The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to be True, by Simon Lack, Wiley, RRP£23.99, 175 pages
The average Pétrus-swilling hedge fund boss will not thank Simon Lack for writing this devastating little book. In it, the author, a professional money manager, applies the same sort of analytical techniques that hedge-funders use when making investment decisions to appraise the hedge fund industry itself. His conclusions will make uncomfortable reading for many self-styled “masters of the universe”.
We all know that hedge fund bosses do pretty well out of the businesses they run, and the lazy assumption is often made that their prosperity is somehow mirrored by that of their fortunate investors. This is an assumption that Lack sets out to challenge. “Who can name even one hedge fund investor whose fortune is based on the hedge funds he successfully picked?” he asks, echoing the age-old Wall Street question: “Where are the customers’ yachts?”
The answer, it seems, is that billionaire hedge fund clients may be far rarer than the so-called “black swan events” on which fund managers blame so many of their mistakes. Quite why can be summarised in the killer statistic that Lack unleashes on the first page of The Hedge Fund Mirage: “If all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good,” he observes.
What this means is that many of the investors who have been paying hefty fees to top hedge fund managers would have done much better had they simply shoved all their money into risk-free short-term government securities, even though these returned just 2.3 per cent a year between 1998 and 2010.
This may come as a surprise to those who follow the published hedge fund indices, which show annual returns averaging between 7 and 8 per cent over the same period. But, as Lack explains, these deceive to flatter. That is because they do not take into account the growth in the total value of assets that hedge funds manage – a calculation known as “money weighting”. To understand how this changes the picture, consider what happened to cumulative returns when markets crashed in 2008. Because more and more people had poured money into hedge funds over the preceding decade – assets under management increased from $143bn to $2.1tn – the $450bn-odd vaporised in that single year, Lack maintains, probably “destroyed all the value that hedge funds [had] ever created”.
Not all investors did poorly, of course. Some made big profits along the way by getting in and out at the right time. But the damning fact remains that the average punter has almost nothing to show for the whole hedge fund experience.
How, one might ask, could some of the world’s most talented fund managers have delivered such a poor result? Lack runs through some explanations. One reason is the problem of size. It was easier for hedge funds to come up with distinctive strategies when there were fewer of them. Bigger funds find it harder to trade in and out of markets without moving prices against themselves. Investors have backed too many duff managers and strategies.
But the biggest reason, predictably, is fees. Once again, Lack helpfully crunches the numbers. From 1998 to 2010, once everything is factored in, including fees paid to managers of funds of hedge funds and investment consultants, the cumulative split was just $9bn to investors versus $440bn to the managers and hangers-on. Even if you accept the industry’s argument that an otherwise adequate record of returns was undone by the 2008 meteorite strike, this still seems a crazy split. “Never in the field of human finance was so much charged by so many for so little,” is Lack’s wry comment.
Hedge-funders will wince at the picture Lack paints of their industry. As well as high fees, the author highlights such things as their reluctance to release performance data or to explain strategies (itself an invitation to the fraud that has afflicted 3 per cent of hedge funds). Investors could be forgiven for concluding that the prime purpose of the sector “is to provide jobs and wealth creation for the industry professionals: managers, consultants, allocators, prime brokers and other service providers”.
The only reliable way to make money out of a hedge fund, it seems, is to own one. Lack’s career bears this out. As an investor at the US investment bank JPMorgan, he made his name and money “seeding” start-up funds, or putting up early-stage capital in return for a share of the future fee income.
Having produced such a devastating exposé, there’s a sense of anti-climax at the end when Lack blames everything on the investors. They are largely responsible for the poor outcome, he suggests, citing their “faulty or weak analysis, performance chasing, shortage of scepticism, and desire to be associated with winners without proper regard for terms”.
All the more reason, then, for investors to wise up. This book should be required reading for pension fund trustees.
In a world of low investment returns, the conventional wisdom has been that paying high fees to hedge fund managers is a necessary evil. If Lack’s analysis is right, and there is no reason to doubt him, the word “necessary” should be scratched out.
Jonathan Ford is the FT’s chief leader writer