The Hedge Fund Mirage, by Simon Lack
Author Simon Lack managed a unit inside J.P. Morgan that
provided seed funding for hedge funds from 2001 to 2006. This entailed getting
under the hood of the industry to findpromising but undiscovered hedge funds in
which they couldinvest.
Consider the plight of a pension fund manager. They are
charged with investing money in such a way that in the future it will give the
participants better returns than they could have received from investing in
Government bonds. These returns would have to include the costs involved in
handling this money. This is a feat that requires exceptional investment skill
based on deep understanding and insight into finance and economics.
For this reason pension fund managers invest in hedge funds
with the expectation of yields higher than those on safer investments. Hedge
funds are aggressively managed portfolios of investments that use advanced
investment strategies such as leveraged, long, short and derivative positions
for the purpose of generating abnormally high returns.
Hedge funds are not a new vehicle, the first fund was
founded in 1949, but the recent growth of this industry has been staggering. In
1998 Lach estimates hedge funds had assets under management of about $140bn and
almost $1.7 trillion by 2010.
The “mirage” referred to in the book’s title is the false
tendency to count on hedge funds to deliver for the investorsand to deliver for
the investors in fair proportion to what it delivered for the hedge fund
managers. In fact, Lack argues very cogently, it is the operators of hedge
funds that get rich and in some cases, obscenely rich, but not the customers.
He titles one of his chapters: “Where are the customers’ yachts?”Lack also
argues very cogently that hedge funds have not delivered on their purpose. If
all the money that has ever been invested in hedge funds had been invested
instead in boringly safe, but reliable, Treasury Bills, the results would have
been twice as good.
In 2008, instead of protecting wealth in these troubled
times,the hedge fund industry lost more money than all the profits it had
generated in the previous 10 years. 2011 was another bad year for the industry
which was down by 6.4%, and yet theassets under management have climbed to $2
How can this be?
Hedge funds are most often set up as private investment
partnerships that are open to a limited number of sophisticated investors and
are therefore not required to report their activities to the SEC. This is why
it required Lack's proficiency with numbers and his insight into the industry
to give a clear picture through the mirage. What he reveals is an industry
where the returns and risks are biased in favour of the hedge fund manager and
where there is surprising frequent fraud.
There are many ways in which one could report the performance
of hedge funds and it is clearly in the interests of the industry to report
these results in the most favourable terms. The typical way of reporting is on
a time-weightedbasis which reflects the performance of the hedge funds over
time. This allows for the early, small funds, which produced the best returns,
to mask the poor performance of the large funds. However, if you report
performance based on a money-weighted basis, the amount of money in the funds,
a very different, but more accurate picture emerges.
From 1998 to 2010 the industry returned only 2.1% annualised
on a money-weighted basis, not 7.3% as indicated when the time-weighted basis
is uses! Calculated this way, during this period hedge fund managers earned
$379bn in fees, while the investors earned only $70bn in profits or 84% versus
16%. This is achieved because hedge fund operators take incentive fees in
addition to operating fees with no downside if they perform poorly and lose
If the situation is this bad, why have we been thinking it
was so good? Clearly a larger part of the answer lies in the way some operators
report their results and how they are able to get away with reporting only when
they have racked up a good score. However, there are also inherent flaws in the
It is far easier to find great investments in small
quantities than in large quantities – they are great because they are so much
better than all the rest. As a hedge fund does well through these rare finds,
it is able to attract larger amounts of money for which it now has to find even
more rare finds, which gets ever harder to achieve.
During the 1990s whenhedge fund investors did well it was in
part because there were relatively few of them.
The truly outstanding hedge fund operators like George Soros
and John Paulson have built famously huge fortunes, the reward for truly
outstanding performance. The problem is that a few dozen have produced most of
investors’ returns, and as with actively managed unit trusts, it is difficult
to identify the strong performers in advance. Investing in new hedge
fundsinvolves a bet of millions of dollars on the stock-pickingability of an
individual and there is always the ever presentdanger of latching onto a
fraudster like Bernie Madoff.
Lack lays the blame for the lopsided rewards of the hedge
fund industry largely on the supposedly sophisticated investors, such as
pension funds, and their consultants. “Star-struck investors have too often
equated enormous financial success amongst managers with high returns for
clients…Faulty or weak analysis, performance chasing, shortage ofscepticism,
and a desire to be associated with winners without proper regard for terms have
all caused the sorry result.”
This is a book that will inform professionals and fascinate
anyone interested in investment.
InsightsHigh +---- Low
PracticalHigh ---+- Low
*Ian Mann of Gateways consults internationally on leadership