The recently unveiled rules proposed by the U.S. Securities and Exchange Commission that would lift restrictions on hedge fund advertising may be welcome news to the industry, but they also provide an occasion to reflect on the challenges of investing in a segment of the money management universe that has chalked up net inflows of nearly $150 billion since the beginning of 2010 alone.
Nowadays, it seems, everyone wants to invest in a hedge fund, start one, or work for one.
But as Simon Lack, CFA, author of The Hedge Fund Mirage, asserted at the recent CFA Institute Financial Analysts Seminar in Chicago, the popularity of hedge funds may be unwarranted given their performance. According to Lack, hedge funds have underperformed a traditional 60/40 stock and bond portfolio every year since 2002, and he expects them to underperform again in 2012. (So far they certainly are: This year through 31 August, the average hedge fund was up 3.5%, according to Hedge Fund Research, versus a 10% gain for the S&P 500 index). Lack asserted in his talk, as he did in his 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.”
That latter contention, in particular, is not accepted by everyone, not least the UK-based Alternative Investment Management Association (AIMA), which recently published a 24-page rebuttal to Lack’s claims. (For more analysis of the book and the rebuttal, read this excellent post by Reuters finance blogger Felix Salmon.)
Nonetheless, Lack’s dissection of hedge funds and the issues that investors should think about before investing are well worth considering. What follows is a summary of his arguments organized by the four factors that he sees as most relevant: the size of the fund, the level of transparency, the fees, and the protections (or lack thereof) offered to investors.
Size of the Hedge Fund
Lack’s primary contention is that size, as measured by assets under management, has become the enemy of hedge funds, rendering them victims of their own success. To back up that contention, he points to research showing that smaller hedge funds outperform larger ones. (See “Size vs. Performance in the Hedge Fund Industry” by James R. Hedges, IV, president and CIO of LJH Global Investments.) When it comes to his own research, Lack finds a negative correlation between the industry’s performance and the growth of its assets.
With regard to performance, the salad days of 1994–1998 — when the average annual return of the industry was 12% — are long gone, Lack asserts. Back then, the industry was relatively obscure and unknown, with assets under management of $131 billion at the end of 1998. By 2002, however, after the dot-com bubble burst, institutional investors and high-net-worth individuals began to view hedge funds as an alternative to equity funds. Assets under management jumped from $279 billion in 2001 to $414 billion in 2002 — and peaked at $1.9 trillion in 2007. At the end of 2011, that figured had dropped to $1.7 trillion.
So why do investors continue to allocate more money to these vehicles? Lack believes it is because investors have forgotten the old adage that “past performance is no indication of future results.” Thus investors are expecting to earn “yesterday’s returns with today’s risks.” A case in point, he said, is another AIMA study that found that:
- the average annual return of hedge funds since 1994 was 9.07%, after fees, versus 7.18% for stocks, 6.25% for bonds, and 7.27% for commodities;
- hedge funds were able to achieve these returns with considerably lower volatility and value at risk (VaR) than stocks and commodities; and
- hedge funds were significant generators of alpha and are uncorrelated with stocks and bonds.
Lack acknowledges that these statistics provide a clear justification for investing in hedge funds. But the problem with this and similar studies, he says, is that they include performance numbers from the industry’s “golden years” of 1994–1998, when there were fewer funds and the asset base was much smaller. The industry has changed dramatically over the past 15 years, and with more entrants in the market and more assets to invest, it is much more difficult for hedge funds to gain a competitive edge and deliver the outperformance that investors expect.
Transparency of Hedge Funds
Lack is surprised that hedge fund transparency remains low, given the large number of institutional players that have become investors. He finds that hedge funds are less transparent then public equity and debt funds, real estate funds, and even private equity funds. This is because most hedge fund managers do not reveal specifically to clients what their money is being invested in or how it is being invested. Clients have no idea about the fund’s positions, its trades, or what the portfolio looks like, Lack asserts. This makes benchmarking or categorizing a fund virtually impossible, he says.
Investor Protections for Hedge Funds
Lack believes that the limited partner structure of most hedge funds favors managers and disadvantages clients. Because hedge funds don’t use separate accounts, it means that expenses are socialized and clients have less control or security with regard to their assets. In addition, the use of side pockets, lock-up periods, and strict rules on redemptions not only limit clients’ access to their capital but also help managers and serve their firm’s business model. What bothers Lack is that many clients are not asking the right questions or demanding more information before investing.
Hedge Fund Fees
Lack is not surprised by the “two and twenty” fee structure. He believes managers are simply selling a service at a market-clearing price. He is surprised, however, that investors are so willing to pay these fees in light of the overall unexceptional returns of the industry. For some reason the “pay it or take your money elsewhere” attitude of the industry seems to work with clients. The large fees may also be why many hedge fund managers are loathe to close funds to new investors. Lack finds that it is more profitable to invest in hedge fund firms than it is to invest in their funds. From 1998 to 2010, 84% of the profits generated by the industry accrued to hedge fund firms, he said, while the net real profits earned by investors were only 2%.
Interestingly, notwithstanding the AIMA’s critique, industry reaction to Lack’s book has been quite positive, he said. Lack gets invited to industry events and finds that most managers agree with his comments. Perhaps not surprisingly, though, they feel that what he is saying applies to other hedge funds, not theirs. (Perhaps that is why Lack finds that most hedge fund managers don’t promote the industry but instead promote themselves and their funds.)
So are hedge funds “bad”? Not per se, in Lack’s view. In fact, he says that he provided seed money to many hedge funds when he worked as a private banker at JP Morgan in the 1990s. His concern today is that too many investors, particularly institutions that should know better, are all too willing to invest without carefully weighing the key factors of performance, transparency, fees, and investors protections.
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