Suddenly, Hedge Fund Fees Seem High

After the average hedge fund failed to keep pace with the S&P 500 in 2006, big investors like CalPERS are starting to complain about fees

by Steve Rosenbush

The top-performing hedge funds and private equity firms have generated annual returns in excess of 50% during the last few years, easily beating the public markets. Pension funds and other large institutions that put their money into these "alternative investments" pay a steep price to share in those profits. The funds typically charge a management fee as high as 2% of the funds that their limited partners—customers—invest. For top players in the hedge fund game, that means hundreds of millions of dollars in fee income from each new fund.

Now some institutional investors have started to complain, noting that the average hedge fund failed to keep pace with the market in 2006. In February, a senior manager at the $225 billion California Public Employees' Retirement System (CalPERS) said at the Institutional Fund Management conference that hedge fund fees have gotten too steep.

While hedge funds are commonly perceived as more risky than the stock market, they're actually supposed to carry less risk, producing relatively consistent results in both bull and bear markets. CalPERS Chief Investment Officer Russell Read said many hedge funds charge too much without delivering high enough returns or low enough risk. "We have no problem paying high-performance fees for a manager's selection, but we find taking on average market risk inherently unsatisfying," Read told attendees at the Geneva conference. CalPERS, the largest U.S. pension fund, said Read wasn't available for further comment on the issue.

Applying Pressure to Funds

A hedge fund typically charges investors a management fee of 1.5% to 2%, and takes 15% to 20% of profits the fund generates. An index fund's management fee, by contrast, is typically just hundredths of 1%. The prominent Vanguard 500 Index Fund (VFINX) has an expense ratio of just 0.18%, for example.

That disparity can be justified in years when hedge funds beat the broader market. But that didn't happen in 2006. A CalPERS spokesman said that the plan's $4.3 billion in hedge fund investments generated a return of 13.4% for the year. That was slightly ahead of the average hedge fund return of 13%, but just below the 13.6% return the Standard & Poor's 500-stock index generated in 2006.

Despite the fact that the average hedge fund lagged the broad market, the top funds remain wildly profitable for their investors. Senior managers of the top 25 funds took home an average of $363 million in 2006, according to a study by Institutional Investor. James Simons, the head of Renaissance Technologies, earned $1.5 billion last year.

Different Rules for Top Performers

In public, fee payers such as pension funds aren't talking about that issue too often. But the market is slowly beginning to apply other sorts of pressure on hedge funds (see BusinessWeek.com, 6/6/05, "A Fee Frenzy for Hedge Funds"). Investment banks such as Goldman Sachs (GS), Merrill Lynch (MER), and Morgan Stanley (MS) have introduced lower-priced investment vehicles that may compete for some hedge fund business. Goldman, for example, introduced a product in Europe last fall called the Absolute Return Tracker, an investment vehicle for pension funds and other large institutional investors.

The tracker uses an algorithm to analyze the returns of hedge fund strategies across a variety of asset classes, such as equities, commodities, and credit. "The Absolute Return Tracker is not designed to track hedge fund returns very closely, but it is expected to display returns over time that resemble some of the patterns of hedge funds as a broad asset class," Goldman spokesman Michael DuVally said. Goldman had no comment on the price or return. Goldman is planning to introduce the product to the U.S. market soon, a step that could put more competitive pressure on hedge funds.