In a time when hedge funds as a group continue to underperform equity market indices for the second year in a row, it could be expected to find books criticising the performance of the industry. But Simon Lack’s “The Hedge Fund Mirage – The Illusion of Big Money and Why it’s Too Good to be True” does not only focus on the failure of the industry to produce adequate returns, but even more so on the way these returns are shared between investors and fund managers.
“Where are the customers’ yachts?” or “Name one person who has become rich from investing in hedge funds?” are only two of the questions Lack asks to illustrate his point.
In a more detailed analysis, however, he makes his case with statistics based on historical hedge fund performance and points to many of the cost factors that investors may face and should be aware of when investing in hedge funds.
In the know
Lack should know what he is talking about.
Sitting on JP Morgan’s investment committee he had to identify up and coming fund managers and help allocate more than $1 billion in seed capital to start-up hedge funds in return for a share of the 2 per cent management fee and 20 per cent incentive fee that most hedge fund managers demand.
This position gave him access to data, for example daily trading positions of the funds he invested in, that average investor does not have.
In his book he reminds the reader that most of hedge funds’ assets under management have been invested for less than 10 years.
However, hedge funds did better in the early years, when the industry was much smaller.
Not always reflected
This is not always reflected in indices.
First off hedge fund indices rely on self-reported data, which in practice means selective reporting by hedge funds managers who have a great incentive to keep negative performance quiet.
Hedge fund indices also tend to measure the industry from a time-weighted first dollar invested starting point.
Based on the HFRX for instance, a hedge fund index by data provider Hedge Fund Research, an investor who would have invested $1 million in 1998 would have earned 7.3 per cent per annum.
But when adjusted for size, using asset under management figures, Lack says, the story is a different one and the dollar-weighted return is a meagre 2.1 per cent.
“It’s the difference between looking at how the average hedge fund did versus how the average investor did.
“Knowing that the average hedge fund did well isn’t much use if the average investor did poorly.”
Lack argues that hedge fund performance generally tends to be better when funds are small, in part because entering and exiting positions is usually easier when funds are managing a smaller amount of capital, they are less likely to move the market when they trade and others are less likely to notice what they are doing.
The issue of size may even lead to conflicting interests.
He states that investors want hedge funds to stay small so they can continue to exploit the inefficiencies that have led to the investment in the first place.
The manager in contrast wants to grow his business and get rich, and thus strives to convince investors that they will not miss the advantages of being small if and when the fund becomes bigger.
The principle of size, he says, applies to some extent to the industry as a whole.
His statistics show that the most important cause for the growth of the hedge fund industry was the collapse of the Internet bubble in 2001 and 2002, when assets under management in the industry grew from $279 billion in 2001 to $1,925 billion in 2007.
But in 2008, the hedge fund industry lost more money than it had generated in the ten previous years.
Although performance rebounded in 2009 and 2010 “this did not dramatically alter the story”, writes Lack.
More than on the average performance of hedge funds, Lack’s criticism is centred on the way returns are shared between investors and the manager.
According to Lack’s calculations, of the $449 billion dollars generated by the industry in profits since 1998 only $70 billion went to investors, as the remainder of 84 per cent was retained by the industry in fees and return on the managers’ capital.
“Hedge fund managers, advisers, consultants and funds of hedge funds have succeeded in generating substantial profits,” he writes.
“However, they have also managed to keep most of these gains for themselves, while at the same time successfully propagating the notion that broad, diversified hedge fund allocations are a smart addition to most institutional portfolios.”
The main culprit is the sizeable fees commanded by hedge fund managers.
Besides the references to scientific papers demonstrating the obvious - that hedge fund managers as a group are overcompensated – Lack shows some evidence that incentive fees lead managers to favour growing AUM over growing return, for example when deciding to close the fund for further subscriptions.
Look to investors
But the often disappointing results of hedge funds are as much the fault of investors than anything else, according to Lack.
Poor analysis that fails to fully grasp the risks and intricacies of a strategy: momentum investing, chasing high performing managers without sufficient regard for whether the conducive environment for their strategy will persist or not; underestimating the negative impact of AUM size (both for the industry as well as the individual manager) are all investor faults contributing to the overall result.
All the overall performance therefore shows is that the 80/20 rule also applies to hedge funds and how important it is to select the right fund and avoid unfavourable terms.
For much of the book Lack revisits the contentious issue laid bare by the financial crisis, such as lock-ups, gates, side letters and a lack of transparency. This is often illustrated by anecdotes from his personal experience with fund managers.
This yields some good advice for investors.
He describes how trading costs can be distributed unfairly between investors, for example when early investors pay for a disproportionate share of the market-impact costs and he shows how the NAV, the value at which investors enter and leave the fund, can be manipulated by establishing the fair value of assets inconsistently.
One of the important questions an investor should ask advises Lack:
“How much should I be prepared to lose on my investment before concluding that I should revisit my original decision to invest with you.”
Asking these open-ended questions can elicit a greater understanding of the manager’s parameters.
Before 2008 the answer was 10 to 15 per cent, he says, but doubts this is any longer the case.
Because Lack invested into hedge funds from a venture capital point of view, his take yields a controversial result for investors.
“Anyway you cut it, hedge funds have been a fabulous business and a lousy investment.”
Simon Lack, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, Wiley, 187 pages