Institutional influence shaping hedge fund investments

Janine Baldridge, Russell Investments’ global head of consulting and advisory services, talks to Kristen Paech about the new terms pension funds are demanding from their hedge fund managers – including lower fees and more control – and how managers are responding.

Earlier this year, the $181 billion California Public Employees’ Retirement System (CalPERS) announced it would restructure its relationships with its hedge fund managers to achieve better alignment of interests, more control of its assets and enhanced transparency.

CalPERS has the scale and scope to be able to dictate terms to a much better degree than other investors, but the move is indicative of a wider shift that’s occurring in the hedge fund world and managers are responding
accordingly.

Janine Baldridge, global head of consulting and advisory services at Russell Investments, and director, research and strategy for its Americas institutional business, says pension funds are demanding more reasonable fees and more control from their hedge fund managers in today’s tougher market environment.

This is leading to closer alignment between the investors and the funds, and is likely to reshape the way the industry operates in the future.

“What we will see is more reasonable investment strategies, and we’ve seen that occur over the years with less independence of the underlying hedge fund managers to do their own thing at the expense of their investors,” she says.

“There’s a lot more discretion in the hedge fund environment and historically some hedge fund managers have taken a lot of discretion. As this market has more institutional money, institutions do want to give hedge fund managers flexibility to make money, but within a certain range. We’re still seeing underlying hedge fund managers take the discretion that they should, but appreciating that if they’re a long/short manager, they’re not going to be digging into credit or doing other things unless they go back to their investors and say ‘here are some good opportunities’.

“It’s appreciating that the investors are long-term investors but only to the extent that they believe they can articulate what their underlying investment managers are going to do for them.”

Widespread asset reductions across hedge funds and fund of funds are the major driver behind the trend.

“Where really good hedge funds had redemptions from good firms – they just needed their money back – we saw a lot offer good terms for new capital coming in,” Baldridge says.

While there’s still not a lot of new capital going into hedge funds or alternatives generally, Baldridge says newer hedge funds are lowering their fees in a bid to attract pension funds back to the market.

Watson Wyatt’s Global Alternatives Survey for the year to December 2008, which analyses the Top 100 alternatives managers by assets under management, found alternative assets managed on behalf of pension funds by the world’s largest investment managers fell by around 1 per cent to $817 billion last year.

The modest decline contrasted with a 40 per cent increase in the amount of alternatives invested with top managers during 2007, compared to 2006.

But it’s not just the new managers that are struggling for new capital. Baldridge says established hedge funds too are reacting to the wane in appetite for risky assets, offering to waive the performance fee temporarily on new capital.

“We have also seen more reasonable terms for experienced hedge fund managers to say ‘Please give me new capital and I’ll bring you in at where everyone else is in the fund’,” Baldridge says.  “‘Your assets aren’t going to come in with a new clock, so every dollar that I make will be hit with a performance fee, but you can come in and let us go back up to our high water mark and we won’t charge you a performance fee on that, and then once we get back to where we were you and everyone else will all start paying performance fees again’. That’s a reasonable, and I think very appropriate, way to get new capital back in.”

Whereas in the past the standard hedge fund fee comprised a management fee of 2 per cent of the fund’s net asset value each year and a performance fee of 20 per cent of the fund’s profit, Baldridge says fees have been trimmed to 1-1.5 and 20.

“And we’re seeing some hedge fund or hybrid private to hedge fund strategies that are clearly long bets,” she says.

“It’s a fixed income play. Those are being offered at much reduced fees, somewhere between a long fixed interest manager and a hedge fund fee, because you are expecting the capital markets to give you a lot of the increase as opposed to a truly skillful manager looking to buy really good things and short really good things.

“We weren’t seeing that a year or two ago; people were trying to call beta plays a 2 and 20.”