Pension Perilously Binging Upon Hedge Funds, Funds of Funds and Funds of Funds of Funds
As pensions load up on multi-tiered hedge fund products created and recommended by their so-called independent consultants, fiduciary principles fall by the wayside.
A debate is swirling in Washington about the risks and rewards of hedge funds and their impact upon the financial markets. Legislators are hearing from hedge fund lobbyists and others who profit as these unregulated, high risk investment products gain acceptance. One of the fundamental tenets of our work is that the greater the marketing dollars behind a financial product, the greater the likelihood that it will be recommended to investors, regardless of the investment merits. Hedge funds, funds of funds and indeed funds of funds of funds created by pension consultants enjoy fees exponentially greater than any other financial product, as well as a lack of transparency and regulation that permit questionable secret compensation arrangements. This is the ultimate marketing gravy train. It has been said that hedge funds are a fee structure looking for an investment rationale. It is not surprising then that the voices opposing hedge funds are few: there’s no money to be made raining on this parade.
What is sorely missing in Washington is practical knowledge about the nature of the abuses that are prevalent in the hedge fund arena today. The politicians (and regulators) involved in the debate have little information about what hedge funds are doing today. The dialogue they are engaged in is focused upon the hedge fund marketplace as it existed ten years ago. In Washington the issue is framed as whether hedge funds should be permitted to market to billionaires gathered around country club swimming pools. Hedge fund marketing has migrated far from its high net worth origins. Today we see the greatest dangers lie where absurdly complex multi-tiered hedge fund products are sold to pensions as a means to solving their funding crises. As a result of our forensic investigations involving hundreds of hedge funds, funds of funds, and funds of funds of funds we have been asked to share our findings with certain key Washington figures. In this article we will address the issues related to so-called independent investment consultants’ recommendations to pensions regarding hedge funds, funds of funds and funds of funds of funds. Our conclusion is that the recommendations of these consultants to invest in hedge funds, funds of funds and funds of funds of funds result in a complete abandonment of generally accepted sound fiduciary standards applicable to pension portfolios. This should be of paramount concern to Washington decision-makers.
Only once you understand the mechanics of pension investing in hedge funds can you appreciate how radically such investing is undermining traditional fiduciary standards. Let’s start with the usual dribble you’ll read in the financial press in articles about hedge funds.
Hedge funds, including fund of funds, are generally unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives). Hedge funds may or may not engage in hedging or short- selling. Today the term “hedge” fund generally refers to these funds’ lack of registration, high portfolio turnover, use of leverage and fee structure, as opposed to any particular investment objectives or practices.
Often described in the press as “lightly regulated,” hedge funds are not subject to the same regulatory requirements as mutual funds, including mutual fund requirements to provide certain periodic and standardized pricing and valuation information to investors. Further, hedge funds are not subject to any regulation regarding custody of assets. Assets may be custodied with a bank, trust company or brokerage domestically or abroad which may not be financially sound or adequately regulated. A hedge fund may provide no transparency regarding its underlying investments (including sub-funds in a fund of funds structure) to investors. If this is the case, there may be no way for an investor to monitor the specific investments made by the hedge fund or, in a fund of funds structure, to know whether the sub-fund investments are consistent with the hedge fund’s investment strategy or risk levels. Further, investors may be unable to verify the valuation of the specific investments or performance of the managers.
In the retail context hedge funds are considered to represent speculative investments that involve a high degree of risk. Generally speaking, a retail investor’s investment in a hedge fund should be discretionary capital set aside strictly for speculative purposes. On the other hand, in the pension context, hedge fund advocates maintain that these funds reduce risk, provide returns that don’t correlate with the stock markets and should be compared to bonds. Hedge fund offering documents are not reviewed or approved by federal or state regulators. Hedge funds may be leveraged (including highly leveraged) and a hedge fund’s performance may be volatile. An investment in a hedge fund may be illiquid and there may be significant restrictions on transferring interests in a hedge fund. There is no secondary market for an investor’s investment in a hedge fund and none is expected to develop. A hedge fund may have little or no operating history or performance and may use hypothetical or pro forma performance which may not reflect actual trading done by the manager or advisor and should be reviewed carefully.
A hedge fund’s manager or advisor has total trading authority over the hedge fund. A hedge fund may use a single advisor or employ a single strategy, which could mean a lack of diversification and higher risk. A hedge fund (for example, a fund of funds) and its managers or advisors may rely on the trading expertise and experience of third-party managers or advisors, the identity of which may not be disclosed to investors. Death or impairment of an advisor may result in assets lacking management at a critical moment and for an extended period of time.
Many hedge funds experience substantial portfolio turnover involving significant commission expenses. Hedge funds may execute a substantial portion of trades on foreign exchanges or over-the-counter markets, which could mean higher risk. A hedge fund’s fees and expenses-which may be substantial regardless of any positive return- will reduce the hedge fund’s trading profits. In a fund of funds or similar structure, fees are generally charged at the fund as well as the sub-fund levels; therefore fees charged investors will be higher that those charged if the investor invested directly in the sub- funds.
