The Teacher Retirement System of Texas (TRS), one of the world’s largest hedge fund allocators, has officially changed the fee structure it will pay fund managers, ValueWalk has learned. We first reported the proposed move to change the hedge fund fee structure on December 20.

With hedge funds generally underperforming their major stock benchmarks – the HFRI Fund Weighted Composite Index, many long bias, delivered +5.6% returns in 2016 while the S&P 500 finished up 9.54% — TRS addressed what it called a “flaw” in the fee structure when rolling out a system designed not to pay excessively for beta or low returns. The objective is for the institutional investor to capture 70% of the alpha generated by the fund manager.

Teacher Retirement System of Texas document
Teacher Retirement System of Texas document

In low returns environment, hedge fund fee structure takes 50% of returns, dramatically underperforms beta

The change in fee structure at the pension plan, which provides retirement benefits to more than 1.5 million Texas teachers and manages assets in excess of $133 billion, making it one of the largest pension funds in Ameirca, is already underway, internal documents reviewed by ValueWalk and confirmed by TRS reveal.

The fee system of offering fund managers either a 1% management fee during challenging market environments or providing them 30% of the performance above a beta benchmark, termed the “alpha share class,” has been accepted by the majority of the hedge funds who TRS provides an allocation, according to the documents.

“Management fees and beta are the biggest impediments to an equitable alpha split with managers,” the document said. “We believe the best way to solve this problem is to introduce hurdles to offset their impact.”

Teacher Retirement System of Texas
Teacher Retirement System of Texas

Working with hedge fund consultant Albourne Partners, the colloquially labeled “1 or 30 fee structure” has three precepts: 1) It “protects” the investor in the event of a low return environment; 2) makes the manager relatively indifferent between fee structures at target returns, and 3) rewards a manager with higher compensation if performance exceeds expectations.

TRS, looking at the HFRI Fund of Funds composite index that delivered 4% gross return over the past five years, notes the fund manager has retained nearly 50% of the gross return mostly through management and a degree of incentive fees. “Management fees should be set at a reasonable level to operate the manager’s business and should not be a profit center,” the document stated, noting that certain situations involve a degree of flexibility.

“Recent performance by the hedge fund industry has exposed a flaw in the traditional hedge fund fee structure,” as stock market long bias fund managers are generally underperforming lower cost alternatives such as S&P 500 index ETFs. From to 2016, the S&P 500 returned 13.41%, 29.60%, 11.39%, -0.73% and 9.54% respectively against the hedge fund yearly average near 4%.

“In low return environments, management fees consume a disproportionate amount of the gross alpha generated by managers. Taking 50% of gross return (and a higher percentage of alpha) for 4% gross absolute returns is an unsustainable model for the industry.”

Teacher Retirement System of Texas – New hedge fund fee structure does not pay for beta

A key component of the new system, which will be watched as a potential trend-setting benchmark among hedge fund allocators, is identifying a hedge fund strategy’s beta exposure and paying only for performance above this level.  Beta levels will be discussed and agreed upon at the onset of the fee structure negations and a manager will not receive incentive fees in a positive absolute return year if there is negative alpha. The structure is expected to be neutral or positive for high-performance managers over most market cycles.

“Hedge fund managers are responding in many different ways including offering founder’s shares, tiered fee schedules based on the size of an allocation, hedge fund light-management fee only strategies and tailored fees to address specific issues of prospective institutional investors, noted Don Steinbrugge, founder of Agecroft partners, a leading hedge fund marketing firm. “In general investors are much more willing to pay for performance than a high management fee. For the top hedge fund managers or capacity constrained strategies it makes a lot of sense to both the investor and manager to structure fees with a low management fee and high-performance fee. This will be a strong trend by large pension funds going forward.”