JANA Investment Advisers believes identifying the beta drivers in hedge fund returns has enabled it to halve fees in the notoriously expensive asset class, as the consultant recommended clients allocate as much as 15 per cent of their portfolios to the strategies. Michael O’Dea, portfolio manager of JANA’s Triplepoint hedge fund-offunds (hedge FoFs), said investors in hedge funds should only pay for manager skill and use a managed account structure to monitor risk and control counterparty relationships. “The only thing worth paying a performance fee for is the skill.

The other exposures can be gained by buying futures contracts and an index fund,” O’Dea said. He said hedge fund returns were primarily generated by four sources: about 30 per cent came from market beta, 30 per cent from the manager’s ability to select outperforming securities, 20 per cent from illiquidity risk and 20 per cent from underwriting risk, which entailed writing options to hedge positions. In contrast, most balanced funds derive between 70 and 80 per cent of their returns from beta, between 10 and 20 per cent from manager skill and 10 per cent from illiquidity risk, O’Dea said.

By separating manager skill from other return drivers, JANA halved the fees it pays to the managers in Triplepoint and sliced 75 per cent off trading costs. The Triplepoint fund runs on a base fee of 80 basis points, while performance fees apply only to 30 per cent of the portfolio, and are paid only when returns from these strategies outperform the cash rate. This is possible because only 40 per cent of the hedge FoF is invested in active hedge funds, which are all market neutral strategies. From the remainder, 20 per cent is invested in hedge funds replication strategies and 40 per cent to traditional market exposures.

Of these return drivers, only skilled managers – “people who select securities and people timing the markets, whether they be quantitative or discretionary” – deserved high fees, O’Dea said. Since 2001, most superannuation funds advised by JANA have increased their investments in hedge funds from 2 per cent to between 5 and 15 per cent. “Now, we’re at the upper end of the range,” O’Dea said. Running these strategies through a managed account gave investors full transparency and control over relationships with service providers, and mitigated the liquidity and counterparty risks that have plagued hedge funds during the financial crisis.

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