With almost $2 trillion in assets under management (AUM), the hedge fund industry has earned a reputation as being at the ‘top-gun’ end of finance. An environment where PhD’s, Nobel Laureates and experts seek out exceptional returns for their clients. The problem is, Simon’s calculations check-out, and the truth is “…Since 1998, the effective return to hedge-fund clients has only been 2.1% a year…” leading to the conclusion that, “…never in the history of Finance was so much paid by so many for so little…”
Simon spent 23 years at JP Morgan (where he sat on the firm’s investment committee allocating in excess of $ 1 billion to hedge fund managers) before founding SL Advisors LLC.
Q: What accounts for the huge growth of hedge funds?
Simon Lack: They have generated some great results for investors, albeit in aggregate during the early 90’s… when it was still a small industry. I remember investing in hedge funds during that period… they were obscure strategies, you’d go and see some trader in an office that very few people knew… and they’d describe a strategy that used a lot of leverage and was based in the Cayman Islands and so on… It didn’t feel risky at the time as we felt that we had good tools to do due diligence and background checks. The truth is, it probably was risky… but there were few clients, and many benefits for the industry in remaining small- so results were good.
When the dot com bubble burst in 2001-2002, hedge funds clearly added a lot of value- preserving capital, generating good returns- and generally did what they were supposed to do! You had a number of years of the hedge fund industry really delivering. Unfortunately, size is often the enemy of performance in investing- so many institutional clients, having lost quite enormous amounts of money in equities, were looking for alternatives. That’s why we set up our incubator fund- we seeded hedge funds! The reason we set that business up in 2001 was that we anticipated a lot more institutional interest in hedge funds because of what was happening in traditional assets.
There are two reasons why the business has grown as big as it has. One is that the average annual returns really do look good- if you don’t make any adjustment for the size of the industry, and for a number of years they were really genuinely good… The other problem is that there’s no business model for people who are sceptical of hedge funds to make any money!
Q: What were the key facts and trends that your research found?
Simon Lack: The first [trend] is related to size. As the industry has grown, returns have got steadily worse. You can see that in any measure… The Internal Rate of Return or the Asset Weighted return show this dramatically. I once did a scatter-plot of hedge fund returns versus their size, and there’s a pretty clear negative correlation. As the industry got bigger, the returns went down. If you had a 60:40 allocation to stocks and bonds, that would have outperformed hedge funds every year since 2002. If you ask most people in the hedge fund business whether small hedge funds do better than big ones, they’ll generally say yes… some may say there’s a greater failure rate and so on.. but broadly speaking, research shows that small is better than big in terms of hedge funds. In addition to that, any hedge fund you see that is successful, almost certainly did better when they were smaller. So… Small hedge funds do better than big ones… big hedge funds did better when they were small… therefore the industry did better when it was small… That third step in the logic is something that investors don’t spend a lot of time thinking about because there’s nobody around to point that out to them! The whole financial model is designed to channel assets to hedge funds.
Q: What about the investor experience of hedge funds?
Simon Lack: The investor experience in aggregate is obviously bad! It’s been less than treasury bills. It’s amusing when you ask people, “…well name someone who became rich as a hedge fund client…?”
You can find research which features surveys of institutional investors in hedge funds… and all of the research I’ve read finds that the actual institutional experience is less than what was expected and less than the indices delivered.
Investors look at the history of hedge funds in terms of the returns. History includes a lot of years when the industry was small, nimble and risky. They turn around and invest in ‘industrial strength’ hedge funds that eliminate a lot of the risk that was present in the time frame of the track-record that they were looking at.
Q: Why do people trust hedge fund managers so much and accept far weaker returns and protections than other investments?
Simon Lack: It’s a strong statement to say that there’s $2 trillion that’s been poorly invested. I wouldn’t’ say that every Dollar has been, but it largely has been. I’ve often wrestled with the thoughts of whether this could be true… could that much money be poorly invested?
I think it’s the flawed analysis of returns… the principle agent problem in terms of the advocates of the industry… those are really the two main issues.
Transparency is also a huge issue. Hedge funds give less transparency than almost anything that people invest money in. Traditional investing is all done through separately managed accounts so clients can see precisely what stocks and bonds they own, and what trades were done on a day to day basis. So if an investor wants to see if their active long-only equity manager did well, they can drill down to the individual trades and calculate the information ratio, tracking error and other well-accepted statistics. With hedge fund investments, they can’t do that, as they don’t have the information. Hedge funds have been able to get-away with providing less information for reasons that generally are not pro-investor.
