Jeff Benjamin

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Liquid alts are a threat to hedge funds as we've known them

As Calpers decision raises questions about high fees, hedge funds are already evolving

Sep 18, 2014 @ 1:53 pm

By Jeff Benjamin

Despite chatter to the contrary, it is way too early to start forecasting the extinction of the $2.8 trillion hedge fund industry. Those ridiculous fees, however, could be headed for the endangered species list.

It is difficult to feel sorry for any industry that gets away with charging a 20% performance fee on top of a 2% management fee, so it makes a certain amount of sense that there would be so much piling on after the country's largest pension fund decided to boot hedge funds from its $298 billion portfolio.

The announcement by the California Public Employees' Retirement System, commonly known as Calpers, could be logically interpreted as adding more momentum to the fast-growing category of alternative-strategy mutual funds.

The so-called liquid alternatives universe has swelled to 465 mutual funds and more than $160 billion under management, according to Morningstar Inc. That compares 217 liquid alt funds and $37.7 billion at the end of 2008, at the heart of the financial crisis.

(More: Is Calpers' move away from hedge funds a bellwether for advisers?)

The Calpers decision indicates a significant boost for liquid alts, because the decision was reportedly based largely on the issue of high hedge fund fees.

Most mutual funds in the liquid alts space have expense ratios of less than 2%, and some strategies go as low as 70 basis points, which is comparable to some bond funds.

For financial advisers and individual investors, the liquid alts space represents a robust, if largely untested, means of diversifying beyond traditional long-only stocks and bonds.

But that's not where Calpers is headed, at least not yet.

While its decision might have been based on the hedge fund fees that reportedly cost the pension fund $135 million during the fiscal year through June, the move out of hedge funds was part of a general move out of absolute return strategies.

In other words, Calpers' relatively small $4 billion allocation to hedge funds is not being replaced by any alternative strategies, which is something close observers have traced to the new chief investment officer Ted Eliopoulos, who had been acting as interim CIO since February, following the death of CIO Joe Dear.

“It was simply a change in philosophy that is very specific to Calpers,” said Rick Lake, co-chairman of Lake Partners Inc.

But even if Calpers isn't turning from hedge funds to liquid alts, marking the beginning of the end for hedge funds, the move can still act as a jumping-off point for a real discussion on hedge fund fees.

“It's not that hedge funds will become obsolete, but the world is changing,” said Nadia Papagiannis, director of alternative investment strategy for global third party distribution at Goldman Sachs Asset Management.

“It is getting tougher for the more liquid hedge fund strategies to justify charging traditional hedge fund fees,” she added. “Most of the more liquid hedge fund strategies now exist in cheaper and more liquid forms in mutual funds and ETFs.”

In essence, the pressure that the liquid alt funds are putting on hedge funds is real, but still limited to basic strategies such as long-short and market neutral.

And for that reason, we already are seeing hedge funds migrate into the mutual fund space with products that make the best use of their strengths and tap into the hungry retail investor market.

Just days ago, Oaktree Capital Group, the world's largest distressed-debt manager at $91 billion, filed to launch its first mutual funds, which will focus on high-yield bonds and emerging-markets stocks.

Hedge fund manager Joel Greenblatt of Gotham Capital has pushed the limits by offering a long-short mutual fund that directly competes with his long-short hedge fund.

Because of the regulatory restrictions applied to registered liquid alt funds, there will always be strategies that are best suited for traditional hedge funds. And in those instances, it is likely managers will continue to command the higher fees.

But for hedge funds running basic long-short portfolios, the message should be getting louder that it's time to either adapt or perish.

“The illiquid hedge fund guys are getting into the liquid space and more partnerships are forming,” Ms. Papagiannis said. “The primary function of a liquid alt is to present a different risk-return profile. And you don't need illiquidity to do that.”

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