The Cranky Camel: Neither Oasis nor Mirage

In January of this year, Wiley published Simon Lack’s critique of the whole hedge fund industry, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to be True.

This was not the standard ‘Occupier’ sort of anti-hedge-fund tract. Wiley, of course, is a reputable publisher of a range of business and finance books, many of which become standard references. The author, Simon Lack, had the background to make his attack credible. He began his financial career in 1980 on the floor of the London Stock Exchange. He was with JPMorgan for twenty-three years; he sat on JPMorgan’s investment committed, allocated over $1 billion to hedge fund managers, and created two private equity vehicles with an intimate relationship to the industry, the JPMorgan Incubator Funds.

Reviewers were inclined, then, to take him seriously when he wrote (as he famously did, in the very first sentence of the book): “if all the money that’s ever been invested in hedge funds had been in treasury bills, the results would have been twice as good.” The implication, then (made explicit in the subtitle) is that the apparent value of stock market managers is a mirage, the false vision of an oasis in a desert.

If that is accurate, then not only isn’t the industry exhibiting alpha, it isn’t benefiting from beta either. It is incurring risk while under-performing the classic risk-free asset.

But Is It Accurate?

Now, though, the Alternative Investment Management Association’s Research Committee has taken on Lack’s book with a 24 page paper contradicting that and several of Lack’s other key claims with extensive references for those who want to do further research.

AIMA claims that there are five fundamental flaws in the approach the book takes to hedge fund returns and the comparison to T-bill: first, it uses dollar-weighted returns rather than time-weighted returns; second, it calculates returns for those T-bills using a simple average, “thereby failing to achieve an apples-to-apples comparison”; third, it wrongly subtracts from hedge fund returns the value of T-bill returns to create a new hybrid statistic; fourth, it uses the HFRX Global Hedge Fund Index, near the low end of the range of indices available; finally, it reduces the results of that index by an arbitrary three points in order to correct for supposed biases – biases that actually correct themselves.

Let us look a bit more closely at two of those points. One that might not seem obviously erroneous is the first listed: Lack is in error in using dollar-weighted returns. A dollar-weighted return is one that sets the present values of all terminal assets and cash flows equal to the value of the initial investment. Why is it unwise to use this in evaluating hedge fund success or failure? Because, as AIMA says, dollar-weighted returns “take into account the effect of capital allocation decisions that are external to and beyond the control of the fund manager.” Many investors could improve their return by better timing their investments and redemptions into and out of hedge funds, but that fact says nothing about management competence or the success of the management’s strategies.

To overcome that, one must switch to a measurement of the time-weighted return, one that presumes that all cash distributions are reinvested and that uses the same time period for all comparisons, whether the investment involved is in hedge funds or Treasuries.

Counterbalancing biases

Another point that requires some expansion is the fifth. Once Lack fixed on an index for hedge fund returns, he also decided that that index (a relatively low one) was still too high and took three points off for its bias. The issues of survivor and backfill bias are of course much discussed in an enormous body of literature. We’ve contributed to that discussion at AllAboutAlpha, for example here, here, and here.

AIMA refers to a recent paper by Vikas Agarwal, Vyacheslav Fos, and Wei Jiang, which makes the case that there are database biases in both directions, and that the biases effectively balance each other out.  You can access that paper here.

On the assumption that Lack should not have subtracted that 3 percent, and correcting for the other mistakes AIMA sees in Lack’s calculations, it concludes that the cumulative profit created by hedge funds in the period 1998-2010 was $541 billion. That is almost twice the profit from those T-bills during the same period, or $283 billion.

The AIMA paper contains much else of interest. For example, it treats in some detail another of Lack’s headline claims, those hedge fund managers who do make profits capture almost all of them for themselves, leaving little or nothing for investors. By AIMAs calculations, the split between managers’ and investors’ share of profits is roughly 28/72.