Investors really can’t see what risks are being taken. Hedge funds take a lot of risks, and not traditional risks. They do have long equity risk, but they may also have a lot more tail risk, equity dispersion risk and other more esoteric factors. You just don’t know! Since investors have accepted much less transparency and much less attractive terms in liquidity and information rights, they have not been able to pick apart the sources of return.
The 20% carry obviously creates a lot of incentive for the manager to take risk. This is often mitigated by the fact that the manager often has a lot of his own money in the fund. It’s not that I think the interests are misaligned, but the terms are so heavily biased in favor of the manager.
If you look at the real problem with the hedge-fund industry, it’s not that they’ve taken masses of risk and lost lots of money- but simply that returns haven’t been that great! 2008 was obviously a disaster, and they did lose more money than they made- but let’s just say that’s a thousand year flood… but just as a general statement, over the past 9 years, returns have been ‘blah…’. They make money but they keep a fifth of it plus the fees, they lose money… and the investor carries all of the loss. All of this adds-up to fairly mediocre results!
Q: How should the hedge fund market be structured?
Simon Lack: The average return has been less than treasury bills… and the fact is… you don’t want to be average. The only way to justify investing in hedge funds is if you think you’re going to be good at manager selection. If you’re not good at manager selection, don’t even bother trying.
If manager selection is your skill… the right thing to do is not have a diversified portfolio of hedge funds. You want to have a small number of hedge funds. You actually want the idiosyncratic risk of the managers where you have an insight into their skill. It’s the counterintuitive argument… if you’re an investor in equities, traditionally you would have a diversified portfolio as you don’t want to be exposed to the specific risk of any individual security. Financial theory tells us that you don’t get paid extra for idiosyncratic risk. For hedge funds, however, because the average return is bad… you really want to embrace the idiosyncratic risk- so the more hedge funds you have in your portfolio, the more likely you are to get the ‘average’ return. I think the right approach is to have a smaller portfolio of hedge funds, therefore have smaller amounts of money in hedge funds and see them as a bolt-on to their portfolio of other- more traditional assets. You would maybe have one or two long short equity managers and attach them to your equity portfolio and so on. You wouldn’t look at it as a 10-20% allocation to make 8% to make the funding shortfall in your pension fund… but rather a marginal additional source of alpha from uncorrelated strategies that has maybe a 2% allocation.
It’s not as if hedge funds haven’t made money, they’ve made fantastic returns, it’s just that the clients haven’t really benefitted. It’s all been taken up in fees and so on. There are some fantastically talented hedge-fund managers, without doubt, but I think investors need to stand back and say, “we’re not really getting a fair shake here!”
Q: Where do you think investors can look to find alpha or outperform alpha in the marketplace?
Simon Lack: Honestly? Life doesn’t have to be complicated. I think the equity market generally offers attractive long term investment prospects. The equity risk premium is very high… it’s the highest it’s been since 1974 because bond yields are so low. Equities have been flat for ten years, but earnings have kept growing. Public equities should be overweight for any long-life investment strategy. I think fixed-income is a bad place to be… there are strategies where you can have a portfolio of dividend paying stocks- and hedge out the equity market risk and still maintain market exposure. There are things you can therefore do with traditional assets to achieve objectives.
We’d love to believe that there’s some magic-wand to solve the problems of the market, but with inflation at 2%, achieving 6% real returns on large amounts of money is obviously going to be challenging on large amounts of money- I think it would be hoping for too much.
What does this mean for investors and risk managers?
In his book, Simon concludes that, “…Since 2002, hedge funds have failed every year to beat a simple blend of 60 percent equities/40 percent high-grade bonds. Annual returns have slipped while AUM has risen, and at its current size hedge funds need to generate record trading profits every year to meet the fairly modest return expectations of their institutional client bases…“.
Within his statement- there is another truth. Investors cannot see hedge-funds as being a mystical panacea for return, and risk managers cannot see them as being a quick-fix to their (potentially unrealistic) return requirements. The fact is, the rush of liquidity into this market can (and does) arbitrage out the very opportunities these funds seek to generate their profits. Their success has- in fact- been their failing.