, and they want performance that is not highly correlated to other assets. They resist paying too much for beta. “That’s exactly the type of thing people weren’t saying 20 years ago,” Beck adds. As investors increasingly focus on the quality of returns, they think more in terms of the Sharpe ratio, which measures a fund’s risk-adjusted performance, and that ultimately translates into a more institutionalized hedge fund industry, he says.
That institutionalization is not necessarily a bad thing. Today managers are more transparent with investors than ever before thanks to institutional demands. They have their operations and the value of their assets vetted by independent third parties, which was not the norm 20 years ago.
But as David Harding, founder of London-based, $25.2 billion asset management firm Winton Capital Management, points out, this business focus has changed the way many hedge fund firms operate — and will likely alter the nature of some of the largest firms. “You have to tick a lot of boxes to get institutional capital,” he says. “Some people have made their peace with that, and others have not. And those with a greater business orientation are more desirous of seeing their firms become money management firms. A lot of people in the hedge fund industry would run a mile from that.”
Harding hopes Winton can strike a balance. He views business-building as an intellectual challenge that requires not only investing talent but the ability to hire the right people and build an operationally sound firm. Owner-operator hedge funds, he says, are not built to be institutions, whereas some of the largest hedge fund firms have evolved into midsize U.S. asset managers like T. Rowe Price or Legg Mason.
Harding notes that the term “hedge fund” will not necessarily become irrelevant, but there will be more segmentation, with the greatest asset growth in lower-fee, lower-return, higher-volume products. Winton has expanded into the mass-affluent market, launching UCITS III funds — essentially, mutual funds that can employ some alternative-investment strategies — in the U.K. and Europe. And it has also branched out into long-only equity funds.
John Bader, chairman and CIO of New York–based Halcyon Asset Management, which runs $12 billion across diversified strategies, including more than $6 billion in hedge funds, says the definition of what it means to be a hedge fund is changing. Bader resists being pigeonholed as a hedge fund manager because many of his clients want customized products that don’t take the shape of a commingled hedge fund vehicle. He sees this trend growing, particularly as institutions gain sophistication — and the desire to invest directly. “The coincidence of these phenomena is leading to substantial growth in assets for institutional managers sensitive to client needs,” he says. “I just don’t know if you’d call what we do hedge fund management anymore.”
Some firms, such as Winton and AQR, are venturing where many hedge funds would not have dared to go even ten years ago: into long-only, mutual fund and other non-hedge-fund products. Asness notes that once a firm decides to go the business-building route, it naturally resists restriction to the hedge fund arena. “You can build a much broader money manager; that lends itself to a business more than even an exceptionally successful cowboy,” he says. Firms like AQR combine alternative and traditional asset management, which is likely to continue, he adds. But when asked what impact this will have on returns, Asness says with typical candor: “The very forces that professionalize hedge funds will probably, by definition, commoditize and somewhat lower returns. I wish I had a more upbeat answer than that.”
Still, most people expect the industry to continue to grow, though some wonder where that growth will come from. The flow of capital from institutions won’t increase forever, and not just because CalPERS is getting out. With the end of QE, managers and investors are closely watching the Fed for when interest rates will rise and what impact this will have. Some strategies will benefit from rising short-term rates. But as longer-term rates rise and yields on long-term Treasuries approach 5 to 6 percent, pension plans and defined benefit investors will start to take a hard look at whether they need hedge funds. Given that ten-year notes at 5 percent will make it easier for defined benefit plans to match their underlying assets with liabilities in a lower-risk fashion, that could mean that some institutions will leave in substantial numbers.
Observers say it could take from six to eight years for this to unfold — a short time frame in asset management. That’s one reason hedge funds are turning to the investor group that built the industry in the first place: wealthy individuals, or, in industry parlance, high-net-worth investors. Firms are jockeying to get on investment banks’ private wealth platforms, so much so that it’s easier to reel in money from a defined benefit plan than to win a spot on such a platform, says Dawn Fitzpatrick, CIO of O’Connor, a $6 billion multistrategy hedge fund in Chicago that is wholly owned by UBS. “I’ve never seen so much interest on the high-net-worth side,” she says. She thinks potential outflows from pension plans could be “more than offset” by wealthy investors. “But it’s going to change the complexion of the industry in profound ways. The industry will look dramatically different in ten years than it does now. Getting from here to there will be interesting, and there will be big winners and big losers.”
Big winners and big losers may be the only constant in an ever-evolving industry. • •
Follow Amanda Cantrell on Twitter at @amandakcantrell.