How Hedge Funds Destroy Value

June 10, 2014

by Robert Huebscher

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All you really need to know about hedge fund performance is evident from the fact that Simon Lack could not produce the pie chart below in 2012. The chart shows how hedge-fund returns have been divided among manager fees, fund-of-funds fees and investor profits. Because investor profits (which Lack defines as returns in excess of the risk-free rate) were negative in 2012, Lack couldn’t create the chart.

Hedge Funds

Lack said that he did not adjust his data for survivor or backfill bias, which are notorious for biasing hedge-fund returns upwards. Moreover, he used the high-water mark at the industry level, despite the fact that many funds did not pay incentive fees during years in which overall performance was poor. Those adjustments, he claimed, painted a more generous view of the industry than is warranted.

Lack is the author The Hedge Fund Mirage, which was published in 2012 and we reviewed here. He spoke at the CFA Institute’s annual conference in Seattle on May 5. Lack is the founder of SL Advisors, a New Jersey-based asset manager. Previously, he worked at J.P. Morgan as part of its hedge-fund due-diligence team, starting in the early 1990s.

The slides from Lack’s presentation are available here.

Lack reviewed hedge-fund performance since his book was published. The returns from the average hedge fund are dismal, according to Lack, unless you happen to be the manager of the fund or a fund-of-funds that sells it.

The problem with the hedge-fund industry, according to Lack, is that it is overcapitalized. At nearly $2 trillion, it is approximately the size of Chile’s GDP.

“There isn’t a Chile-sized inefficiency lying around, year-to-year,” Lack said.

Using data starting in 1998, Lack showed that industry performance was great until around 2002, when hedge-fund popularity spiked. Since 2002, a 60/40 stock/bond portfolio has outperformed the average hedge fund every single year. Hedge funds as a whole have only earned 7% (a typical target return for an institution) once, in 2009, when they bounced back from the financial crisis, according to Lack.

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