Priced for perfection, but performance pretty ordinary

Dirty Wall Street Secret: Hedge Funds of Funds Pay T-Bill Rates By Katherine Burton and Christine Harper

Pennsylvania's 200,000 public employees are paying Morgan Stanley some of the money-management industry's steepest fees to get returns that aren't much better than yields on U.S. Treasury bills.

Securities firms will collect more than $1 billion in fees this year to keep clients such as the New Jersey and Philadelphia pension plans invested in funds of funds. Those who assumed that Goldman Sachs Group Inc.'s Global Tactical Trading LLC would provide the best returns for the lowest risk in the hedge fund industry were mistaken. They got 1.7 percent through October -- a situation all too common on Wall Street, where every firm selling funds of funds is a winner even when their customers aren't.

"For these large institutions gathering assets is the name of the game, not performance," said Edward Bowman, a partner at Veritable LP, the Newtown Square, Pennsylvania-based consulting firm that oversees $8 billion for wealthy families.

Sarah Gardner doesn't make enough as an associate director at the Center for Environmental Studies at Williams College in Williamstown, Massachusetts, to be an individual investor in Goldman's funds of funds. Most of her retirement money is in a stock fund run by New York-based TIAA-CREF, which charges a 0.48 percent management fee and doesn't keep a slice of the profits. It's up almost 18 percent this year.

The Vanguard 500 Index Fund, which levies a 0.16 percent fee to track the Standard & Poor's 500 benchmark index of U.S. stocks, has returned 16.3 percent through Dec. 15.

Goldman spokeswoman Andrea Raphael said Hedge Fund Partners has underperformed other funds of funds because it invests with managers who trade futures contracts and others who employ so- called macro strategies, which bet on global stocks, bonds, currencies and commodities.

Jeffrey Slocum & Associates Inc., a Minneapolis-based consultant to pension plans, doesn't recommend any Wall Street- managed funds of funds because they tend to underperform, said Sean Goodrich, the firm's director of alternative investment strategy research.

All told, nine of the world's biggest banks and securities firms -- Goldman, Morgan Stanley, JPMorgan Chase & Co., Citigroup Inc., UBS AG, Societe Generale SA, Credit Suisse Group, Credit Agricole SA and Royal Bank of Scotland Group Plc -- rank among the 50 largest operators of funds of funds, managing a collective $140 billion, according to a survey by Institutional Investor's Alpha magazine.

Investors pay twice to invest in funds of funds. The charges by the firms come on top of fees levied by the hedge fund managers themselves, typically 1.5 percent of assets and 20 percent of investment gains.
"The layering of fees makes it difficult to produce the type of returns that investors are hoping for," said Geoff Bobroff, an industry consultant in East Greenwich, Rhode Island. "With the underlying fund fees, and the fund of funds fees, you nail investors."

It's no surprise that Wall Street has its eye on funds of funds. Not only do they require fewer investment professionals to run than a traditional hedge fund, institutional investors are flocking to them. Of the $7.6 billion that U.S. pension funds farmed out to hedge fund managers this year, 62 percent went to fund of funds, according to Louisville, Kentucky-based Eager, Davis & Holmes LLC.

The fees for overseeing hedge fund assets are so lucrative that Goldman's money-management unit reported a 19 percent increase in fourth-quarter revenue. Goldman's so-called incentive fees, the slice of investment gains it keeps, plunged 78 percent in the quarter as some its own hedge funds, such as Global Alpha, declined.

Goldman's clients would have done better investing in the firm instead of its funds of funds. Goldman shares have gained 56 percent this year, after rising 23 percent in 2005.

``This is a great business for brokerage companies,'' said James Ellman, president of Seacliff Capital LLC in San Francisco, which manages more than $100 million in financial-services stocks. ``The market likes asset management more than investment banking because the booms and busts are much less pronounced and the more that brokers can make their earnings stable, the higher their stock price multiples will be.''

While funds of funds spread the risk of investing in hedge funds, they aren't immune to the industry's periodic blowups. Returns at funds managed by Goldman, Morgan Stanley and Deutsche Bank were hurt this year by the implosion of Amaranth Advisors LP, the Greenwich, Connecticut-based hedge fund manager that lost 70 percent of its $9.6 billion in assets in September because of wrong-way bets on natural gas.

New York-based Morgan Stanley had $6 billion in fund of funds assets as of June 30, according to data compiled by Alpha magazine. Owen Thomas, 45, runs Morgan Stanley's asset-management division.

Morgan Stanley CEO John Mack, who has made five hedge fund acquisitions this year to close a $80 billion gap in so-called alternative assets with Goldman, was awarded a $40 million bonus for 2006 -- the biggest in Wall Street history -- after putting the firm on track for record earnings.

Some investors aren't as concerned that Wall Street-managed funds of funds are dragging down returns for pensioners. New Jersey entrusted Goldman to invest some of the state's $79 billion in public savings in a customized fund of funds three months ago. "I have an extremely high regard for the quality of service at Goldman," said Orin Kramer, chairman of the New Jersey State Investment Council.