The Hedge Fund Mirage: Q&A With Simon Lack via The Brandes Institute

In his 2012 book, The Hedge Fund Mirage, author and investment industry veteran Simon Lack argued that since the late ‘90s:

  • While hedge fund industry assets grew from under $200 million to more than $2 trillion, hedge fund returns had not kept pace with Treasury Bills.
  • Over this period, hedge fund fees totaled about $566 billion in aggregate vs. roughly $30 billion in actual profits for hedge fund investors.
  • Limited transparency on hedge fund philosophies, processes and holdings made it difficult for investors to accurately assess a growing range of offerings.
  • Despite these issues, hedge funds could still have a place in portfolios; but investors needed to be thoughtful about hedge fund managers and allocations.

Just after it was published in 2012, some industry experts and members of the financial press questioned Lack’s methodology and results and sought to dismiss his findings. In May 2014, Lack presented his work at the CFA Institute Conference in Seattle where Brandes Institute Advisory Board member Bruce Grantier talked with him.

Grantier recently published a review of Lack’s presentation at (available to subscribers). Grantier also helped arrange for the Brandes Institute to question Lack via email. Here, we share excerpts from that email exchange.

The Hedge Fund Mirage: Q&A With Simon Lack

Q: You were the target of criticism when The Hedge Fund Mirage was first published. Do you feel your work has been vindicated?

Simon Lack A: I think the results since my book came out have shown that I’m right. Hedge fund industry advocates have little evidence to support their criticisms beyond asset flows, which must be a highly unsatisfactory prop. They failed to consider size, and the results are relentlessly demonstrating that total hedge fund assets under management and an assessment of what is a sustainable level ought to play a part in any large allocation to hedge funds. Since the original reaction, a number of hedge fund managers have agreed that my original remarks were valid.

Q: A central tenet of your book is that it’s becoming increasingly difficult for hedge funds to replicate their earlier success given the growth in collective assets under management. Do investors have to identify new, smaller hedge funds with limited capacity to have a chance at strong returns?

Simon Lack A: I think it’s almost cognitive dissonance for today’s investors to fail to consider industry size when contemplating their hedge fund allocations. Everything about past returns as well as anecdotal evidence overwhelmingly support that too much money hurts returns. This is why large hedge fund allocations don’t make sense–they require large individual allocations to large managers as the only plausible implementation. Once a public pension plan recognizes that 5% is a better allocation to hedge funds than 20% they’re no longer relying on hedge funds to solve their funding gap, and consequently they can select more esoteric managers. This is how hedge fund investing was done during the period of time whose historic returns were generated that they’re seeking to emulate.

Simon Lack Hedge Fund Mirage

Q: You have been critical of hedge fund fees. In your opinion, what is wrong with the current fee structure? And what fee arrangement would you suggest for hedge funds?

A: Fees are simply too high, and although they’re coming down somewhat they still appear to average around 1.9% and 17.5% of profits (vs. the popular 2.0% and 20.0% arrangement). I think incentive fees should be subject to a hurdle. Even with near zero interest rates it’s ridiculous for managers to earn a fifth of the gross nominal return, but even more so in years past when risk free rates were 2-5%. I think the difficulty is hedge funds are heterogeneous and few investors think about negotiating fees until they’ve completed their due diligence. At that point they’re in a weak negotiating position as they’ve identified their chosen hedge fund and failure to agree to terms leaves them with no near-identical alternative. Nonetheless, I think large allocators should set out their maximum terms in an RFP and eliminate managers from consideration whose terms don’t match.

See full Q&A With Simon Lack in PDF format here.