Conflicts of interest that are impermissible with respect to registered investment advisers are commonplace and may not be adequately disclosed.
Enough!! Notwithstanding the above list of formidable risks (and many additional risks not mentioned above), many pensions today are turning to hedge funds in pursuit of above-market rates of returns that will enable them to meeting their funding deficits. The degree of additional risks related to hedge funds and the incremental investment returns related to such funds, if any, are hotly debated.
Hedge Funds
For example, according to a new global survey by Mercer Investment Consulting, less than a quarter (23%) of 180 pension funds surveyed that invest in funds of hedge funds are satisfied with their investment returns, while 28% are dissatisfied. The survey also found that just 58% of respondents understand their fund of hedge funds manager's investment approach. Globally, a third of the pension funds surveyed (33%) invest in funds of hedge funds, and despite their apparent lack of satisfaction, 54% intend to increase their allocations to hedge funds within the next two years. Dissatisfaction. Lack of knowledge. Intention to increase hedge fund exposure? This is hardly a very pretty picture. As bad as it is, the news about hedge funds of funds is even worse.
Hedge Funds of Funds
According to a report entitled “Hedge Funds. Too Much of a Good Thing” in Bernstein Wealth Management Research, June 2006, there is some merit to investing in as much as 20 hedge funds if an investor’s portfolio consists solely of hedge funds; however, if only 20% of an investor’s total portfolio is in hedge funds, the advantage of owning 20 hedge funds is much diminished. However, in our experience many pensions are advised by their so-called independent consultants to invest a significant percentage of their assets, say 20%, in not just one but multiple hedge funds of funds, involving 50 to 150 underlying hedge fund managers. This is insane. While the fund of funds approach permits diversification into a greater number of funds than a direct approach, multiple funds of funds appears to be unnecessary diversification. It is impossible for any one manager to significantly add value and it seems likely the vast number of managers will result in, at best, a market rate of return net of fees, with significantly greater investment and operational risk. In our opinion, at most, only one fund of funds makes sense for pensions investing a limited portion of their assets in hedge funds.
Further, research has shown that on average fund on fund managers fail to deliver additional return. Over the last ten years the compound pre-tax return of a fund of funds composite would have been 1.5 percentage points lower than Bernstein’s hedge fund composite. The reason that funds of funds have not fared well, according to Bernstein, is their multiple fee structure. Fund of fund managers need to pick not just better-than-average funds to produce incremental return, but among the best, concludes Bernstein.
A December 18, 2006 Bloomberg News article entitled “Dirty Wall Street Secret: Hedge Funds of Funds Pay T-Bill Rates,” also questions the investment merits of hedge funds of funds. The title of the article says it all.
Hedge Funds of Funds of Funds
If that’s not bad enough, it seems that no pension consultant is able to resist feeding from the hedge fund trough. Pension consultants are increasingly recommending that their clients invest in funds of funds of funds whereby the consultant is paid an asset based fee to select and monitor the funds of funds that, in turn, select and monitor the actual managers. Three layers of fees virtually guarantee that the net returns will be uncompetitive to the pensions. On the other hand, the fund of funds of funds vehicle is a clever way for pension consultants to exponentially increase their fees. Instead of being paid a fixed fee of $100,000 to provide advice to a billion dollar fund, the consultant can earn $300,000 or more as an asset based fee related to the 20% of the pension invested in hedge funds-- this in addition to his $100,000 retainer.
Are consultants actually providing important due diligence and monitoring services in exchange for these hefty fees? From our experience we have concluded that the consultants fail to add any meaningful value. They are generally capable of only parroting the information the hedge funds provide to them. The relationships are too cozy. Everybody’s getting fat on fees and it’s in no one’s interest to scrutinize what’s really going on. Consultants serving as funds of funds of funds managers maintain they focus upon the funds of funds managers and will acknowledge that they do not perform any due diligence of the underlying managers; indeed they do not even determine whether the different funds of funds are using the same underlying managers. If they are using many of the same underlying managers, then the multiple fund of funds managers approach really doesn’t make any sense. Since the pension is not generally provided with the lists of managers each fund of fund utilizes (because this is really secret proprietary intellectual capital stuff— like the human genome), in addition to not knowing the identity of its managers, the pension is unable to determine the degree of duplication of managers where multiple funds of funds are hired. Information regarding both of these issues is critical in order for a pension’s board to fulfill its fiduciary duties.
Generally pensions investing in hedge funds of funds do not receive the audited financials of the underlying funds or monthly or quarterly performance reports. Whether their consultants receive such reports or even know what to make of them is unclear.
