The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True

The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True

hedgefundmirragebookThe Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True - A New Book by Simon Lack     

   The Hedge Fund Mirage is a tell-all expose of the $1.6 trillion hedge fund industry and how poorly served its investors have been. A true industry insider, Simon Lack spent 23 years with JPMorgan where he played a large part in allocating over $1 billion to “seed” hedge fund managers. Upon leaving JPMorgan, he formed an investment advisory firm where he implements hedge fund-like strategies such as “low beta long-short” for his clients. His well-articulated views on the disappointing performance and outrageous expenses of hedge funds cannot be dismissed as the rantings of an “indexing extremist.”

               The first of Lack’s devastating conclusions is that hedge fund investors as a group would have been better off if they had simply invested in Treasury bills, the quintessential risk-free investment. Lack reached this conclusion by using publicly available data from Hedge Fund Research, Inc., and he reminds us that his computations are likely overstating the true hedge fund returns because of survivorship, selection, and backfill bias. Specifically, hedge fund managers decide whether or not to report their returns (self-selection bias), and they will often report after a good run (backfill bias), and they can cease reporting if returns go south or if the fund folds (survivorship bias).

               Lack’s analysis was inspired by the research of Ilia Dichev and Gwen Yu1 who published a paper in the Journal of Financial Economics which showed that the annualized dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold (time-weighted) fund returns. The essential recurring problem is that hedge funds that have a strong beginning (incubation bias) attract a large amount of new capital which hinders them from repeating their outperformance (which may have been due to luck anyway). For the hedge fund industry as a whole, the attractive returns were achieved when there was relatively little invested. By the time of the 2008 financial crisis, the poor performance of hedge funds completely reversed all the investor profits made in the prior period.

               The second major problem in the hedge fund is the imbalance between fees paid to managers and returns received by investors. Lack delves deeply into the returns data and finds that since 1998, hedge fund managers have kept 84% of profits, leaving a paltry 16% for investors. At the root of this problem is the common 2% of assets and 20% of profits charged by hedge funds. The 20% of profits often creates a perverse incentive for the hedge fund manager to take inordinately high risks since he shares only in the gains and not in the losses. Lack does not hold hedge fund investors blameless, as most of them have the sophistication needed to realize just how much the playing field is tilted against them. Although anyone with a passing familiarity with the hedge fund industry can name a few “superstars” such as John Paulson who have become multi-billionaires, it is far more difficult to find an actual hedge fund investor who vastly increased his wealth due to his manager-picking acumen. As Lack repeatedly states, the best way to make money in hedge funds is to manage one or provide seed money which entitles you to a share of the expenses collected from the other investors. The question, “where are the customer’s yachts?” is completely rhetorical.

               Interspersed throughout the book are entertaining anecdotes concerning various characters that Lack encountered among hedge fund managers. While they tended to be incredibly smart and gifted people, some of them exhibited questionable if not outright dishonest behavior. To summarize, although we disagree with his utilization of hedge fund-like strategies for his investment advisory clients, there is no denying that Lack has made a unique and valuable contribution to the literature of popular finance. Anyone who is either currently a hedge fund investor or is contemplating becoming one would do well to read this book, and so would any financial professional who is looking for deeper insight into how the hedge fund industry operates.

 

1Dichev, I.,Yu, G., 2011. Higher risk, lower returns: What hedge fund investors really earn. Journal of Financial Economics 100, 248-263.