The Hedge Fund Mirage

By Simon Lack

Late last year just after Christmas my book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good To Be True, was released for publication by John Wiley. Up until then, all the hedge fund books available were written by advocates. Investing in or starting a hedge fund were well-covered topics, and that hedge funds were good for your financial health was beyond question.

My book is controversial, but only because it is contrary to conventional wisdom. There is over $2 trillion invested in hedge funds and increasingly they are regarded as the vital link connecting the 8% returns desired by public pension plans and the apparently paltry ones available from traditional assets. An entire industry of consultants, prime brokers, fund of hedge fund professionals, accountants and fund administrators is dedicated to channeling increasing amounts of assets to this inappropriate solution. Casting doubt on this mission could appear heretic, with almost commensurate results for the non-believer.

Which is why the widespread positive public reaction to my book has been so welcome. Mainstream financial press coverage including The Economist, the Financial Times, the Wall Street Journal and The New York Times has correctly focused on the poor results earned by investors and has raised legitimate questions about the applicability of the “Yale Model” with its heavy allocation to alternatives so successfully pioneered in the 90s by David Swensen.

But there is a group, the Alternative Investment Managers Association (AIMA), based in London, to whom the unenviable mission of promoting hedge funds falls. And after a faltering start earlier this year they have warmed to their task. Undaunted by the fact that only those with an economic stake in the industry’s growth are vocal, AIMA in partnership with KPMG opened their assault in the Spring with a glossy marketing brochure noting the jobs created and taxes paid by hedge funds. Their defense is based on the average return earned since 1994 by a hypothetical investor with an equally balanced portfolio, who earned 9% per annum. Whether or not this investor really exists, my point is that as assets have come into hedge funds, returns have gone down. This relationship exists at all levels of the industry. Small hedge funds tend to outperform big ones; most big hedge funds performed better when they were smaller; logically, a smaller hedge fund industry was better than a big one at least for the clients, if not for the gatekeepers. Fees have eaten up fully 100% of the excess return over treasury bills, an issue to which AIMA scarcely pays serious attention because the math is what it is. And since 2002 hedge funds have failed to outperform a simple 60/40 traditional allocation to stocks and bonds. They have done this not just over the most recent ten years but in every year of the past ten.

In August AIMA made a more serious attempt to defend their paymasters with “Methodological, mathematical and factual errors in ‘The Hedge Fund Mirage.’” Since the financial media is delivering a steady diet of disappointing hedge fund returns, AIMA’s paper promoting them seemed sharply at odds with the actual experience of their clients. Consequently, it received scant attention from serious journalists and neither they nor I bothered responding to what I felt was old analysis from a marketing group. But a notable exception was Felix Salmon, an erudite and prolific blogger with Reuters. Felix effortlessly shredded AIMA’s effort with his usual eloquence: “…the AIMA paper has convinced me of the deep truth of Lack’s book in a way that the book itself never could.” Felix’s point-by-point dismissal of the arguments made by AIMA stands as a service to hedge fund investors everywhere. The business model built on a skeptical view of hedge funds has few obvious sources of revenue, while a vast array of professionals is available to guide clients towards the “2 and 20 Crowd” (so named for the ubiquitous 2% management fee and 20% profit share charged by the typical hedge fund manager).

In my book I made a controversial forecast at the end, in which I stated that at current levels of AUM investors were likely to be disappointed. And in fact since I wrote those words in June 2011 the industry has provided empirical support for this view through continued poor results delivered at great expense.

It should therefore not be surprising that the investment business I run, SL Advisors, LLC, provides clients with access to its income-oriented strategies through separately managed accounts that include transparency, liquidity, and non-hedge fund fees. SL Advisors naturally does not run a hedge fund. 

Some of the most talented investors around run hedge funds, and no doubt that will always be so. That is where the big money is to be found. And there are happy clients, though they are the exception. In fact, the best use of hedge funds for an investor is sparingly, where his skill at manager selection and ability to negotiate fair fees, access to capital and transparency can be put to good use. For it turns out that diversification, normally the only free lunch on Wall Street, is no friend of the hedge fund investor. The poor returns earned by the average client ensure that proficient manager selection is critical. Diversification serves only to dull that advantage, drawing the portfolio toward the mediocre, average return. Two or three well-chosen funds can probably get the investor most of what’s good, with the obvious constraint that the “normal” 10-20% hedge fund allocation needs to be dialed down to only 1-2%. This is not the message the hedge fund consultants would like investors to hear, but it is the common thread connecting many of the happy clients I know, and is most assuredly the safest way to navigate a $2 trillion industry struggling to profitably deploy more capital than it needs to generate what are no longer absolute returns.

Following 23 years with JPMorgan, Simon Lack founded SL Advisors, LLC, a Registered Investment Advisor, in 2009. Much of Simon Lack's career with JPMorgan was spent in North American Fixed Income Derivatives and Forward FX trading, a business that he ran successfully through several bank mergers ultimately overseeing 50 professionals and $300 million in annual revenues. Simon Lack sat on JPMorgan's investment committee allocating over $1 billion to hedge fund managers and founded the JPMorgan Incubator Funds, two private equity vehicles that take economic stakes in emerging hedge fund managers. Simon Lack's deep experience in financial markets, managing complex trading businesses and overseeing hedge funds provide him with a unique perspective from which to manage investments and advise clients. Simon serves on the Board of Trustees of Wardlaw-Hartridge School in Edison, NJ where he chairs the Investment Committee, and also chairs the Memorial Endowment Trust Investment Committee of St. Paul's Church in Westfield, NJ. Simon is a CFA charterholder, and the author of The Hedge Fund Mirage (release date January 2012).



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