| Simon Lack: Hedge funds have been a fabulous business and a lousy investment. Photographs by Michael Rubenstein |
Simon Lack is an unlikely hedge fund critic. As the founder of the JPMorgan Incubator Funds, which seeded hedge funds, he spent several years evaluating and investing in hedge fund managers, giving them start-up capital in exchange for a percentage of their gross revenues.
But this experience also made Lack uniquely qualified to spot problems in the industry. And there are plenty, he says. In his new book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, excerpted here, Lack delivers a stinging rebuke of a system that he argues has created tremendous wealth for hedge fund managers but has not passed those spoils on to investors in anything close to equal measure.
Investors are partly to blame for this, Lack says, because they have been so starstruck by hotshot managers that they’ve failed to press for fair deals. For a start, investors should negotiate aggressively for lower fees and demand more information about what’s being done with their money, he adds.
“There are some fantastic hedge fund managers whom I respect a great deal; there always will be,” Lack explains. “The challenge for investors is accessing them on fair terms. There are happy clients and there are good hedge fund managers, but for every dollar that’s invested well, there is a dollar that is invested poorly.” — Amanda Cantrell
Everybody knows the top hedge fund managers earn vast sums of money. One can debate whether the most successful managers, athletes or actresses deserve what they get paid, but the marketplace rewards exceptional talent and always will.
Frankly, after hearing John Paulson describe his enormously successful investments against subprime mortgages, it’s hard not to admire the fresh perspective he brought and his unshakable conviction as he bet heavily against almost the entire market. The Financial Times reported that since setting up his fund in 1994, John Paulson has made investors $32.2 billion, making his the second most profitable hedge fund for clients in history, behind only George Soros at $35 billion (although Paulson’s sharp reversal in fortunes in 2011 knocked him down the list).
| The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True By Simon Lack John Wiley & Sons $34.95 |
While the fees earned by the top managers are presumably acceptable to their clients, the hedge fund industry in aggregate has pulled off a quite remarkable split of the profits — even more so considering how little investors as a whole have made. It’s not that hard to estimate hedge fund industry fees. Given annual assets under management data and annual returns from whichever index provider one prefers, the standard “2 & 20” (2 percent management fee and 20 percent incentive fee) can be applied to come up with some reasonable estimates. Of course, not all managers charge a 2 percent management fee — many smaller funds charge 1 percent, and some larger funds charge more. The 20 percent incentive fee is reasonably standard although a profit split of up to 50 percent has been known.
However, estimating fees on the industry in this way — as if it’s one enormous hedge fund — does include one simplification: It excludes any netting of positive with negative results. To use a simple example, if an investor’s portfolio included two hedge funds whose results canceled each other out (for instance, one manager was +10 percent while the other was -10 percent), the investor’s total return would be 0 percent and for our purposes here we’ll assume that no incentive fee was paid on the 0 percent return. However, in reality the profitable manager would still charge an incentive fee. It’s not possible with the available data to break down the returns to that level of detail, so the fee estimates derived here are understated, in that they assume incentive fees are charged only on the industry’s aggregate profits, whereas in fact all the profitable managers would have charged incentive fees with no offset from the losing managers.
In assessing how much investors have paid for their hedge fund love affair, there are a couple of ways to look at it. One is to express the fees paid as a percentage of overall assets, which allows easy comparison with mutual funds. The other is to look at what share of the overall profits are being returned to investors, versus those retained by the industry. In this case, excess profits over Treasury bills is the relevant measure of profits, since in years when the industry has failed to do better than the risk-free rate it can hardly claim to have generated any profits. So the definition of Real Investor Profits used here is the return on hedge funds minus the return that could have been earned by investing in Treasury bills. Earning 5 percent when Treasury bills are 2 percent is a 3 percent excess return or profit to the investor, although incentive fees are normally charged on the total return.
As a percentage of AUM, hedge fund fees have actually come down since the late 1990s. The 27 percent return in 1999, when the industry bounced back from the Russian default and the collapse of Long-Term Capital Management, was very strong by any measure, and the normal 20 percent incentive fee led to managers keeping almost 9 percent of AUM. And in fact, the $36 billion of Real Investor Profits earned by investors in 1999 stood as their best-ever result for the next three years, even while the industry’s AUM more than doubled [profit estimates are based on return data from the HFR Global Hedge Fund Index and industry AUM data from BarclayHedge]. During the 2000 to 2002 equity bear market, hedge funds really did add value as they preserved capital and this performance led to strong institutional inflows.
But the Industry Share of Total Profits has been growing steadily. To get Total Profits I’ve added fees back to Real Investor Profits, since the investors’ returns have already had fees deducted. Total Profits is how much is made before the managers’ fees are deducted. In 1998, for example, Total Profits were $17 billion ($10 billion Real Investor Profits + $7 billion in Fees) and so the Industry Share of Total Profits was $7 billion divided by $17 billion, or 40 percent. Since 1998 hedge fund managers have kept 84 percent of the profits, leaving 16 percent for the investors.
