Simon Lack: The Hedge Fund Mirage

It is one of the financial world’s strangest anomalies that there are neither regulatory nor legal definitions of what constitutes a hedge fund. The very term “hedge” can be somewhat misleading as although the traditional hedge fund is indeed comprised of investments that are “hedged”, that is not necessarily the case today. But hedge funds are usually used by high-net-worth individuals and institutions to invest aggressively in equities, bonds, commodities, futures, swaps and options.

These funds might go long, sell short, use leverage, rely on programme trading or arbitrage. There are also funds that try to capitalise on merger and acquisitions, but the majority of hedge funds follow the classic investment strategy of 60% equities, 40% bonds and seek out disparities, price anomalies and asymmetries in the market in order to exploit them and gain their edge, and hence their profit.

While there may be no simple classification of a hedge fund, in South Africa at least the Financial Services Board, in its joint discussion paper The Regulatory Position of Hedge Funds in South Africa, proposed the following definition that: “they utilise some form of short asset exposures or short selling to reduce risk or volatility, preserve capital or enhance returns” or they are funds that “use some form of leverage, measured by gross exposure of underlying assets exceeding the amount of capital in the fund”.

This is a very wide definition, but one that encapsulates the key factors that differentiate the wide category of investment funds that might call themselves hedge funds, from conventional investment funds where shorting and leverage are not permitted.

The history of modern hedge fund (originally termed a “hedged fund”) began with Alfred Winslow Jones. After being as a pre-war anti-Nazi activist in Germany, he turned his remarkable intellect to finance and the markets. He raised $60,000 from friends and put up $40,000 of his own money to start an investment company, and by 1968 had realised cumulative returns of 5,000%. A $10,000 stake in 1949 was worth $480,000 by 1968.

But the industry’s more recent history has been rather less spectacular. Although awarded the epithet of ‘Masters of the Universe’, hedge fund managers have also been variously accused of being directly responsible for the sub-prime financial crisis and other excesses. Yet, although the ‘greed is good’ boom-time era may be over, the hedge fund industry continues to cast its allure.

The statistics are truly awesome. The hedge fund industry has grown from $100bn assets under management in the 1990s to $1.6 trillion today. The top 25 hedge fund managers collectively earned $25.3bn in 2009. So it comes as something of a shock to learn from this powerful new book that the average hedge fund investor has done rather more poorly than his well-heeled hedge fund manager. Indeed, author Simon Lack makes the extraordinary assertion that if all the money that has ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good.

The author speaks with authority. He spent his entire career in trading and hedge fund investing beginning on the floor of the London Stock Exchange before spending 23 years with JP Morgan trading fixed-income derivatives and forward foreign exchange, managing a team of 50 professionals that generated revenue of $300m annually. He went on to found his own investment advisory firm in 2009.

While with JP Morgan, Lack sat on the bank’s investment committee, which allocated over $1bn to hedge fund managers – and he helped found the JP Morgan Incubator Funds, two private equity vehicles that establish economic stakes for emerging hedge fund managers.

He describes the atmosphere at the investment bank’s offices as being timeless and unhurried, “all designed to project safety of capital, combined with exclusive opportunity for their wealthy clients, while quietly extracting healthy fees”. And over the years, he and his colleagues considered around 3,500 proposals from hedge fund managers looking for seed capital. So Lack’s qualifications for writing this book are unquestionable, and he does a brilliant job of explaining just why hedge funds represent such a poor investment class.

Where are the customers’ yachts?

By using a famous observation that asks, “Where are the customers’ yachts?”, Lack makes the astonishing case that little to no regulation, excessive fees and a crowded industry have all led to hedge fund investors, on average, experiencing woeful returns. Many assume that fabulously wealthy hedge fund managers are the result of fabulously wealthy investor customers. That is not so, Lack insists. “It is simply a huge misconception in public opinion,” he goes on to explain.

“I started out believing the villains were the hedge fund managers and all the advisors who had channelled substantially too much capital to them. But my view shifted as I researched this book, and if there is a fault, it lies squarely with many supposed sophisticated investors who have applied far less critical analysis and cynicism to their allocation decisions.” Lack adds damningly that “an industry has developed to meet demand, and the buyers have freely agreed to pay high prices for often mediocre results”.

Perhaps those sophisticated investors should have done what Lack did and devote the time to calculating, as a whole, the industry’s internal rate of return. In short, Lack has conducted the same sort of rigorous due diligence exercise that hedge funds use when making investment decisions, and appraised the hedge fund industry itself. Early in the book, the author comes up with the truly startling conclusion – that from 1998 to 2010, hedge fund managers have kept 84% of the profits, leaving 16% for the investors (or $440bn went to the managers and just $9bn to investors). Paraphrasing Winston Churchill, Lack comments: “Never was so much charged by so many for so little.”

But saying that hedge funds have been a bad investment for many should not be confused with saying they are all bad or that nobody has made any money. “There are many supremely talented hedge fund managers,” Lack clarifies in the afterword. “[They] have provided enormous value to their astute clients, and there are many highly successful clients of hedge funds. That will most likely always be the case.”

And yet it is sobering to consider the number of fraudulent operations masquerading as hedge funds. Lack puts the criminal element at some 3% of all hedge funds, quoting Castle Hall Alternatives, a consulting firm whose business is dedicated to helping investors avoid ‘operational risk’ – in Lack’s words, “a wonderfully anodyne way to describe fraud”.

It has to be recognised that a 3% fraud rate is an amazingly high figure. As Lack points out, if eating at your local restaurant carried a 3% risk of food poisoning, you would probably choose to eat elsewhere.

“Hedge fund investing exposes the investor to an additional risk that is almost nuclear in its ability to visit devastation on its victims,” Lack comments, before suggesting that it is the process of due diligence that is the only way to really confirm the veracity of a hedge fund’s investment proposition.

Interestingly, Lack had a brush with the legendary Bernie Madoff when he was offered the opportunity to invest in Fairfield Greenwich, a fund of funds that fed money to Madoff’s Ponzi scheme. The proposal described how Madoff was operating a brokerage that executed trades for clients and a money management firm that ran a hedge fund.

That was unusual and it also raised the question of whether Madoff’s extraordinarily consistent returns were in fact due to what is known as ‘front-running’. Front-running is illegal. It is the practice of a broker who benefits by placing orders in the market ahead of their clients. “Years later,” Lack writes, “when Madoff was exposed and the tragic losses suffered by so many investors became clear, I thought back to that meeting [with Fairfield Greenwich]. It occurred to me that this [front-running] was probably what they themselves believed was supporting the consistently successful results of Madoff’s hedge fund.”

Lack also observes that among Madoff’s many victims was not one of the large Wall Street firms. “Goldman Sachs, Morgan Stanley, Citigroup, Merrill Lynch were all notably absent, no doubt because even the most cursory due diligence revealed some insurmountable issues,” he writes. Nor of course was JP Morgan, that Lack was working for, among the Madoff victims, for the author had concluded it was not an investment proposition that would survive the bank’s due diligence review and the proposal was declined.

But if Fairfield Greenwich had thought that front-running clients was giving Madoff’s hedge fund its edge, then, as Lack says, “There is sweet irony in that professional investors, having willingly invested to profit unfairly from other clients, instead became victims themselves”.