Hedge funds enjoyed record inflows in 2011 as new assets from US pension funds poured into their coffers. But it was also a horrible year for their performance and investors put a lot of pressure on them for better terms.

In the first nine months of 2011, more than $70bn (€53bn) in new money went to hedge funds, mostly from pensions and endowments, which have become the most important investors in this ‘alternative’ asset - they hold around 60% of hedge funds’ total $2trn. Public retirement systems desperately need to make up the gap between the benefits they promised their members and the money they have to pay for them. The gap is as large as $1trn, according to Pew Center on the States - or $3trn, according to Professor Joshua D Rauh. Public pension funds hope hedge funds will deliver higher returns. Unfortunately, 2011 has proven that this bet is far-fetched.

In the first 11 months of last year, the average hedge fund lost 4.37%, according to data from Hedge Fund Research, while the S&P 500 index gained 1.06%.

The poor results have not dissuaded pension funds from investing even more money into hedge funds, but they are demanding a different relationship, starting with a change in typical ‘two-and-twenty’ fee structures where they pay hedge funds 2% of assets under management annually and 20% of excess returns. Since the 2008 financial crisis, pension funds have been in the forefront of the push to better match fees with long-term investment results. The largest are now paying an annual fee of around 1.6% and a 19.20% performance fee, which is the current average for the hedge fund industry, according to the last Preqin’s Hedge Fees Survey. Moreover, some institutional investors are looking at a new incentive compensation system, which was created in 2009 but is still in its infancy - Fund Appreciation Rights (FARs). This is a variation on stock options and stock appreciation rights for corporate managers, and tackles the problem of investors paying annual management fees even when the funds are losing money.

FARs set the performance portion of the fee structure to be paid out through a stock appreciation right that gives the hedge fund manager its share of the cumulative profits at the end of the investment, or at a date pre-determined by the investor and the manager.

“US and EU regulators have led the call for incentive compensation that rewards service providers for the value created over the period of the service recipient’s risk. FARs - in the form of fair market value (FMV) options - are the best method of providing such alignment,” claim the managers of Optcapital, the first firm in the US offering a platform for FARs. They further explain: “FARs give the investment manager the terminal, or cumulative, tax-deferred profits on a specified percentage of the investment (for example, 20%). So instead of ‘banking’ taxable interim profits each year, the manager ‘banks’ its share of tax-deferred profits at the end of the performance period, whether two years, five years or 10 years.”

Another way to cut expenses is to stop using funds of funds, which add an extra layer of fees. The $48bn Massachusetts state pension fund has decided to do that. During the last three months of 2011, it hired 21 individual hedge fund managers as part of a $500m pilot programme into direct investing in hedge funds. “If the pilot programme is successful we will be moving more hedge fund assets out of the fund of funds programme into the direct programme,” explains Michael Trotsky, the executive director of the pension fund that has 10% of its capital ($5bn) invested in hedge funds.

The second largest public pension fund in the US, the $148.2bn California State Teachers’ Retirement System (CalSTRS) also intends to select individual managers for its new global macro hedge fund strategy. However, this philosophy is not universal. The $119.6bn New York City Retirement Systems invested a total of $450m in hedge funds of funds managed by Permal Group in the first half of 2011.