The $202 billion Texas Teachers is pioneering efforts to change the fee structure in hedge funds. Two thirds of its allocation is managed on a 1-or-30 structure and it is leading an industry-wide initiative, with more than 60 other asset owners, calling for cash hurdles in incentive fees. CIO Jase Auby says earning cash returns is not the reason institutional LPs invest in hedge funds.

The $202 billion Teacher Retirement System of Texas (TRS) pioneering effort to transform hedge fund fees is gathering momentum, according to chief investment officer Jase Auby, speaking during the investor’s July board meeting.

He said that around two thirds of TRS’ hedge fund allocation is now managed on a new 1-or-30 model counting for around two thirds of the number of managers in the portfolio. TRS has been investing in hedge funds since 2001 and has around $20 billion in the allocation.

Earlier this year, the pension fund launched an industry wide initiative to advocate for cash hurdles in the calculation of hedge fund returns that included an open letter to the industry signed by 29 Limited Partners. This year’s push builds on an initiative dating from 2016 when former CIO Britt Harris first began advocating to move from a 2:20 structure to a new 1 or 30 model. [See a podcast conversation with Albourne CEO, John Claisse, on the innovative fee structure Are managers rewarded for fee alignment?).

Under a 2:20 structure hedge funds are paid a 2 per cent base fee and 20 per cent of the profit. TRS is advocating to lower the base fee to 1 per cent and “make it an or, rather than an and” 30 per cent of the profit. Under the model, TRS pays hedge fund performance fees only after managers meet an agreed upon hurdle rate. Managers can then earn whichever is greater – either a 1 per cent management fee or a 30 per cent cut of the alpha or performance after benchmark.

Auby said that over the years the initiative has been well received, but that was when cash was at zero per cent and so the concept of a cash hurdle was not as necessary as today.  With cash currently up at 5.25 per cent approaching the industry again to put meaningful hurdles in place to better calculate hedge fund returns has been even more welcomed.

“We had 29 total signatories to our letter in May, now this is up to 60 and we’ve also received numerous calls (double than that amount) from others that are similarly inclined rooting us on anonymously,” he said.

The TRS portfolio is divided between (54 per cent) global equity (22.3 per cent) stable value including government bonds, absolute return and stable value hedge funds ( 21.6 per cent) real return and (7.3 per cent) risk parity with remainder in cash.

Introducing new fee structures takes time

However, Auby cautioned that introducing new fee structures takes time.

“We approach the ones that have had the worst performance recently first because they are the most amenable. As we go through the cycle we will approach others.”

Auby explained how the cash component is the preferred return. For a long only large cap manager the SP&P500 is the risk appropriate benchmark. For hedge funds which are not supposed to have any residual market risk, he said the risk adjusted return should therefore be cash.

“We are approaching the industry and advocating for a cash hurdle and the risk appropriate hurdle,” he said.

His comments are echoed in the industry letter, published in May, which stated how hedge funds may collect significant incentive fees based solely on skill-less returns generated from short rebate, securities lending, or unencumbered cash.

“These returns are easily obtainable by LPs outside of a hedge fund structure for free. Earning cash returns is not the reason institutional LPs invest in hedge funds,” it stated.

“In 2023, a $1 billion market neutral hedge fund could have earned ~$52 million (5.25 per cent) returns just by holding cash, and if that fund charged a 20 per cent incentive fee on absolute returns, would have taken home $10.5 million in compensation for taking zero risk. This is not sustainable, especially as it seems the risk-free rate may remain elevated for the foreseeable future; and it is not what LPs are asking GPs to do.”

Signatories to the letter include Canadian pension fund CDPQ, Singapore’s GIC, Korea Investment Management, UTIMCO, Healthcare of Ontario Pension Plan  Brightwell Pensions and Trans-Canada Capital.

Singapore’s sovereign wealth fund GIC is bracing for a period of “profound uncertainty”, as the fund looks to rely on more “granular” diversification and maintaining price discipline to traverse the environment.

In its 2023/ 2024 annual report the fund’s chief executive Lim Chow Kiat warned there are “no maps” for investors to navigate the volatility ahead, and the fund is looking to play into its strength as a provider of long-term capital.

The report said that several key markets had priced in a very positive outcome for the macroeconomic environment since the short-term probability of recession in the global economy had been reduced. Lim highlighted the benefits of nimble capital and a more bottom-up approach in this environment.

“Credit spreads in the US and Europe, in particular, are below or close to their lowest quartile in the past decade,” the report read. “However, there is a wide dispersion across markets and within asset classes.”

“This dispersion favours a more bottom-up approach, alongside more nimble capital allocation across different opportunities.”

In the report Lim said many markets are primed for a Goldilocks economy and “have not yet priced in the level of uncertainty investors face”.

“It is a plausible scenario, but only one of many,” he said.

“This signals a potential mismatch between investor confidence and the range of plausible outcomes.

“In such an environment, GIC must practise price discipline.”

The fund indicates that it intends to remain level-headed in the well-documented AI hype, as Lim said some early-stage AI businesses are commanding a lofty valuation.

“Hardware makers, including semiconductor firms and the infrastructure layer businesses such as cloud platforms, have less downside, though their valuations have also expanded recently,” he said.

“Each case requires careful assessment of its potential risk-return trade-offs.”

GIC has a total portfolio approach and when it comes to diversification, its process is to start with understanding of the real underlying risks, then stress test different combinations of investments in various amounts.

Lim said the fund won’t stop at diversifying on an asset class level but really digs into the “granularity” of investment opportunities, especially in private markets where the fund has built comprehensive capabilities over the years.

“Take real estate as an example. We have picked our spots across different sub-sectors — including data centres, student housing, and logistics — and different geographies,” Lim said.

“In a world where uncertainty has shaken the foundations of the investment environment, our response is to be ever more sure of who we are and to abide by our core investment principles.”

In the year to March 2024, GIC cut exposure to nominal bonds and cash by 2 per cent while upped allocations to inflation-linked bonds by 1 per cent. Private equity is also occupying a bigger part (up 1 per cent) of the portfolio due to capital deployment and returns.