Hedge funds had another rocky year in 2011, down 6.4%, as measured by the Dow Jones Credit Suisse All Hedge Index. And yet industry assets under management have climbed back to $2 trillion, having reached $2.1 trillion in 2007 before plummeting in the 2008 market crash. After reading Simon Lack’s just-published The Hedge Fund Mirage (John Wiley & Sons), one wonders why the assets continue to flow in. Here’s how the book begins: “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.”
Lack is an industry insider, having spent a career at JPMorgan, where he helped to allocate more than $1 billion to hedge funds and to seed emerging hedge fund managers. Immersed in the industry, he eventually came to the conclusion that: “While the hedge fund industry has generated fabulous wealth and created many fortunes, it has largely done so for itself.”
Lack notes that the industry is full of super-smart investors, some of whom have been able to generate superior returns. The problem is that a few dozen have produced most of investors’ returns, and as with actively managed mutual funds, it’s difficult to identify the strong performers in advance. Moreover, the persistence of compelling relative performance is not strong, market inefficiencies can quickly disappear, and the investing rewards are heavily skewed in favor of themanagers. As a result, the average hedge fund investor has not done as well over the years as the numbers might suggest.
Funny Numbers
To test his thesis, Lack deconstructed industry performance data.
The HFR Global Hedge Fund Index puts the industry’s annualized return from 1998 to 2010 at 7.3%. In Lack’s mind, those return figures are distorted by several factors. One is that these returns are calculated on a time-weighted, rather than asset-weighted basis. As he shows repeatedly in the book, both fund and industry performance suffers with growth in size (he calculates the correlation between hedge fund size and performance as -0.42). In other words, the index numbers overstate the strength of hedge fund performance due to stronger results in the early years when hedge funds and the industry itself were both smaller.
So Lack performs his own asset-weighted calculations (similar to the internal rate of return methodology of measuring private equity or real estate fund performance) using BarclayHedge data to measure how the average investor—as distinct from the average fund—has done. He argues that hedge funds are similar to private equity funds in that the hedge fund manager (who holds himself out as providing absolute, uncorrelated returns) has control over when to take clients and to commit their capital. Therefore, he feels that returns should be calculated using private equity industry standards versus mutual fund industry ones.
His conclusion: from 1998-2010 the index returned only 2.1% annualized on a money-weighted basis, not 7.3%. During that time frame, he estimates that hedge fund managers earned $379 billion in fees, while “real investors” earned only $70 billion in profits. Thus, the operators earned 84% of the investment profits and investors only 16%. But wait, there’s more. These figures don’t account for fund of funds, which add another layer of fees and through which around one-third of hedge funds are purchased. Including these brings industry fees up to $440 billion, or a whopping 98% of the profit pool, leaving only $9 billion for investors.
And to add insult to injury, Lack notes that HFR Global Hedge Fund Index returns are also overstated due to statistical biases such as “survivorship” (lousy performers shut down or stop reporting) and “backfill” (strong performers start to report). Academic estimates are that these statistical biases of self-selection (reporting is optional for the largely unregulated hedge fund industry) add 3-5 percentage points to index returns. Adjusting for these biases, Lack estimates that from 1998-2010 investors collectively lost $308 billion in hedge funds while the industry earned fees of $324 billion.
Conclusion: Caveat Emptor
Lack writes that when he started researching the book his animus was pointed towards the hedge fund managers. But as he progressed, he shifted the blame towards 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 of skepticism, and a desire to be associated with winners without proper regard for terms have all caused the sorry result.” Investors considering an allocation to hedge funds could do much worse than to first pick up a copy of The Hedge Fund Mirage.
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