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The Hedge Fund Mirage Hardcover – December 8, 2011
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"Simon Lack, a hedge fund veteran exposes some unforeseen and uncomfortable truths about the industry in his new book." (Hedge Fund Net, January 2012)
"...a cautionary tale from one who knows just about all the tricks...an easy, largely fun and certainly instructive read" (Financial World, February 2012)
"Devastating little book.... His conclusions will make uncomfortable reading for many self-styled 'masters of the universe'.... This book should be required reading for pension fund trustees." (Jonathan Ford, Financial Times, 19th February 2012)
From the Inside Flap
Sure, hedge funds have produced some of the greatest fortunes in recent years, but the shocking reality is that investors would have made more putting their money into treasury bills instead. And while hedge funds have proved to be serious moneymakers for those that manage them, investors themselves rarely reap the benefits. In The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True, hedge fund expert Simon Lack blows the lid off the secret world of this class of investments, teaching you everything you need to know to maximize your own returns.
Drawing on an insider's view of hedge fund growth during the 1990s, a time when investors in the field did well in part because there were relatively few of them, The Hedge Fund Mirage chronicles the history of the hedge fund, highlighting the many subtle and not-so-subtle ways that returns and risks are biased in favor of the fund manager, and how investors and allocators can redress this imbalance. Packed with information about the industry and what's wrong with it, the book steers you away from the traps that befall so many investors. Full of helpful pointers on how to really get the most out of your hedge fund investments, it encourages using new and emerging hedge fund managers whose returns are generally better, negotiating more assertively for stronger investor rights, and warns anyone putting their money in the hands of a manager to demand complete transparency at all times.
Hedge fund investors have had it tough in recent years, but that doesn't mean that there isn't money to be made. As the success of hedge fund managers shows, opportunities are there. The dilemma for investors is figuring out how to identify managers you can trust and learning the techniques to keep more of the money generated using your capital. The Hedge Fund Mirage is here to help, turning the tables on conventional industry wisdom to put you, the investor, back in charge.
- Publisher : Wiley; 1st edition (December 8, 2011)
- Language : English
- Hardcover : 210 pages
- ISBN-10 : 1118164318
- ISBN-13 : 978-1118164310
- Item Weight : 14.4 ounces
- Dimensions : 6 x 0.67 x 9 inches
- Customer Reviews:
Top reviews from the United States
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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 that 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 reasons 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 Lack estimates hedge funds had assets under management of about $140 billion 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 investors and 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 troubles 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 the assets under management have climbed to $2 trillion.
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 is requires 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-weighted basis 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% annualized 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 $379 billion in fees, while the investors earned only $70 billion 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 investor’s money.
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 system.
It is far easier to find great investments in small quantities than it 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 when hedge 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 funds involves a bet of millions of dollars on the stock-picking ability of an individual and there is always the ever present danger 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 of scepticism, 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.
Readability Light ---+ Serious
Insights High +---- Low
Practical High ---+- Low
Ian Mann of Gateways consults internationally on leadership and strategy
All this is somewhat entertaining and educational until we focus on his main argument- That HFs have taken 80%+ of the industry's excess profits relative to their clients' gains. The math doesn't seem to add up if I'm reading it correctly. He seems to take NET HF returns and then apply fees to those returns to demonstrate how large a cut the industry is taking. This grossly overstates the size of the fees relative to client returns and makes it hard to believe the point he is trying to make (though he has a point that fee structures and payouts need to be changed in a manner more favorable to clients.)
Also, his big question that he thinks will awaken the masses to the charade that is HF investing is, "Can you name a rich HF investor- NOT manager?" This is a diversionary tactic. Let's say a HF manages $1B and has a 20% year, his 2 & 20 will net him $60M in total fees thus making him "rich"- but someone(s) had to give him that $1B to begin with- the already rich. The vast majority of individual HF investors are ALREADY rich and most very private. Since they're not the ones making the big bets or blowing up they don't get on the cover of the WSJ, nor do they want to. The Bass or Ziff family has seeded and invested in a number of HF & Private Equity firms and have done very well for doing so. So this "great conundrum" isn't so strange after all.
In the end, it's a good book with some interesting and salient points to help those who may invest in HFs, but it's nowhere near the HF Mitchell Report Mr. Lack thinks it is.
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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. The performance fees of 20% get all the headlines, but if you drill into the numbers, the main sources of income for the hedge fund managers is management fees, which represent 66% of the total fees earned if we exclude Fund of Funds. Also, the weighted average ratio of fees (excluding Fund of Funds) to funds under management (again, using Lack's numbers) is 2.8%. As an expense ratio, this does not look much larger than it would be for active fund managers in the Mutual Fund world, certainly in Europe where fees are generally higher than they are in the US. When the fees were a higher percentage of assets was in the earlier years, when the performance was better. So we come back to the point that performance in the last few years has been poor, not necessarily that hedge funds are taking any more out of their clients than the rest of the investment industry (which is not the same thing as saying the fees are reasonable!).
Lack's choice of data sources is interesting: he takes hedge fund performance from HRFX, but assets under management from Barclays. It is not clear why he doesn't use the same source for both. He states that he uses HRFX because their main index is weighted by asset under management rather than by an arithmetic average of the returns of each manager (i.e. it is more like the S&P 500 than the Dow 30). Most indices in the industry are not asset -weighted, and it is clearly correct to use asset weighting in this context, as we are trying to determine how much has been returned to investors compared to the managers. However, last time I looked, HRFX showed lower returns than other asset weighted indices like the Dow Jones Credit Suisse. Also, whilst the index might be asset-weighted for the industry as a whole, the Hedge Fund Research Indices for individual strategies are equally weighted, and Lack does drill down into individual strategies. Therefore his choice of index is questionable.