Conflicts of Interest
Every conceivable conflict of interest scenario involving pension consultants is possible where hedge funds and funds of funds and funds of funds of funds schemes are involved. Again, the lack of regulation and transparency allows all kinds of crazy things to happen. The consultant may receive brokerage, investment advisory fees, or special treatment as an investor from the hedge fund operators. The types of conflicts that are possible are truly mind boggling. There is little consensus as to the nature of conflicts that must be disclosed and disclosure practices are wanting.
SEC Registration
With respect to the underlying fund managers, pensions may be unaware whether the hedge funds or funds of funds they utilize are registered with the SEC. Registration of money managers or lack thereof is important information for fiduciaries to consider. The fund of fund managers we interviewed indicated that 50% or less of the underlying managers they utilize are registered with the SEC and that the percentage is declining as a result of reversal of the SEC’s new hedge fund registration rule. This trend toward deregistration may be disturbing to fiduciaries. On the other hand, some may argue that underlying liquidity may be enhanced as lock-ups instituted as a defense to registration are eliminated. In any case, registration (or lack thereof) of the underlying managers should be considered by fiduciaries.
Securities Holdings
With respect to securities holdings, many pensions and fund of funds managers are unaware (either completely or on a timely basis) of the underlying managers’ securities holdings and investment practices. As a result, if the pension’s investment restrictions are violated by the underlying managers buying a forbidden security, the pension will not know. For example, if underlying hedge funds were to purchase financial futures contracts for speculative versus hedging purposes, which is common, pension investment restrictions may be violated. Some funds may be of the opinion that for purposes of their investment restrictions there is no “look through” to the underlying portfolio securities and the pension’s investments in the fund of funds or fund of funds of funds are merely considered limited partnership interests. If this were the case then the purpose of the investment restrictions would be effectively undermined with respect to the hedge fund of funds hired. In the mutual fund context, ownership of shares in an equity mutual fund is generally considered the equivalent of owning equities. Thus, a fund that is prohibited from investing in equities generally cannot invest in equity mutual funds. In our opinion, it is imperative that fiduciaries scrutinize investments in order to determine whether the investments are consistent with the investment objectives of the pension. To waive the investment restrictions with respect to unregulated money managers, while upholding them with respect to regulated managers appears illogical and imprudent.
Use of Leverage
With respect to use of leverage by the underlying hedge fund managers, our findings indicate while pensions, consultants and funds of funds managers maintain that hedge funds that engage in “high leverage” are excluded from their programs, they often are not fully aware of underlying managers’ use of leverage. How can pensions and consultants be confident about use of leverage when they may not even know who the managers are or what assets they are invested in?
Securities Trading
With respect to securities trading, generally neither pensions, consultants nor fund of fund managers are aware of the brokerage practices of the underlying managers. Some of the underlying managers own affiliated brokerages and may execute trades at commission rates that are not competitive or churn portfolios to generate trading commissions. Hedge funds may have affiliated brokerages that enable them to profit at the expense of their clients and irrespective of the performance of their client portfolios. Fiduciaries are responsible for monitoring trading costs and generally today do monitor such trading by their traditional managers. It is illogical that unregulated, high risk, high portfolio turnover managers’ trading is not scrutinized.
Custody
Hedge fund custody issues, which are highly problematic, are generally completely overlooked by pensions and their advisers. Each hedge fund within a fund of funds custodies the assets it manages, including pension assets, wherever it chooses. Thus, when a pension invests with multiple fund of funds managers, pension assets may be custodied at over a hundred entities, such as banks, trust organizations and brokerages, located domestically and abroad, which may or may not be regulated and which may or may not be financially sound. Generally pensions have sought to consolidate custody with one or two financially sound custodians for safety and ease of administration. Hedge fund of funds custody arrangements agreed entered into by pensions clearly do not enhance safety and reduce the administrative burden. Such arrangements are, in our opinion, inconsistent with fiduciary duties regarding safekeeping of assets.
Conclusion
The drawbacks related to the funds of funds of funds approach recommended to pensions by their investment consultants today are enormous and can be summarized as follows: a pension may end up having hundreds of millions of dollars or approximately 20% of its assets invested with over 150 largely unregulated high-risk money managers scattered throughout the world whose identities, securities holdings, trading costs and custodians are unknown. Would the promise of any return justify these practices? We are firmly of the opinion that most of the hedge fund schemes we have reviewed will produce returns insufficient to compensate pensions for the costs and risks involved. Of course, we can’t be certain how these investments will turn out.
On the other hand, it is certain that pension consultant funds of funds of funds and funds of funds and hedge funds will all derive significantly greater compensation from pensions as a result of elaborate hedge fund schemes.
It is also certain that as hedge funds proliferate, prudent fiduciary standards that have slowly developed and been refined over the past 40 years as pension assets have grown are being summarily discarded.
Setting Standards For The Investment Management Industry
