One of my New Year resolutions – and sadly the first to be broken – was not to write any more negative articles about hedge funds. Some of the poor chumps in the industry seem to be sensitive to anything remotely critical of their activities. My measured comments in this space last August prompted the industry’s official lobbyist, the Alternative Investment Management Association, to complain that I was peddling “hoary old myths” about the hedge fund business.
It was unfortunate perhaps that this peevish response should come just as hedge funds were entering what has become their worst run of performance since the great financial crisis of 2008. Many well-known names lost money in 2011 while the hedge fund indices declining on average by around 4-5 per cent. The complex, volatile and Euro-obsessed markets that characterised the second half of the year proved too difficult to navigate for many masters of the universe.
I have no animus against hedge funds per se. Many of the hedge fund managers I know personally are hardworking, smart and charming, as well as very wealthy, an attractive combination when it can be found. It is not difficult to sympathise with their concerns that ill-informed regulators and politicians will make them pay for crimes, such as causing the global credit crisis, for which they are in reality hardly to blame.
Apart from the guilty pleasure of tweaking the tails of a powerful elite, the main substantive issue in raising questions about hedge funds is whether they offer good value for the very high fees that they charge. A powerfully argued new book on the subject answers this question with a resounding no. The Hedge Fund Mirage, by Simon Lack, carries weight because it is written by an industry insider who bravely raises precisely the issue that has always troubled me, which is the disproportionate way in which the rewards of success are distributed between hedge fund managers and their clients.
Anyone who has ventured into this territory will know of the many hazards involved in extracting meaningful answers from public industry data about hedge funds. Correcting for survivorship bias, the massaging of NAV data, hidden trading costs and so on makes this a statistical minefield for the unwary. What Mr Lack does brilliantly, drawing on many years of experience in investing in and seeding hedge funds for J.P.Morgan, is to focus unerringly and in great detail on the difference between the time-weighted and asset-weighted performance of the industry.
Just as individual hedge funds tend to do better when they are small, so too, his analysis shows, the industry as a whole much performed better when it was still a largely unknown $200 billion business, rather than the high profile $1.9 trillion industry it had grown to become, before the financial crisis in 2008 so dramatically exposed some of its shortcomings. The comforting compounded rates of return reported in hedge fund indices give a fundamentally misleading impression of the actual cash returns achieved by hedge fund investors. Most of the client money that has flowed in since the industry began to be institutionalised has not achieved anything like the returns the long term headline index figures suggest.
In fact, concludes Mr Lack, while many hedge fund managers have prospered mightily from the hefty fees they have charged, the bulk of their investment gains have not been shared with their clients.
On an asset-weighted basis, measuring cash invested to cash returned, hedge fund investors in aggregate, while narrowly beating the average return from equities, would have made more money over the last decade from investing in Government bonds, and even from Treasury Bills, than they would have done from investing in hedge funds. That is a worse outcome even than I would have dared to suspect.
Of course the experience of 2008 colours these figures a good deal. According to Mr Lack, the hedge fund industry lost more money in that one year than all the profits it had generated during the previous ten years. In fact most likely, he says, is that hedge funds lost more money for their investors in 2008 than the industry has made it in its entire history to that point. If true, that would put the industry up there with airlines and banks in the annals of long term non-productive performers from an investor perspective.
Not that the managers have suffered the same way, of course. That is the brilliance of the hedge fund model. Between 1998 and 2010, the book shows, even on favourable assumptions hedge fund managers earned – and of course kept – an estimated $379 billion in fees, out of total investment gains (before fees) of $449 billion. In other words, they took 84% of the investment profits that their funds made, leaving just 16% for the investors.
Once you make further adjustments for survivorship bias, fund of funds fees and so on, it is probable, he suggests, that hedge fund managers have kept all the money that’s been made, and the investors have in aggregate received nothing. Skilful investors such as Yale’s David Swensen have shown that it is possible to make money from picking hedge funds knowledgeably and carefully. Mr Lack shows in his book how that can be done. But for every long term success story, the fact remains that there are more which have ended much less well, highlighting the huge gap between perception and reality.
The Hedge Fund Mirage is published by John Wley.