Why would an allocator pay significant fees to hedge funds that are making “skill-less returns,” when they can make better returns by sitting on cash? This was a question posed by several allocators, led by the Teacher Retirement System of Texas, who wrote an open letter to the hedge fund industry titled Regarding the Usage of Cash Hurdles in Incentive Fee Arrangements, calling for cash hurdles before being charged management fees.
“We believe incentive payments on true value-add fixes a misalignment that has been present in fee structures throughout the maturation of the hedge fund industry,” the letter stated.
In 2023, a market neutral hedge fund with $1 billion in assets would have returned 5.25%, or $52 million by holding cash. Using a traditional 20% fee as a measure, that hedge fund would have taken home $10.5 million in compensation for taking on zero risk, something that the letter calls unsustainable. Three year treasuries are currently 5.4%.
With a cash hurdle, such as the letter suggests, hedge funds would not start to earn fees until a fund’s return exceeded the cash return rate.
“This is not sustainable, especially as it seems the risk-free rate may remain elevated for the foreseeable future; and it is not what LPs are asking GPs to do,” the letter stated. “Earning cash returns is not the reason institutional LPs invest in hedge funds.”
The letter was signed by 29 allocators, including pension funds, corporate defined benefit pension funds, endowments, sovereign wealth funds and foundations. Signatories of the letter included the Texas Permanent School Fund, Canadian pension fund CDPQ, Singapore’s GIC, Korea Investment Management, UTIMCO, PERA of New Mexico, among others. The letter was also signed by investment consultant firms Aksia, Albourne and Verus.
“PERA is signatory to the open letter because we agree that hedge funds broadly should employ hurdle rates. While some in the hedge fund industry do use hurdle rates in incentive fee calculations, many do not. PERA believes that those in the industry that do not should at least employ the cash rate as a minimum hurdle rate,” says Michael Shackelford, CIO of the Public Employees Retirement Association of New Mexico.
A spokesperson for the Teacher Retirement System of Texas says that LPs interested in adding their name to the letter are encourage to reach out to the pension fund directly.
Hedge funds returned 4.9% in the first quarter, according to data from Aurum. While the asset class outperformed bonds, which returned –2.1%, they underperformed equities, which returned 7.3% during the same period.
Hedge funds have become less popular among institutional investors, and allocators are likely to continue cutting their allocations to these funds soon, according to research from Agecroft Partners. Public pension funds increased their hedge funds allocations to 6.5% in 2022 from 3.3% in 2010, but the firm expects a reversal in the coming years.
“We recognize that the implementation of cash hurdles means adjustments to fee schedules and operational procedures within funds. However, it is our firm belief that the long-term benefits of proper alignment vastly outweigh short term challenges,” the asset owners’ letter states. “Therefore, we urge the hedge fund industry to embrace better alignment and adopt cash hurdles in incentive fee arrangements as a best practice standard.”
The signatories of the letter are:
- BCV Asset Management
- Bimcor Inc.
- Brightwell Pensions
- BW Gestão de Investimentos Ltda.
- CDPQ
- Credit Suisse Pension
- Employees Retirement System of Texas
- Fire & Police Pension Association of Colorado
- FS Fiduciary Services LLC
- GIC
- Healthcare of Ontario Pension Plan Trust Fund
- Indiana Public Retirement System
- John D. and Catherine T. MacArthur Foundation
- Kern County Employees’ Retirement Association
- Korea Investment Management
- Pragma Gestão de Patrimonio LTDA
- Public Employees Retirement System of New Mexico
- South Carolina Retirement System Investment Commission
- Suva
- Teacher Retirement System of Texas
- Texas Permanent School Fund Corp.
- Texas Treasury Safekeeping Trust Co.
- Trans-Canada Capital
- UTIMCO
- University of Toronto Asset Management Corp.
- Utah Retirement Systems
- Virginia Retirement System
- West Virginia Investment Management Board
- Wyoming Retirement System
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Tags: allocators, Hedge Funds, institutional investors, Michael Shackelford, New Mexico PERA, Pensions, Texas TRS