Hedge funds, private equity chasing retail investors but fees are high and returns aren't

Once the domain of institutions and ultra wealthy, alternatives seek access to 401(k) cash

Jan 26, 2014 @ 8:08 am

hedge funds, private equity funds, 401(k), main street
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Did you hear about how the S&P 500 trounced hedge funds last year? And did you feel the tiniest bit of schadenfreude?

For a while there, it was hard not to feel jealous of hedge fund investors. Only certain classes of investors get the chance to pay fund managers their exorbitant fees, typically a 2% annual charge on top of 20% of any investment gains. The whole spectacle was a bit like watching a long line of clubgoers clamoring for the chance to pay a $20 cover and $1,000 for bottle service. To justify that, surely there must be some awesome stuff happening beyond the velvet rope?

Generally, if you have less than $1 million, you're banned from this exclusive world. That's because of U.S. rules designed to protect retail investors from risky investments. Even run-of-the-mill millionaires have trouble getting past the bouncers at the most famous and successful hedge funds and private equity firms. But now, after five straight years of hedge funds trailing the S&P 500 — last year, by 23 percentage points — a growing number of investment companies are trying to convince employers to add hedge fund-like “alternative” investments to their 401(k) retirement savings plans.

Rank-and-file investors can be forgiven if they're not jumping up and down in excitement at the prospect.

TARGETING MAIN STREET

"Alternative" is a catch-all term for almost anything beyond fairly plain vanilla traditional stock-and-bond strategies, including hedge-fund-like strategies, commodity funds and private equity. Not coincidentally, giving regular investors more access to alternative investments would also give many financial firms a new route into the $2.8 trillion pot of savings in 401(k) retirement plans, and allow firms to charge higher fees than they do on simpler mutual funds. (Private equity funds have been in defined-benefit pension plans for decades.)

Last September, $25 billion money manager Pantheon announced the first private-equity product for 401(k) plans. The response of employers who sponsor retirement plans has been "fantastic," says Pantheon spokesman Carsten Huwendiek, with employers lining up for second meetings. No companies have signed up yet. "The process of getting them on board is a very slow one," he says. On Feb. 11 in New York, a conference on the topic of alternatives in defined-contribution retirement plans is being sponsored by Pantheon, along with BNY Mellon, Goldman Sachs Asset Management, John Hancock Investments and Neuberger Berman.

Meanwhile, firms continue to trot out new alternative mutual funds that are aimed at retail investors but copy hedge fund strategies. Almost half of the 92 U.S. mutual funds Bloomberg classifies as “alternative” have been launched since 2011. Overall, their average expense ratio is more than twice the average fee investors pay on equity funds.

Should those who don't own Gulfstream jets want access to such products? Figuring that out is surprisingly difficult because, for alternative funds off-limits to retail investors, managers usually aren't required to reveal performance numbers.

Studies of private equity performance found the investments underperformed the S&P 500 by up to 3% per year — until a new, better database was found that seemed to show the opposite, private equity beating the S&P 500 by at least 3% per year.

IMPERFECT DATA

One of the authors of the earlier papers, the University of Oxford's Ludovic Phalippou, said this new result seems "sensible" while also lamenting the fact that the data are so lousy to begin with. "It seems extraordinary that an issue with such important public consequences is allowed to languish with imperfect data," he wrote. "It is hard to imagine this being tolerated in other fields (e.g., medical research)."

The reputed outperformance of private equity is one reason it's escaped the outright mockery recently heaped on hedge funds. (As Bloomberg Businessweek's cover story declared in July, "Hedge Funds Are For Suckers.") Recent studies of hedge fund returns don't paint a pretty picture. A 2011 paper found that the sometimes-stellar results that hedge fund managers report don't trickle down to the typical client. Investments in hedge funds lagged the S&P 500 by almost 5 percentage points per year from 1980 to 2008.

One problem, Emory University's Ilia D. Dichev and Harvard University's Gwen Yu concluded, was that investors were chasing returns. A fund would report excellent results, money would flow into the fund, and then performance would drop back to normal. Only the lucky original investors benefit alongside the now-famous manager. Overall, the actual returns that investors realized were behind the fund's stated returns by 3 to 7% per year.

University endowments were among the pioneers in using alternative investments back in the 1970s, and their enthusiasts still abound on campus. Commonfund, an investment firm that serves many colleges and other nonprofits, issued a report Jan. 8 defending private equity and hedge funds. The report's author, Commonfund Chief Executive Officer Verne Sedlacek, says that alternatives aren't merely designed to keep up with stocks. They also diversify portfolios and can provide protection in down markets.

EXCESSIVE FEES

Still, when interviewed, Mr. Sedlacek offers warnings about alternatives for retail investors. Fees in hedge funds are "too high," he says, and not every investor wants to lock up their money for 10 years, as many private equity funds require. Also, he says, doing well in hedge funds and private equity requires finding the top managers and avoiding the worst. That's difficult and expensive for smaller investors to do.

Finally, the performance edge of even the best managers may be eroding. Competition among funds is hot, and the bigger financial incentives at hedge funds have lured away many of Wall Street's most talented investors. "There are a lot more people trying to do the same things," Mr. Sedlacek says. For example, he estimates, while private equity still beats public markets, its outperformance has shrunk by about a third over the past few decades.

Declining performance is sparking debates about alternative investing even among college endowments, Mr. Sedlacek says. Also bothering institutional investors: There's something unseemly about how external managers profit so handsomely handling money for pension funds, universities and charities. "It doesn't feel good for an endowment that's trying to fund scholarships to see guys drive around in Lamborghinis," he says.

(Bloomberg News)

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