Alternative investing boom has spawned a fee frenzy BULLS & BEARS:

Readers of this column know I’ve been critical of the institutional-feeding frenzy that is pouring fiduciary money into alternative investments.

My premise isn’t that institutions all will end up losing a lot of money by investing in private equity, hedge funds and venture capital. But I am suggesting that aggregate returns from alternative investing merely will be mediocre.

Indeed, 2006 will mark the third year in a row that the average hedge fund has failed to keep pace with the return of the stock market.

The “low-hanging fruit” that generated the higher returns in the past for these nonconventional investments has been picked, and investors in alternative vehicles today are buying in at high prices.

I also would submit that in their haste to increase their allocations to these vehicles, institutions are being careless in not demanding fee structures that protect plan participants.

The valid question is this: If alternative investments struggle to match the return of an index fund, what is the value to a pension plan beneficiary in paying more than 10 times the amount in fees that a simple index fund would charge?

A recent article in the International Herald Tribune, noted, “Pennsylvania’s 200,000 public employees are paying Morgan Stanley some of the money-management industry’s steepest fees to get returns that are not much better than yields on U.S. Treasury bills.”

The Pennsylvania pension plan, which is invested in a hedge fund-of-funds, pays a fee of 2 percent of assets and 20 percent of profit and through September had earned a mere 5 percent return.

Unfortunately, the common fee schemes used today are a “heads I win, tails I win” venture for investment mangers. Ultimately, it would be wise for institutions to insert a few new guidelines in their decision-making process for alternative investments.

First, they should avoid investing in a fund-of-funds, mockingly referred to as “fees of fees” funds. If a pension plan already has one consultant overlooking a plan, it certainly doesn’t need another. Investment committees across the country would be well served by reading the section in Warren Buffett’s 2005 annual letter titled “How to Minimize Investment Returns.”

Institutions should request hurdle rates on their investments-a rate of return that must be surpassed (such as the 10-year Treasury bond rate) before a performance fee kicks in. Other variations might include performance fees that are calculated over a period of years and “clawback” features that return a portion of fees earned in prior periods, if future investment results are poor.

It will be interesting to see when pension funds have that eureka moment and figure out that they are paying too much for uninspiring investment results. Most likely it will take a few years of sub par performance and a change in heart from the investment consultants who are pushing them.

Until then, the real beneficiaries of this cascade of money into alternative investing are the principals managing these funds.

For those in search of alternative investments, here is something to consider: There are hedge funds now being formed whose stated objective is to invest in the debt they expect will sour from the big private equity acquisitions being done today. Now, that’s irony.