Many
superannuation funds have been left disappointed by their hedge fund and fund
of fund providers, who promised low correlation relative to the mainstream
assets in their portfolio and high absolute returns, yet delivered neither. Mixed
performance in 2008 is expected to put greater cost pressure on alternative product
fees, and many fundof- fund providers will have their work cut out to defend the
scale of fees they have been charging.

New global research from Mercer
Investment Consulting suggests that while asset management fees remained stable
last year, greater willingness to negotiate fees downwards, especially in
alternative asset classes, will emerge in 2009 and beyond. “Historically, fees
are higher in those strategies where asset managers have the most potential to
outperform,” says Divyesh Hindocha, worldwide partner in Mercer’s investment consulting
business. “However, anecdotal evidence suggests that increasingly asset
managers will have to negotiate their fee structures with ever more
cost-conscious clients. Alpha is now competing with cheap and plentiful beta
and capacity is no longer an issue for most strategies.

There is the
recognition that institutional investors are no longer willing to pay, upfront,
such large proportions of the potential alpha, especially for the more complex
strategies.” Mercer’s 2008 Asset Manager Fee Survey is a biennial report
analysing fee data on 19,000 asset management products from 3400 investment management
firms. The survey shows alternative investment strategies to have the highest
fees for each dollar of investor capital allocated.

The most expensive
mainstream category was global emerging markets equity, with median fees in the
sector averaging around 0.9 per cent. Damien Hatfield, director of boutique
hedge fund research and placement firm Hatfield Liptak Advisors, says he began
to see evidence of super funds negotiating fees downwards as early as last
year, before the year-end performance numbers were published on fund of funds. “I’m
seeing transactions as low as 50 basis points, no incentive fee, for large
mandates [that are] $100 million plus,” he says. “It could be as low as 50 [basis
points], probably the sweet spot is between 60 and 75 basis points, no
incentive fee.

The fund-of-fund groups see the writing on the wall and 50 to 90
per cent of them are willing to do those deals. The issue is: what sort of
quality are you going to get in terms of relationship?” Poor quality of service
is potentially the biggest risk facing super funds that are too uncompromising
when it comes to bartering over fees. Mercer says that for most investors, fees
are not a critical component in the evaluation of an investment manager product;
however they can reduce the expected added value by anywhere from 20 to 50 per
cent.

“We don’t expect investors to be buying first on price,” says Marianne Feeley,
head of manager research for Mercer,
Asia
Pacific. “The risk and return characteristics are the most important factor.
[But] once a mandate is decided on, you could see investors willing to be a
little bit more aggressive and fund managers willing to negotiate more.” Richard
Keary, hedge fund expert and adviser to NWQ Capital Management, agrees it is
the net outcome, rather than the quantum of fees, that is important.

If the fee
issue drives investment selection, Keary says investors will get second class
outcomes. “If someone can generate a really interesting return stream that the
investor can’t get anywhere else, and they want to keep 20 per cent of that,
and the investor gets the residual 80 per cent, then the investor should be
indifferent, but the investor’s not,” he says. “In some cases the nominal fees
are high but the outcomes are fantastic, and you should pay for them. In other cases
the nominal fees are high and the outcomes are rubbish.

The fees are both the
same, but one is worth it and one is not. Surely that should be the debate: is this
investment worth this fee?” The debate around fees is not a new one; however in
the current context, it could prompt a rethink over the nature of the
relationships superannuation funds have with their hedge fund-offund providers.
Super funds are beginning to question the level of service for the commensurate
fee structure, and many are honing in on the fees they pay intermediaries. “It’s
fairly obvious that the fund-offund model has broken down,” Hatfield says.

“A
number of the fund-of-funds will survive with a standard

Cayman
Island
product for people who want a passive exposure to a group of hedge fund
managers, with a 1 per cent management fee and a 10 per cent incentive fee….
But the larger investor, particularly Australian superannuation funds, with
what’s happened over the last 12 months, that original concept of an Australian
super fund putting money into a large fundof- fund group’s

Cayman
Island
fund at that fee structure is dead in the water.”

Going forward, Hatfield
believes fund-of-fund groups are likely to form “partnership” relationships
with super funds, provide greater transparency around their hedge fund
exposures and allow them to participate in the due diligence process. He says:
“A lot of super funds are reviewing their exposure to fund of funds and they
will say to their existing provider: ‘Forget going into your standard
structure, we want to go into a mandate, we want to be involved in the due
diligence process for the managers you select for that mandate, we want to see
a heightened level of transparency; we don’t want to see daily or monthly positions
down to individual securities but we do want to see reports around your
collection of that data so that you can convince us that you actually
understand the underlying exposures in those hedge funds’.”

Hatfield Liptak
Advisors represents Ramius Capital, a global alternative investment firm based
in

New York, whose
fund-of-funds group is already offering this type of relationship to pension funds
globally. “They’re looking to partner with a super fund in a clean portfolio of
brand new investments [and] they’re going to be mindful of where the
opportunities will be this year, which will probably be in credit,” Hatfield
says.

The new market environment could also change the way fees are structured in
the hedge fund-of-fund space, with the concept of charging a high fixed fee in
addition to a performance fee potentially phased out. Lakeview and
Saguenay Offshore Fund, the two fund-of-funds within the NWQ
stable, offer products that charge a performance fee only – an indication that
the managers back their own ability to add value. “The quantum still needs to
be reasonable but I think that’s where the model is going – the fixed
management fee for fund-of-funds will come down,” Keary says.

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