The Emperor’s Old Clothes: Simon Lack Rains On Hedge Fund Parade

We caught up with Simon Lack, author of The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True. This tome explains why ’tis better to manage a hedge fund than to invest in one.  We got to thinking about reader reaction to this.  After all, what master of the universe wants to hear that he may not be so masterly after all, simply being paid better because he calls his vehicle a hedge fund instead of an institutional investment fund? On the other hand, the more spirited among you may appreciate that there’s more opportunity now than ever, considering the recent track record of your competition.

Methodology Tells the Tale

One of the first points Simon Lack made during our discussion was that the true picture is revealed by assessing how each dollar invested fares, rather than the hedge funds themselves. To illustrate, we created a simple example. 9 of 10 hedge funds  manage $100 million each and outperform, earning 15% for the year. Another larger one manages $1 billion but earns only 5% for the year. The average performance of the 10 funds is 14%, but the blended ROI is 9.7%.

Although this was an arbitrary example, apart from Simon’s own research, we found this report in the Financial Times from 2010:  “Ilia Dichev at Atlanta’s Emory University and Gwen Yu of Harvard, in a forthcoming paper, have found that actual returns to investors are three to seven percentage points lower than headline returns. Since 1980, the average hedge fund annual return was 12.6 per cent. But, weighted for investment flows, the average investor received only 6 per cent, they found, well below equity returns and not much better than bonds.”

Simon noted that it’s generally accepted that small funds have a higher likelihood of outperforming than large ones. As a corollary, big funds probably did much better when they were small. Simon says:  “Size is the enemy of performance.”  In his opinion, a signal investor error in the evaluation of hedge funds is extrapolating returns on small funds. He may well be right. If he is, your next question may well be  “So now what do I do?”  That, friends, is an excellent question.

There may be something of an answer later. But first, a bit more drizzle. It’s true that there are the occasional great hedge funds who truly stand out. In Simon’s view, the best justification for hedge fund investing is because you can choose hedge funds better than most. And a choice based on historicals may not be wisest. Even if you choose from the top 40% managers in terms of performance, you should know that over 90% of that group will drop out of the top 40% before so very long.

We wondered why, if hedge funds are hedging, their returns tend to approximate the returns on the S & P Index. Simon pointed out that hedgies DO take market risk. At least there are studies that show that hedge fund returns approximate a short put market strategy. A review of recent market history supports Simon’s point about size being an impediment to performance. Hedge funds did fairly well in the market downturn of 2001-2. In 2008, returns were abysmal. But in 2008, the hedge fund industry was 10 times its 2002 size.

Simon also noted a recent study commissioned by AIMA, a British hedge fund marketing association, which inadvertently proved his point. AIMA claimed correctly that the industry had averaged 9% per year since 1994, which sounds plenty good. There’s one small detail that also emerged. The industry averaged 12% per year from 1994 to 1998, when its total size was probably 1/20th of today’s size. From 2007 to 2011, the industry averaged 2% per year on a capital base around 20 times that of the mid-nineties. You can do a rough estimate of the dollar returns if you like.

How Much Is That Doggie in the Window?  The One with the Waggly Tail.

If you’re running a hedge fund, you can take some pleasure in knowing that the venture capital community has a similar problem with their size to performance ratio. Simon observed that the Kauffman Fund had uncovered that problem in the VC world too. Their report echoed Simon’s complaint about returns, and suggested that manager income was not altogether transparent. Simon described the typical hedge fund fee structure of 2 and 20 elegantly and succinctly as “a knuckle-headed fee structure.”  Gee, we wish we’d said that. Simon went on to observe that the 2% used to be 1%, which was enough to cover fund operating expenses…..and probably still is.

This led us to ask Simon:  if the pros understand that small is more likely to be beautiful, why would professionals, allocators and otherwise, knowingly invest with hedge funds which were statistically likely to underperform?  His answer:  negative optionality. With regard to their careers, that is, which may or may not have much to do with investor returns. Everyone has pressures of a different sort. As with bank employees, one may get fired for making a mistake or looking stupid, but not for underperforming in a perfectly rational fashion. Scooting out a little on the risk curve to earn 1% more may not justify the risk to the allocator if he’s wrong. The system allows fund managers to rise to their level of incompetence, and doesn’t resolve the inherent conflicts between allocators and investors.

How Fund Managers Can Improve Their Results

We asked Simon about this, hoping that someone who saw systemic flaws might also see remedies. He did offer some suggestions. He thought that it would help if managers practice a version of self-deportation, a la Romney, although they wouldn’t have to leave the country. Simply capping their fund assets or giving money back would easily suffice. And a greater openness to the smaller funds might also smooth things out a bit.

Investors’ Arab Spring?

Simon leaned towards the thought that investors also bear some responsibility for hedge fund underperformance. There is no reason investors can’t demand greater transparency from the funds in which they invest. This will give investors greater insight into how returns are being generated. They can certainly negotiate fees that fit the current value add of the industry. It may be that investors have forgotten that they are the hedge funds’ employers. Simon suggested that in an industry that may have structural underperformance, a portfolio of hedge funds is an inherently flawed concept, as it only results in diversified underperformance. This is where investors may, instead, want to confine their choices to several managers whose ability and strategy makes intuitive sense. Trying to find best of breed may well be the most rational investor move.

Simon also advanced the notion that the amount of outperformance within a marketplace is finite, not infinite. This would mean that as more money sloshes through the system, there is less alpha to go around amongst the managers. One could well infer that the nature of the system ensures lack of alpha. Except that can’t be, because if it were true, what would we all write about?