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.
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.