The following is an excerpt from “The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to be True,” by Simon Lack (John Wiley & Sons Inc., 2012).
Why can less be more with hedge funds? Broadly speaking, inves-tors have not fared that well with such funds. If all the money ever invested in them had gone instead into Treasury bills, the investors would have been better off. Few outsiders believe it when first presented with this fact. Yet I've spoken with people who've dedicated most of their careers to the hedge fund industry and they are rarely surprised. This gulf in perceptions between the hedge fund industry and everyone else is a stunning indictment.
Poor timing, weak analysis and hefty fees have all contributed to this outcome.
Of course, saying that hedge fund investors in aggregate have done poorly isn't the same as saying everybody's lost money. This book shouldn't be interpreted as making that assertion, because it's plainly not true.
Just as the average income tells you little about the range of incomes in a country, so it is with investing. However, most of us have assumed that the average in this case was pretty good, whereas it turns out to be pretty poor. But even though there are hedge fund investors who have done very well as clients, it's surprisingly difficult to identify them. I've looked for clients who have made substantial profits as clients, excluding any fees they've earned from others' money.
This excludes George Soros, for example, whose fortune clearly began with fees earned from managing money. Over time, as his wealth grew, he became a substantial investor in his own hedge fund, and no doubt his current wealth has been augmented by trading profits — but he clearly wouldn't have reached his current state without the “2 and 20” combination of management fee and incentive fee.
Steve Cohen of [SAC Capital Advisors LP] is famous for being such a talented trader that he was able to take fully 50% of the profits he earned for clients as his incentive fee and still generate consistently high returns. He eventually made so much money from this arrangement that an increasing portion of the money he was managing was his own, and clients became an unnecessary distraction. Eventually, he gave back pretty much all the clients' money, preferring to focus just on managing his own.
Of course, George Soros and Steve Cohen are examples of highly successful hedge fund investors. They've made substantial sums managing their own money as well as charging fees to manage others' money.
Nevertheless, if they are the best examples of profitable hedge fund clients, then the industry looks increasingly as if it exists to serve itself. In that case, the purpose of hedge funds is to provide jobs and wealth creation for the industry professionals: managers, consultants, allocators, prime brokers and other service providers. Can any commercial industry thrive, or even survive, if its clients aren't the fundamental reason for its existence, the purpose behind all this activity?
The spectacular growth of hedge funds seems to refute the notion that they haven't added any value. In a capitalist system, the market decides winners and losers, and since there are clearly so many providers of hedge funds that are winners, their continued presence can only be because they're providing something worth more than what they charge for it. It's possible we're measuring the wrong things in trying to establish value received by clients. Maybe investment profits aren't the sole yardstick.
THERE ARE STILL WINNERS
Plenty of investors are happy with their hedge fund investments. Since the clients have to be wealthy enough to be “accredited investors,” they're not that easily tracked down. Very rich people maintain discretion about their financial affairs.
But some institutional clients do disclose their results. University endowments such as Yale and Princeton, and public pension plans such as the California Public Employee Retirement System, have noted generally satisfactory results. But for every $1 well invested, there's another $1 that wasn't, since the results in total aren't good.
Hedge funds are said to provide diversification, and they certainly do. Most investors will happily accept a lower return on investments that are not highly correlated with their current portfolio. If a new investment isn't as likely to go down when everything else is going down, the more helpful it is to your overall portfolio, which means that the return doesn't need to make as much to justify the investment.
But if profits aren't what hedge funds are after, they don't really serve any other useful purpose. Of course, philanthropy is a happy byproduct of hedge funds, not the reason they exist.
Perhaps because there has been so much wealth created by hedge funds, establishing how well clients have done receives less scrutiny than it might. The combination of a respectable long-run average annual return (which ignores the fact that the best years were when the industry was small) with many extremely wealthy practitioners, is a powerful reason to join in.WHOSE FAULT IS IT?
Why have investors done so badly? Whose fault is it that the results have been so skewed in favor of just about everybody — except the providers of the capital from which so much has been earned? What should investors do to restore some balance to the relationship?
Who can fail to marvel at John Paulson, an experienced merger arbitrage manager with little experience in credit derivatives, who identified and constructed dazzlingly high payoff trades with remarkably little risk to profit from the inevitable collapse in the housing market? The acute risk management judgment of Alan Howard, who has guided his portfolio of traders through successive crises with an incomparably deft touch — knowing just when to reduce risk and just when to press his advantage — is almost awe-inspiring. Bruce Kovner, David Tepper, Louis Bacon and others at the top of the industry possess great abilities and have been able to implement them across large pools of capital.
Hedge funds are not short of investing talent — far from it. But star-struck investors too often have equated enormous financial success among managers with high returns for clients.THE AMERICAN ATTITUDE
When I first moved to the United States in 1982, I noticed a subtle difference in attitudes toward wealth between Europeans and Americans.
In Britain, an accountant/doctor/ lawyer parking his S-class Mercedes would cause onlookers to comment disapprovingly at how he must be ripping off his clients in order to afford such a car. In America, the same scene would cause most to conclude that the individual must be successful and therefore worth doing business with. Although hedge funds and their investors are global, the American attitude toward wealth — to staying close to winners — has prevailed.
If there is such a thing as hedge fund IQ, or a quality which combines superior investment analytical ability, a trader's instinct for survival, well-developed commercial sense and a highly competitive winning attitude, it would have its own brutal hierarchy. Hedge fund managers would be at the top; next would come the traders at banks who trade with them and against them (the best of whom move to hedge funds or start their own). After them would come those who invest directly in hedge funds (funds of hedge funds and other institutions), and below them, the consultants that advise others on their investments. At the bottom, the trustees and investment committee members of the large institutions who so recently have added alternatives to their portfolios. All of these levels include highly intelligent people in the conventional sense, and this description of the hierarchy should not be regarded as demeaning to those not at the top.GOLF AND BASKETBALL
Golf includes players of wide-ranging abilities, and you don't have to be as good as the club pro to enjoy the game. Nor does mediocre golf ability say much about how well you play basketball. Hedge fund IQ is a highly specialized, narrowly defined quality. Those possessing it in abundance run hedge funds, while the rest get as close as they can. You can play a round of golf with the club pro for money, but you'd better use your handicap to get fair odds. Hedge fund investors need to acknowledge that they are unequal partners with their chosen managers and pursue negotiating strategies that compensate them — or invest elsewhere.
If investors have done so poorly, whose fault is it? When looking at the split of profits between fees and returns and the extremely modest share of the pie retained by investors, it's tempting to condemn hedge fund managers as representing the worst excesses of Wall Street, exploiting markets, investors and knowledge for their own benefit. The capital markets fundamentally exist to channel savings in directions where they can be most effectively deployed.
Few would argue that the efficient allocation of capital requires the creation of today's hedge fund fortunes in order to be carried out effectively. But that philosophical question is for others. Hedge funds are meeting a clear demand from the market. And the vast majority of capital in hedge funds is provided by “qualified” investors — either individuals with sufficient net worth to be deemed “sophisticated” or institutions fully capable of accurate analysis. The fact that it hasn't turned out well is very largely the fault of the investors themselves.
Faulty or weak analysis, performance chasing, shortage of skepticism and a desire to be associated with winners without proper regard for terms have all caused the sorry result.
