Is it back to the drawing board for direct investors?

Thu Mar 3, 2011

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It might be time for some institutional investors to take a deep breath before plunging back into the offering memorandums


By Susan Barreto

Given events of the past few months it might be time for some institutional investors to go back to the drawing board, or at least to take a deep breath before diving into the offering memorandums once again.

The combination of the SEC and FBI investigations into insider trading, the success of distressed debt plays and portfolio manager exits have created enough mayhem for US pensions with newly minted direct hedge fund portfolios.

For the New York State Common Retirement Fund, Indiana Public Employees and Ohio School Employees' Retirement it means they will need to replace mandates held by Diamondback and Level Global, which are both voluntarily returning capital to investors following federal investigations into the allegations of insider trading. New Jersey Division of Investment and Texas Teachers also have Level Global holdings, while New Mexico PERA (see page 14), Missouri State Employees' Retirement System and Philadelphia Board of Pensions and Retirement each had Diamondback in their direct portfolios.

Then at the Florida State Board, Alaska Permanent Fund, Texas Teachers, China Investment Corp and other small municipal pensions across the US the lesson has been that hedge funds strategies such as distressed debt are time-sensitive. Oaktree, which is in all of these portfolios, is likely to be returning money to some investors as one of its funds reaches its three-year investment period.

At Texas Treasury Safekeeping Trust, the lesson of the new hedge fund economics has been especially taxing, as its initial hedge fund allocations last year were to Level Global, Diamondback Capital and Shumway Capital, which is returning capital to investors after management changes.

Direct investors right now feel they are paying for extra control of assets and getting the same oversight as they would from funds of funds at less cost. But is that what is really happening?

Perhaps the part that most institutional investors forget is that a consultant is not incentivised to ensure top-quartile performance. Unlike principals at funds of funds, a consultant is not (and should not) be invested in the portfolio they create. This means that consultants are much more apt to go for the tried and tested safe bets, which may be why the herd mentality is seen with capital flocking to groups like King Street, Brevan Howard, Citadel and Paulson.

Funds of funds charge a management and performance fee on top of manager fees or in some cases simply charge an advisory fee for a customised portfolio. So the overlap in fees is the common drawback for large pensions. They have rightly seen that the hedge fund economics are no longer driven by access to hot new fund launches but in ensuring brand names are delivering the performance they said they would.

The current shake-out with Diamondback, Level Global, Shumway and Oaktree may help investors figure out which route has fewer headaches for sure, as headline risk is now equal between direct and fund of fund programmes. So now is a perfect time to calculate the returns versus the fees and compare the expertise of funds of funds with that of specialist consultants. An upcoming panel discussion at the InvestHedge Global Fund of Hedge Fund Forum on March 10 in New York will do just that.

Economics 101 says investors should be getting better long-term returns net of fees in direct portfolios, but it just might be that the class lesson isn't over yet. Those looking to shave a few basis points may be missing other opportunities as they wait for trustee approval on a new batch of individual hedge funds. The focus now needs be on long-term success rather than short-term price breaks.

ISSN: 2151-1845 / CDC10004H