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Some investors rethinking stakes in hedge funds

The state has seen disappointing hedge fund returns. It also was exposed to several scandals, including that of Bernie Madoff (above).

Timothy A. Clary/Getty Images/File

The state has seen disappointing hedge fund returns. It also was exposed to several scandals, including that of Bernie Madoff (above).

Is the hedge fund, as we know it, dead? Fifteen years ago, they were the hottest investments around. Every pension fund, endowment, and foundation clamored to get into this elite club, willing to pay hefty fees for the prospect of outsized returns.

But much has changed since the financial crisis. Except for the top hedge funds, most have shown disappointing performance since 2008, not even beating stock index returns. It seems the edge many had in outmaneuvering the markets has evaporated in more complex times. Red Sox owner John Henry is shutting down the commodities hedge fund shop that made him rich, the latest in a line of big names to retire. Others have been ensnared in a federal insider-trading inquiry that has tainted the industry, revealing a host of players who used unfair, and illegal, tactics to notch big gains.

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Now many large investors that favored hedge funds — from the Massachusetts state pension fund to Harvard University to small-town retirement funds like Plymouth’s — are rethinking their approach to this once high-flying sector. They’re looking less for the shoot-the-lights-out performance that hedge funds touted in the ’90s, and more for traditional hedging and ways to reduce volatility.

“It’s very crowded, and more and more difficult for them to show good performance,” said Michael Trotsky, head of the $50 billion state pension fund and a former hedge fund manager himself. “The challenge becomes gaining access to only the very best, or you might as well go home.”

Hedge funds are designed for institutions and the wealthy; they can invest in almost anything and usually take bigger risks than, say, a mutual fund meant for a typical investor with a 401(k) plan.

To be clear, hedge funds are still getting launched and money is still gushing into them; the sector recently notched a record $2.2 trillion in assets. But a majority of the new funds are shifting away from classic stock strategies and focusing instead on approaches such as interest rate bets and positions following the moves of the economy.

One reason for the shift: Far fewer hedge funds are producing big returns. And the gap between the best and the worst is enormous, suggesting that risks far outweigh the rewards when it comes to less-than-stellar funds. For the 12-month period ended Sept. 30, the top 10 percent of funds reported an average gain of 34 percent, while the bottom 10 percent saw an average 19 percent loss, according to Hedge Fund Research Inc. of Chicago.

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Sophisticated investors like the Massachusetts state pension fund and Harvard University are able to get access to the best hedge funds. But even they are looking more critically at these investments and considering alternatives.

One of Trotsky’s first tasks running the state pension fund was explaining losses in two hedge funds raided by the FBI for alleged insider trading. These were relatively small holdings, worth $66 million. But the revelations laid bare a bigger issue: Three of the middleman firms the state used to gain access to hedge funds — called funds-of-funds — all had invested in one of the raided managers.

So much for spreading the risk. The state is now abandoning funds-of-funds,reasoning that they did not come up with original investment ideas or properly monitor their picks. Even with money divvied among more than 230 hedge funds, the state saw disappointing returns and high fees while becoming exposed to a number of investment scandals, including the Madoff scheme.

The state has 10 percent of its assets, or $5 billion, in hedge funds; Harvard has 15 percent, or about $4.7 billion. Both have increased their hedge fund allocations over time, although Harvard in the past year has backed off from 16 percent.

These and other institutional investors are also looking more critically at the firms they’re willing to invest with and their costs. Many are abandoning funds-of-funds because of their lack of transparency and extra layer of fees.

Investors pay a fee of 1 percent to 2 percent upfront for access to most hedge funds, (plus another 1 percent or so in a fund-of-funds). After that, the hedge fund manager gets 20 percent of any gains they make on the investments, after certain hurdles. So, if you make $1 million, the hedge fund manager gets $200,000 of that.

Investors were willing to pay up when hedge funds generated fat profits for them during long bull markets. But in the volatile markets since 2008, many hedge funds have been unable to beat the Standard & Poor’s 500 index, or even the bond market.

Some argue they’re not supposed to — they’re oriented so they don’t correlate directly with the movements of stocks or bonds. But it’s hard for many investors to justify the extra risk and enormous fees if they could do better in a simple index fund.

“When asset values are going up, regardless of strategy, people aren’t focusing on fees as much as they should,’’ said David Scharfstein, a professor of finance and banking at Harvard Business School. If gains continue on a more modest track, he said, there will likely be more pressure on fees.

Another strike against hedge funds is the cash crunch they caused investors during the crisis. Institutions couldn’t get their money out, because many hedge funds impose lockups, allowing money to be withdrawn only quarterly or less often. And in bad times, they can put up “gates,” barring withdrawals until markets calm down. In 2008 and 2009, many investors were suddenly faced with not only poor results, but a serious liquidity problem.

That led to a massive exodus from some funds once investors were able to get their hands on their money. Harvard has made a concerted effort to bring more assets in-house since 2008. The endowment’s chief, Jane Mendillo, is a fan of “real assets” — including real estate, natural resources, and publicly traded commodities — which make up 25 percent of the portfolio, significantly more than hedge funds.

Gaining access to the best hedge funds matters more than ever. Dan Farley, senior managing director of State Street Global Advisors in Boston, said clients need to be clear on what they are looking for in a hedge fund, and realistic about whether they can get it.

“If you can’t get into the funds that meet your objectives and have top managers,” Farley said, “you’re probably better off looking to other alternatives.”

Trotsky is spending a lot of time on this issue, even teaching a class last year at the Isenberg School of Management at UMass Amherst where he assigned students to look for products that could model the risk/return profile of hedge funds at lower cost. He recently hired Eric Nierenberg, a Harvard-trained economist, to help analyze hedge funds, and to start thinking about alternative investments for the state. Trotsky has pledged a goal of saving the pension fund $100 million in fees in coming years, and a big part of that would come from hedge funds.

“What I want Eric to investigate is whether there are other techniques, or products, or ways to do it as effectively at a much reduced price,’’ Trotsky said.

Dozens of towns and cities around the Commonwealth are counting on Trotsky and the Pension Reserves Investment Management Board to deliver better returns from hedge funds, to help meet their retirement obligations. Thomas Kelley, chairman of Plymouth’s retirement board, which oversees about $120 million, said he’s keeping a close eye on the new approaches.

“I think it may be a change for the better,” Kelley said, “but if it doesn’t work out, we’ll take our money out.’’

Beth Healy can be reached at bhealy@globe.com.
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