Less than two years after the author of The Hedge Fund Mirage argued that the average hedge fund investor has gotten a raw deal, Simon Lack, CFA, founder of SL Advisors, has written a second book, Bonds Are Not Forever, asserting that another asset class is set to reap dismal returns for investors.
Lack claims that investors are in the midst of an “extraordinary time” because the “Federal Reserve has made an entire asset class expensive as part of the unraveling of 2008.” That asset class is bonds.
Thus, diversification — one of the central principles of basic investing — can do more harm than good today if investors continue to hold 10-year or longer bonds (in the sense of a 60/40 stock/bond allocation). Instead, Lack proposes that a less risky strategy is to hold 25% of the desired allocation to bonds in equities and the balance of 75% in cash. According to Lack, that “barbell” approach should outperform bonds, whose interest income — held artificially low by the Fed — will be negated by loss of principal when interest rates rise as quantitative easing is abandoned.
Similarly, diversification in a hedge fund portfolio can actually work against investors, says Lack. The goal is to unearth the unique hedge fund manager (or two or three) who can consistently deliver exceptional returns from within the universe of hundreds of mediocre managers.
The limited supply of alpha-earning hedge funds is directly and negatively correlated with the average hedge fund’s size — too many dollars chasing too few opportunities. Another major factor in the industry’s lackluster performance is the fee structure, ultimately responsible for hedge fund investors capturing only 2% of all industry investing gains from 1998 to 2010. Lack came to his conclusions during the last decade of a 23-year career at JPMorgan, when he guided the organization’s hedge fund seeding operation. That experience led him to conclude that managers, not investors, gathered the majority of the spoils. In The Hedge Fund Mirage, Lack returns to the question previously asked by Fred Schwed, Jr., and others: “Where Are the Customers’ Yachts?”
On an asset-weighted, or internal rate of return (IRR), basis using BarclayHedge data, Lack calculates that from 1998 to 2010, the average hedge fund investor earned 2.1% a year versus the 7.3% reported by the HFR Global Hedge Fund Index for the same period. Because hedge fund managers, similar to private equity managers, control when they accept and commit capital, Lack believes IRR is the proper method to calculate hedge fund returns. Treading on the hedge fund industry’s toes, Lack claims in the opening sentence of his first book that “if all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good.”
Hedge fund investors — who, by definition, are sophisticated investors, such as pension funds and their consultants — are ultimately to blame for their own hedge fund investments’ lackluster results. These are the exact people, Lack believes, who should understand the changes that the industry has undergone since its inception and the resulting corrosive impact the changes have had on investor returns. And yet they keep investing.
Hear Simon Lack discuss his assessment of the hedge fund industry at the 67th CFA Institute Annual Conference to be held in Seattle, Washington, on 4–7 May 2014. You can register to attend the conference and follow this blog for news and updates about the event.
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