This book has shaken a few feathers in the Hedge Fund community. Its basic take is that the apparently superior returns of the hedge fund industry compared to traditional sources are not real, & to the extent that they do exist they have been taken in fees by the manager. The real return for investors, over the long term has been little more than 1%, half what could have been earned from just investing T-Bills he claims. This is a startling claim, but unfortunately the way that Lack derives these numbers does not seem to be internally consistent, or even reasonable in some cases, which unfortunately casts doubt on his whole approach.
I should say at this point that I have seen many hedge funds at close quarters, both from the inside and outside, but have no current involvement with the industry & no axe to grind. Also, I have long suspected that much of Lack's basic position is true: that overall the hedge fund industry has not performed as well as the hype would suggest, that hedge funds performed better when they were smaller and more nimble, & that the fee structure is inequitable, with the managers keeping too much of the upside for themselves. In fact this is a view that is pretty widely held & is not in itself controversial, if not universally accepted. However, Lack takes this view further than most, arguing that investors would have been better off investing in Treasuries! It is this conclusion, and the way Lack supports this with a detailed analysis of returns & fee structures that is controversial
Lack has an immense amount of experience of investing in the industry, and for anyone looking at hedge funds as an investment there is a wealth of practical advice about how to look at these strange animals. For example, he points out that transaction costs for new entrants & leavers are socialised in a pooled fund, because the spread paid to invest new capital or to reduce positions in respect of exiting capital are borne by the fund as a whole, something which funds are beginning to recognise. Elliott Management has been charging a 1.75% entry & exit fee since 2009, which whilst prima facie appearing to be yet more cost, is arguably fairer in the long run. In fact, the problem is actually worse than Lack states: most funds value investment positions at mid- market prices, which is not really correct, and anticipates profits. Long positions should be valued at bid, short positions at the offer price.
His basic approach is that healthy cynicism is more appropriate than approaching managers as financial wizards whom one is lucky to have managing one's money, which is obviously right. There are plenty of good war stories, and Lack doesn't pull any punches, naming names when he has something critical to say. His description of a meeting with one of the `feeder' funds who were the largest investors in Bernie Madoff's operation, full of unspoken hints that Madoff was really making his money by front-running his brokerage clients (whereas in fact it was just a Ponzi scheme),rings very true.
The book is certainly worth reading therefore, and has the added virtue of being quite short: my advice would be just be wary of the numbers & the sensational claims about returns.
The underlying premises supporting Lack's claim about just how poor the returns have actually been is that Hedge Fund returns should be measured on a dollar- or value-weighted basis (in other words, the internal rate of return over time). This is traditionally how the returns on Private Equity are measured, on the basis that the manager can control when funds are invested and withdrawn (through capital calls and lock-ups for 5 years or more). However, mutual fund managers are usually judged based on the unweighted average of their returns, on the basis that because they offer daily liquidity, the managers cannot control the timing of in- and out-flows for the fund.
Lack argues that hedge funds are more like private equity funds than mutual funds. Well, yes and no. The managers certainly have more control over fund flows than mutual fund managers but generally lock-ups are for a year at most, and are becoming less common. There are notice periods and redemption periods but this just means that the redemption is postponed, very different to private equity where if you sign up you are in pretty much for life (the life of the fund, that is). Also, hedge fund managers increasingly have to offer monthly liquidity, or even better to attract inflows after investors' experience during the Financial Crisis, as demonstrated in a recent report by Dow Jones Credit Suisse. So arguably they are getting closer to the mutual fund structure. At most, one could argue that hedge funds are a hybrid type of structure where both the average return and IRR should be measured, but neither should take primacy over the other. Lack raises some important issues here, but as so often he overstates his case.
However, the biggest problem with Lack's argument in this area is that the sums are just wrong, even in the basic example of the difference between average annual returns & geometric returns on page 8. The example is of investing $1m in year 1 for a 50% return, then investing a further $1m in year 2 where the manager then loses 40%. Lack states that `the average annual return' will be +5%' & `his marketing materials will likely show a geometric annual return of +5.13%, compared to an IRR of -18%'. In fact, the geometric average annual return is -5.13%! OK, this is just an example, and the average return is still better (or less bad) than the IRR, but it doesn't inspire one with confidence over the more detailed calculations.
I have tried to replicate Lack's calculations of the IRR for the HFRX (2.1%) from 1998 to 2010 using his own data , but was unable do so (I make it closer to 4%). Also it is not clear how the he calculates the comparative IRR for e.g. the S&P 500 or Treasury Bills. This is important as the poor comparative return is one of Lack's big claims and calculating this comparison is not straightforward. Does he assume the same net investment flows over the period as into hedge funds & calculate the return on that? I have again tried to replicate this and on this basis the IRR on Treasuries is always lower than for hedge funds (about 2.5%). Again, the return on Hedge Funds on this basis is arguably not sufficiently higher than T-bills to justify the additional risk, but this result is not as dramatic as Lack's claim.
The impact of 2008 and afterwards is important here: most money went into hedge funds in the mid-noughties just before the mother & father of all drawdowns (23% according to HFRX, although this was much lower than the losses in the stock market). If we just analysed the period up to 2007 the gap would be much larger, with the hedge fund IRR increasing to over 6% (still hardly spectacular) with the return on treasuries at about 2.4%. Was 2008 a one off event which distorts the comparison? Only to some extent: if hedge funds have anything in common other than the fee structure, it is that they are providers of liquidity, and are therefore vulnerable when fear overtakes greed as the driver of the market, which happens every few years (in the jargon, the distribution of their returns can be particularly `fat-tailed'). However, 2008 was more than the normal downturn, and regulatory intervention, particularly the sudden ban on short selling, which had a huge impact on many funds' performance, should arguably be discounted.
One of the most controversial chapters in the book has a great title: "where are the customer's yachts?" In this chapter Lack claims that the bulk of the money earned by hedge funds has been kept by the managers. He takes the average management and performance fees as being the industry benchmark of 2%/20% (and 1%/ 10% for Fund of Hedge Funds), and subtracts the earnings on T-Bills (as a proxy for the risk free rate which alternative investments should beat), and then 3% pa for estimated biases in the indices. This is inevitably going to be a broad-brush estimate given the lack of detailed data, as Lack acknowledges, but I personally have much less of an issue with this calculation than with the IRR. I think it is fair to judge `real investor profits' as those being earned above the risk free rate (assuming one is still comfortable with this as a concept, of course!): this is a perfectly reasonable way to estimate added value on a risky asset. In fact one of my biggest beefs with the industry structure is that performance fees are not charged on earnings above a hurdle rate like the yield on Treasuries. This is more common in the Private Equity business and is clearly a fairer measure. Whether deducting 3% pa for biases is fair is more debatable as the range of estimates for biases in index performance varies wildly depending on which academic study is quoted, and 3% is arguably on the high side (although lower than some estimates). In any event, Lack gives the before and after figure (84% and 98%), so the reader can take his or her pick. Either way it doesn't affect the conclusion too much.
As Lack states, because the performance being used is for the industry as a whole, overall fees will be understated using this measure because the performance given is net across the industry, and funds that lose money will not earn performance fees. Actually it is even more of an issue than that because Lack calculates the performance fee as a percentage of the index return but this is itself stated net of fees. Generally I could replicate the calculations in this area with one or two exceptions.
But has Lack shown that the industry as a whole is a rip-off, as he claims? It depends what you judge it against.
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