By Nishant Kumar, Simon Jessop and Anthony Deutsch
LONDON (Reuters) - Pension schemes are starting to rethink their hedge fund investments in the face of high costs and poor returns, putting at risk the heady pace of capital flows into an industry with nearly $3 trillion (1.90 trillion British pound) of assets.
Investors pulled more than $15 billion from hedge funds in the September quarter, industry data showed, ending six quarters of net inflows. Investments from such large institutions such as pension funds contribute about 63 percent of hedge fund capital, according to industry tracker Preqin.
Pension funds are turning to cheaper, more transparent and liquid products mimicking hedge fund strategies, as well as so called 'smart beta' funds, which aim to capture a part of a hedge fund strategy's returns at a fraction of the cost.
For some, such as 63-year-old Dutch pensioner Jelle van der Linde, the switch has come too late.
Van der Linde has seen his benefits cut by more than six percent since last year, partly because of the high investment fees his metalworkers and engineers pension fund, PMT, paid.
"I would have been better off putting it into an old sock. I would at least have had more than I do now," he said.
At less than 2 percent of PMT's $70 billion assets, its hedge fund bets accounted for nearly a third of its total expenses, according to a statement by the pension fund in September, in which PMT said the slight benefits from spreading its risks were insufficient.
PMT and others such as the $296 billion California Public Employees' Retirement System (Calpers) and Britain's Local Pensions Fund Authority (LPFA) with assets of 4.8 billion pounds($7.6 billion), are among those who have already ditched hedge funds this year. Several others, including Britain's 20 billion pound ($32 billion) Railway Pension Scheme and San Francisco's city pension fund are reassessing their hedge fund allocations.
"In terms of hedge funds, overall, we are sceptical about the value for money they provide for us as a pension fund," Susan Martin, LPFA's chief executive, told Reuters.
"The lack of transparency and high fee structure is not aligned with the interest of asset owners such as ourselves," said Martin, whose firm removed one of Europe's largest hedge funds, Brevan Howard, from its portfolios earlier this year.
In a survey of institutional investors released on Friday, Ernst & Young said that only 13 percent of the respondents said they planned to raise bets on hedge funds in the next three years, down from 20 percent in 2012 and 17 percent in 2013.
Recent volatility in stock and currency markets could help hedge funds to attract investment given their expertise in managing downside risk, but average performance of funds in recent years has been weak.
Of the 51 negative months recorded by the MSCI World index over the last decade, hedge funds - which aim to make money in both rising and falling markets - have on average lost money in 36 months, the Eurekahedge Hedge Fund Index shows.
Of the 69 positive months recorded by the index, equity hedge funds have lagged on 57 occasions.
Calpers, the largest U.S. pension fund, said in September that it would pull all $4 billion it had invested in hedge funds such as Och-Ziff Capital Management (OZM.N) and Metacapital because it found them costly and complicated.
A typical cost structure for a hedge fund is an annual 2 percent of the value of assets as a management fee plus 20 percent of any profits, although big clients can negotiate.
The cost of 'smart beta' funds, which capture part of an actively managed strategy, say by buying and selling merger candidates at a set point in the deal, can be less than 1 percent.
European mutual funds now also offer hedge-fund-like strategies - so-called 'liquid alternatives', which allow investors to get money out quicker than a normal hedge fund - for a management fee as low as 1 percent and a lower performance fee. U.S. peers, meanwhile, charge no performance fee.
Liquid alternatives can also be sold to retail investors - opening up a source of capital for both mutual and hedge funds that launch their own versions.
Investments in liquid alternatives are expected to grow about 44 percent in 2015 according to a Deutsche Bank survey of almost 300 hedge fund managers and investors. Traditional hedge funds have grown about 13 percent annually since the financial crisis.
The New Zealand Super Fund, a government superannuation savings vehicle which terminated some of its hedge fund investments this year, is building a team to manage money in-house, as is the LPFA.
At the LPFA, roughly a tenth of its 5 billion pounds in assets are now managed in-house from zero two years ago, helping it save 3.5 million pounds in annual fees. Calpers paid $135 million in fees for its exposure to hedge funds last year.
"Building in-house expertise is a way to get better returns, to manage our liabilities and ensure that we have cash available when we need it to pay our pensioners," Martin of LPFA said.
Some hedge funds have begun to respond to the threat to their business by becoming more like asset managers; lowering costs and diversifying their products in similar ways. Others are looking to attract alternative investors, such as the rich individuals who formed the pre-crisis industry backbone.
Meanwhile, top performing funds, even at the highest fee levels, will continue to attract capital, although many of them are closed to new money.
Jack Inglis, chief executive of industry body Alternative Investment Management Association said that the equities boom will not last forever and investors will contiunue buying for capital preservation, diversification and reduced volatility.
"Individual pension fund investors in hedge funds may come and go, but the case for including hedge funds in institutional investor portfolios has never been stronger," he said.
($1 = 0.7950 Euros)
(1 US dollar = 0.6279 British pound)
(Additional reporting by Anthony Deutsch in Amsterdam; Editing by Alexander Smith and Elaine Hardcastle)