While hedge funds have proved to be serious moneymakers for those that manage them, investors themselves rarely reap the benefits. In The Hedge Fund Mirage, hedge fund expert Simon Lack gives a controversial insider’s guide to these investments. John Gent concludes that the author’s desire to recuse himself from all the industry’s rent-seeking behaviour, as well as from all errors made by its investors, detracts from the power of the book. 

The Hedge Fund Mirage. Simon Lack. Wiley. January 2012. 188 pages.

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In The Hedge Fund Mirage, Simon Lack explains how, since 1998, the average hedge fund investor would have been better off investing in Treasury Bills. This is primarily because the industry retained in fees 84% of the total Dollar profits generated from the invested capital, leaving just 16% for investors. Including fees charged by fund-of-funds (to whom nearly half the investors delegate the hedge fund selection and portfolio construction), the share enjoyed by investors falls to just 2%.

With this book Lack adds his name to the small number of finance professionals that have written ‘whistle-blower’ accounts of their industry based on their insider’s knowledge. Lack speaks knowledgably, having learnt financial trading during the 1990s and then worked JP Morgan’s Incubator Funds that seeded new hedge fund managers with starting capital in return for an economic stake.

The evidence for this “J’accuse” is presented in Chapter 1 and in more detail in Chapter 4. After a brief personal perspective of Chase Manhattan Bank’s evolution during the 1990s (Chapter 2), the rest of the book reads like an instruction manual for those contemplating investing in hedge funds, systematically recounting all the visible and less visible pitfalls, illustrated through the lens of Lack’s own experiences. The reader can only concur with the book’s understated epitaph that a “lopsided relationship…has long existed between the industry and its paymasters”.

The book describes the many risks of investing: new managers unable to manage the business as well as the portfolio; operational failures; liquidity and lock-up provisions; legal and impact costs generated by open-ended vehicles; the scope for manipulation of reported Net Asset Values; the lack of transparency on portfolio contents; the complexity of understanding the positional information when it is provided; ineffectual boards of directors; and the magnifying effects of leverage on all of the former. To these we can add the higher risk of execution errors created by the administrative complexity faced by investors when moving in and out of hedge funds, including staggered redemption payments based on partial price estimates. After considering all these risks, investors still need to avoid outright fraud: this has accounted for 3% of invested capital, and the author provides some colourful examples in Chapter 8.

First presented in an essay for Absolute Return in November 2010, Lack’s message has unsurprisingly elicited less than warm reactions in some quarters, as he explains in the book’s Afterword. The main debate is over the use of asset-weighted returns (used by Lack) and time-weighted returns (used by the industry), and whether these should be measured as the total return or only that part that exceeded Treasury Bills (what investors would have earned anyway by parking their money in this ‘riskless’ asset). In a review of the book in FTfm (16.1.12), Andrew Baker, chief executive of AIMA argues that the lower returns found with Lack’s method only tell us “that investors tend to buy when returns are rising and sell when returns are falling” and that this is also true of other asset classes. I doubt many investors will be reassured by the argument that because the average investor’s performance in other asset classes is lower than the published index returns, this is good cause for accepting near-zero excess returns for the average hedge fund investor. Baker’s logic also implies that hedge fund returns have been a random walk, but Lack’s point is more subtle, namely that the attractive returns that most investors look at when deciding to invest were generated before 2000, when both the industry and the median fund were much smaller. The lower returns since then are not part of a random walk, but a reflection of the industry’s near-tenfold increase in size. As he concludes “there’s almost certainly too much capital in hedge funds today for the available opportunity set”.

Lack is far too intelligent not to be aware of the potential charge of hypocrisy of “this industry insider now disdainfully commenting on his profession”, which he counters by stating that his journey “was guided by the same principles I espouse, but that too few investors follow.” The author has indeed turned away from investing in hedge funds with his new venture. While we do not doubt his sincerity, the book does not analyze the performance of his own Incubator funds, nor tell us why he believes the fees they charged accurately reflected their value added to investors. It seems naïve not to recognize that an incubator’s profits benefited from the same wall of ‘dumb money’ that flowed into hedge funds, paying full fees but not benefiting from the incubator’s additional economic stake. To this reader, this desire to recuse himself from all the industry’s rent-seeking behaviour, as well as from all errors made by its investors, detracts from the power of this book. Indeed, I could not find a single example of a mistake that he either did not successfully avoid, or which failed to lead to a net loss in the long run.

“Whistle-blower” publications (such as the recent one by a departing Goldman Sachs employee in The New York Times) reflect sentiments common to many who leave the financial industry in middle age. Choosing to publicize them meets a set of complex needs: a desire to draw a line under a lifetime spent operating inside the everyday intensity, only to struggle in hindsight to justify the value added to society by that activity; the wish to express a mea culpa, to oneself as much as to the world, for having at least partially succumbed to the industry’s monstrously misaligned incentives; a wish to earn forgiveness by warning others; and sometime the sheer shock and anger at discovering (like the Goldman Sachs employee) that corporations cannot be expected to be anything other than amoral, and the quietly corrosive effect that that misunderstanding has had on the employee. Simon Lack’s story would be more powerful if he applied to his own motives the same clear intellectual inspection he applies to those of others.

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John Gent is a Cambridge Economics graduate of 1978 with over 30 years experience of working in financial markets in London, Geneva and New York, and is currently a first year PhD researcher in Economic History at the LSE. Before returning to academia, John worked twelve years in private banking at J.P. Morgan, where in 2000 he was chief executive of JP Morgan International Bank when he left to become one of the three founders of Lord North Street Limited, a multi-family private investment office. His research interests are the history of money, debt, the measurement of modern economic progress – and other crowd delusions. Read reviews by John.