Probably the best way of thinking about hedge funds is not as an oasis in a desert of unproductive investments, nor as a mirage falsely suggesting such an investment. The best image is of a vehicle that may help you get through the desert: a camel, if you will.

Yet hedge funds are somewhat cranky beasts, also in this like camels, and they have to be employed with care.

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2 Comments

  1. The Rhino
    August 13, 2012 at 4:51 pm

    The discussion above about time-weighted and money-weighted returns can miss the important question for for users that needs to be asked: by looking at money-weighted returns, Mr Lack is interested in the returns experienced by investors, which I suggest is the correct perspective for any service provider. The simple fact is that, because managers aggressively seek to raise capital when they can, and investors tend to hand out money when they can, and there is a tendency for returns to revert, the actual returns experienced by investors is materially below the returns from T-Bills (let alone other risk-free assets like long duration Treasuries).

    A prominent recent example is the Paulson hedge fund returns – because Mr Paulson experienced his worst returns when the dollar value of investments was greatest, the effect for investors is cumulatively negative. Despite a period of spectacular returns through 2009, the negative returns experienced in 2010 and 2011 collectively destroyed more value than was created in the period leading up to 2009.

    For anyone in the industry to argue that time-weighted returns is an appropriate measurement, funds would have to actively hand back capital after periods of strong returns, and investors in aggregate would have to actually petition for such action and them actually take the money back. This would have allowed investors to lock in some of those gains above, and avoid losses, if they wanted to – but if HF lock-ups etc prevent such actions from taking place, then managers ARE exerting control over the timing of client cash flows and arguments in favour of time-weighted returns evaporate.

    Unfortunately, this is almost certainly not going to happen, from either side.

    What is my point here? Trying to consider either HF returns or investor return in isolation is probably a waste of time. It is the interaction of the two (I.e. the ability of HFs to generate genuine excess returns after fees, taxes amd risk-adjustment, and the ability of investors to have greater discipline and control over the size and timing of their HF cash flows) that matters.

    Yes, investors should exert more discipline over their capital allocations – but funds must also stop aggressively raising capital at times detrimental to their clients, and must provide clients with a greater ability to withdraw capital when they want.


  2. Tom Adshead
    August 21, 2012 at 2:33 am

    I really enjoyed Simon Lack’s book, mainly because it has a lot more than its statistical analysis of hedge fund returns. It’s a very good primer on how to run a hedge fund, and how to think about investing in one. It’s well-written, and it has a lot of informative evidence from someone who has actually been in the trenches.

    To discuss the statistics – I agree with the first poster that money weighted returns do make sense, because they reflect the actual money that was made – the argument for time weighted returns is better applied to comparing managers within an asset class or an investment group, rather than to an asset class as a whole.

    The point about the choice of index makes sense (I think Lack discusses this in his book). There are lots of indices with different merits. The fact is that an index for hedge fund is a crazy construct in any case – like taking the average speed of swimmers, sprinters, marathoners and cyclists, and computing the average speed of an athlete in the Olympics. The point is they are all doing different things. But Lack discusses this, and is aware of the shortcomings, but he needed to do the calculation in any case, and made the best he could of the data available, which is not that great.

    Lack’s basic thesis makes sense to anyone who is running a fund (which I am). The first defense of a hedge fund manager would be that the data set includes the recent fallout from one of the biggest crashes in history, so he’s measuring at the trough of one of the worst episodes in the sector’s history. Things may look different in ten year’s time, although that is scant comfort to the investors who were promised market neutral returns. Lack addresses this, and points out that the returns were not that great in the period to 2007, too.

    The second defense, which I haven’t heard anyone make, is that it was standard practice for the fund manager to keep their fees in the fund, and withdraw only that which they needed for lifestyle purchases. So many of them ate their own cooking, and were just as devastated as their investors in 2008. Lack’s accusation that the managers (as a whole) made more money than their investors (as a whole) assumes that the managers withdrew all their fees and performance fees in cash. In reality it was reinvested, and the managers hurt just as much. Barton Biggs’s novel tells this story well.


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