On the cover of The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True is a photo of a pair of hands attempting to hold onto sand — but of course, the sand keeps sifting through the fingers. “Like trying to hold sand, clients didn’t always get what they were supposed to get in terms of returns from the hedge fund industry,” the book’s author, Simon Lack, CFA, said at the 67th CFA Institute Annual Conference in Seattle.
In his presentation, Lack discussed the evolution of the hedge fund industry and the issues that prevented clients from sharing in the industry’s phenomenal growth and profitability since the 1990s. Lack, a former hedge fund investor at J.P. Morgan, was always impressed by the managers he interviewed but wondered how much money the hedge fund managers were making relative to their clients. “Hedge funds were great until you showed up to invest,” Lack quipped.
Lack took the audience back to 1998, when the industry was less than $500 million in assets under management and the number of funds was relatively small. “The most important cause of growth for the hedge fund industry was the collapse of the internet bubble,” he said. In the early 2000s, after the bubble burst, hedge funds did fulfill their promise to investors: they hedged, they preserved capital, and they were clearly uncorrelated. Over that period, hedge funds truly added value as investments and as a result, investors “fell in love.”
But beginning around 2004, something went terribly off track. Hedge fund returns as a whole began to underperform a static 60/40 mix of the public equity and bond markets. Real investor profits turned negative even as total assets under management (AUM) and fees continued to rise dramatically. Lack described exactly what went wrong.
Hedge Fund Fees Too High
Clients did not share in the profits of the industry. Using annual industry returns and AUM (both as measured by the HFRX) and applying the typical hedge fund fee (2/20 plus 1% as applicable for assets in a fund of funds), Lack estimated total industry fees and profits from 1998–2013. In slicing the pie for the 16-year period, real investor profits (above the risk-free rate) were only $30 billion, as compared with the estimated total fees to hedge fund managers of $566 billion. And since 2008, the industry as a whole has been below its high-water mark, so no incentive fees were included. Clearly with this type of split, customers were not purchasing any yachts.
Lack of Transparency
Though transparency is improving from client demand, hedge funds as a whole still have less transparency than virtually any other asset class (including public equities and debt, private equity, and real estate). Lack says that the opaque nature of hedge funds means it’s often impossible to determine the sources of risk and factor bets that the fund is taking (as well as the hedge fund’s added value). The hedge fund industry convinced clients early on that they didn’t need transparency (e.g., it could compromise the hedge fund’s ability to implement its strategy), and clients basically accepted that as truth until recently.
Fund Structures Not in the Best Interest of Clients
“Hedge fund structures have a lot of features that are not in the best interests of clients,” Lack said. For example, hedge fund agreements may allow mid-market valuation (midway between the bid/ask spread) to calculate net asset value (NAV) until money is contributed or withdrawn by a client. Then managers have discretion to use the bid or the ask to their valuation advantage. “There needs to be more consistency in the valuation process,” Lack said.
Another problem is the way transaction costs are not equally shared by investors, and early investors pay a disproportionate share of the costs. “Transactions costs are the dirty little secret in the hedge fund industry,” Lack said. “The managers all understand it, but the clients do not.”
As the hedge fund industry matured, investors began to accept certain “articles of faith,” Lack continued. “Small hedge funds were better than big ones. Big hedge funds were better when they were smaller (that’s how they got to be big).” But, as Lack lamented, investors haven’t taken the next step to observe that the hedge fund industry as a whole was better when it was smaller. Today at $2 trillion, the industry, Lack believes, is overcapitalized, and the numbers bear it out.
“Hedge funds will not disappear,” said Lack. “The question for hedge fund investors is how they can more reliably identify the good ones and also keep more of the winnings that are generated using their capital.” Maybe now the sands will shift.
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Photo credit: W. Scott Mitchell