Author Simon Lack managed a unit inside J.P. Morgan that provided seed funding for hedge funds from 2001 to 2006. This entailed getting under the hood of the industry to find promising but undiscovered hedge funds in which they could invest.
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
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