A powerful coalition of pension funds led by the Texas Teachers Retirement System and including global giants such as Korea Investment Corporation (KIC), Singapore’s GIC and Canada’s CDPQ has targeted the hedge fund industry, demanding that a cash hurdle be introduced on incentive fees.
In other words, to earn the incentive fee, a hedge fund must outperform cash or the equivalent three-month Treasury note.
The open letter, signed by organisations representing over $200 billion in hedge fund investments, is unsparing.
They argue that the current fee structure creates a “misalignment of interests” between hedge fund managers (GPs) and investors (LPs).
With three-month Treasury yields above 5%, you can earn a pretty reasonable income just by holding cash, and some hedge funds charge incentive fees, typically 20%, reaping large rewards without demonstrating any real investment skill.
Skillless Return
What the letter calls “skill-free returns” is at the core of what investors are demanding.
“In 2023, a $1 billion market-neutral hedge fund could have earned approximately $52 million (5.25%) by simply holding cash. Also, if the fund charged an incentive fee of 20% on absolute returns, it would have received $10.5 million as a reward for eliminating risk,” the letter said.
Institutional investors argue that this is “unsustainable” and “not what LPs want from GPs.”
This frustration may be amplified given the recent performance of hedge funds.
Performance rebounded in the first quarter with an average return of 6.4%, according to Preqin data, but this was mainly driven by equity correlation strategies, which essentially rode the bull market wave.
The sustainability of these returns depends heavily on broader market trends rather than any proprietary strategy, which could further raise investors’ questions about the justification of high fees.
The history of hedge fund fees also adds fuel to the fire.
The traditional “2-and-20” structure, while showing some signs of tapering off, remains a major burden for investors.
The fact that multi-strategy funds, known for their high pass-through fees, are growing in popularity despite passing on a smaller percentage of returns to investors raises further questions about the value proposition of current fee structures.
A subtle perspective
A senior executive at one asset management firm said: Asian Investors One company interviewed said the concerns in the open letter were legitimate, but that imposing a uniform cash hurdle across the industry may be an oversimplification.
“Not all hedge fund strategies are created equal,” the executive said.
Lumping in equity-focused funds, which have benefited from the recent market rally, with low-correlation strategies such as global macro and alternative investment strategies, which typically perform well in economic downturns, paints an incomplete picture.
“Imposing a cash hurdle could also discourage or discourage managers from employing complex, uncorrelated strategies that could potentially outperform in volatile markets at a time when investors need them most,” the executive said.
Furthermore, the current high interest rate environment, which is the main driver of the “skillless return” theory, is likely to be temporary.
new era?
Still, aggressive stances, exemplified by a recent open letter from major pension funds, suggest that institutional investors are frustrated that some hedge funds are charging fees on returns in which they have little or no involvement.
No longer satisfied with the status quo, these investors are using their collective power to drive change.
The open letter, coupled with increased regulatory scrutiny in the United States, Singapore and China, could signal a move toward greater accountability globally.
It will be interesting to see how hedge funds adapt to the pressure from big investors and regulators.
Greater transparency in both fee structures and investment strategies may no longer be an option if they want to retain the support of large asset owners.
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