By 2003 rebounding markets, combined with a 50 percent increase in AUM, led to the industry’s best-ever Real Investor Profits — an estimated $82 billion after fees. Management and incentive fees garnered $36 billion, almost three times the prior year’s profits and 30 percent of Total Profits. This also represented a high point for investors, in that profits in subsequent years never reached $82 billion again until 2009, when the industry earned $200 billion, making back less than half of its losses from the catastrophic prior year. From 1998 to 2010 the industry’s earnings from fees eclipsed or were roughly equal to the returns of its clients. In three years (2005, 2007 and 2008), it generated billions in fees while its clients lost money. Overall, since 1998 fees have totaled $379 billion, compared with Real Investor Profits of $70 billion.
Fees as a percentage of Total Profits is probably the fairest way to assess the split between the industry and its clients. Over the long run, investors in hedge funds are interested in what they’ve earned in excess of the risk-free alternative and in how much they’ve paid in fees to achieve that. These investment returns are also better if uncorrelated with returns from traditional assets, of course, although 2008 (when hedge funds lost $448 billion) established quite clearly that at times of extreme crisis almost all risky strategies suffer together. The net result is that the hedge fund industry has kept more than four-fifths of what they’ve made in the form of fees, leaving the investors far behind.
As lopsided as this sounds, it’s really even worse. This analysis does not include an adjustment for survivor bias or backfill bias, which can cause hedge fund returns to be overstated by 3 to 5 percent. (Since only successful funds are going to report, a fund can easily choose to stop reporting during a string of bad results, leading to the so-called survivor bias. In addition, some indices incur backfill bias; when adding a new fund to a benchmark, some index providers will “fill in” prior months’ results with the presumably positive results of the fund.) No doubt the thousand-year flood that was 2008 is skewing the result, but even if the industry had been flat that year, Total Profits over this time period would have been $194 billion compared with $324 billion in fees. If we employ a 3 percent adjustment for survivor bias, and if that is a true reflection of what’s happened, it means that hedge fund managers have kept all the money that’s been made, and the investors have in aggregate received nothing.
Then there’s netting. We’re treating the entire industry like one giant hedge fund which charges a 20 percent incentive fee when returns are positive. However, hedge funds that lose money don’t pay investors (i.e., there’s no negative incentive fee) and of course investors are charged incentive fees even when their overall portfolio loses. John Paulson alone was estimated by Alpha magazine to have earned $3.7 billion in 2008 (largely incentive fees but this includes the profits on his own capital). But to keep it simple, and conservative, the calculations above assume that there were no incentive fees charged across the entire industry in 2008 because performance was negative, or during 2009 and 2010 because so many funds were below their high-water marks. There’s no reasonable way to estimate the effect of this without having the returns of all the individual managers, but not adjusting for this presents the industry in a more favorable light.
Any way you cut it, hedge funds have been a fabulous business and a lousy investment. The hedge fund industry is global, so this isn’t simply a case of Wall Street keeping more of the spoils, although the United States and United Kingdom represent a substantial chunk of the industry. Nevertheless, what investors have paid compared with what they’ve received is almost breathtaking. Hedge fund managers, advisers, consultants and funds of hedge funds have succeeded in generating substantial profits. However, they’ve also managed to keep most of these gains for themselves, while at the same time successfully propagating the notion that broad, diversified hedge fund allocations are a smart addition to most institutional portfolios. That’s quite a trick!
Next time you find yourself in a social setting with anybody from the hedge fund industry, you can entertain yourself and others by performing this simple exercise: Name a hedge fund client who has made a substantial amount of money by being a hedge fund investor. Note the word “client” is key here and the question deliberately excludes hedge fund managers themselves, managers of funds of hedge funds, consultants or anyone who’s in the business of making a living from fees charged on hedge fund investments. We’re looking for pure investor clients. I started playing this game recently at gatherings of hedge fund professionals, and I can tell you the responses are quite amusing. Once people understand that “George Soros” isn’t an acceptable answer, they stare quizzically at the ceiling while racking their brains for someone, anyone, who’s come out ahead.
Hedge fund managers are rational businesspeople, as well as often being talented investors. As in any free market economy, the provider of a service will seek to maximize his profits in part by raising prices, until competition and sagging demand indicate resistance. In the case of hedge fund managers, the “price” is really the split of total trading profits that investors require in order to remain as clients. The split of profits has been steadily shifting in favor of the hedge fund industry, because investors have broadly accepted steadily worsening terms. Fees charged are high by almost any reasonable standard, but willing buyers (clients) and sellers (hedge fund managers, funds of hedge funds and consultants) continue to do business at prevailing rates. If consumers continue to pay higher prices for something, it’s hard to blame the retailers, who are simply meeting that need. However, in this case the consumers are sophisticated institutional investors and one might think they’d be pressing for more equitable terms.
Following the end of the Battle of Britain in 1940, when the Royal Air Force held off the German Luftwaffe in the skies over southern Britain, scuttling Hitler’s planned invasion, British Prime Minister Sir Winston Churchill praised his gallant fighter pilots with the words, “Never in the field of human conflict was so much owed by so many to so few.”
Presented with today’s hedge fund business, Churchill might comment that, “Never in the history of finance was so much charged by so many for so little.” AR
Excerpted with permission of the publisher John Wiley & Sons, Inc.(www.wiley.com) from The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True by Simon Lack. Copyright (c) 2012 by Simon Lack.
