| || Lack at the 2012 Absolute Return Symposium |
(Photo: Axel Depeux)
By Simon Lack
A friend drew my attention to a thoughtful article on the benefits of using a fund of hedge funds compared with going direct. Mesirow's Greg Fedorinchik has presented a justification for the extra layer of fees by showing how little additional performance is needed to reach a better outcome, particularly when the fee discounts that FOHFs can negotiate are figured in. Greg compared the additional cost of a FOHF with the expenses of investing in hedge funds directly, including staff and other expenses. He also assumed that FOHF's are able to negotiate lower fees than other investors, an understandable assumption but one for which there's little hard evidence.
There are many talented people working at FOHFs. I worked for JPMorgan Alternative Asset Management for a number of years where I focused on smaller managers where you can often achieve better returns. I still have many friends there (and yes, they've all read my book The Hedge Fund Mirage!).
However, there are some problems with Greg's analysis. First of all, he assumes that the industry will generate 8.5% per annum. In my book I famously showed that all the money ever invested in hedge funds would have done better in treasury bills, a surprising result. There are great hedge funds and happy clients, but analyzing asset weighted returns so as to capture the results of all the clients reveals that the average is far worse than realized.
Some have argued that asset weighted returns are an unfair way to measure the past, since poor timing decisions by investors (they buy high/sell low) can distort the industry's results. Personally, I think measuring how everybody did is better than considering the theoretical investor who started a long time ago, but put that aside for a moment. I've also heard that the HFRI Index is a better benchmark than the HFRX, although many FOHFs use HFRX as their own benchmark.
But hedge funds are a soft target, so let's go with time weighted returns using HFRI and contemplate this 8.5% return expectation. It's been a very long time since hedge funds consistently delivered this much. In fact, for the theoretical investor who started his portfolio long ago and didn't add or subtract (i.e. not very realistic but nonetheless how proponents like to present results) if you made your hedge fund investments any later than 1995 you haven't yet earned 8.5% per annum. Even if you had the heroic insight and cash to begin in 2009, as markets were recovering, you've only earned 7.5% per annum; not much for catching a falling knife.
It turns out that in the 1990s hedge fund investors did very well. There just weren't that many of them. Those early years of success have attracted too much money and now the industry is overcapitalized. Every quarter hedge funds collectively provide empirical support for the findings in my book. Some of the smartest people in Finance run hedge funds, and there's now $2.5 trillion competing with itself in looking for an edge. The goals have evolved -- they no longer seek Absolute Returns (maybe AR should change its name) or Relative Returns but now Uncorrelated Returns. It's still called alpha (though the benchmark needs to be flexible) but investors are discovering with real money just how much alpha is really out there. For even assuming FOHF's can consistently select managers who will work for a discounted 1.5% & 17% (versus 2% & 20%) the 8.5% net return requires a gross return of 11.74% (8.5%/(1-0.17) + 1.5%). On $2.5 trillion that's almost $300 billion every year, just below the GDP of Chile (#41 on the IMF's list). Hedge funds have never made that much (apart from in 2009 following a far greater loss in 2008). Hedge fund investors are betting on a record year, every year. The analysis that begins in 1995 and ignores AUM in assessing the appropriateness of hedge funds for a client assumes no size-related constraints. Such analysis is resulting in many years of disappointment and missed targets for pension funds.
The deep flaw in the FOHF model is diversification. As counter-intuitive as this may sound, if you're investing in a sea of mediocrity where occasional nuggets of value can be found, manager selection is critical. Assuming you possess such skill (and some do) more numerous investments to achieve diversification draw the portfolio toward the prevailing mediocrity of the average. If you're good at picking hedge funds just choose a couple. Naturally, the 10%-20% conventional allocation will be far too much for this investor; 1-2% is more appropriate, but it provides a greater chance of higher returns. Hedge funds are just not going to solve every pension fund's problem of underfunded obligations. Diversification suits the allocator as it reduces the risk of substantial underperformance which would jeopardize the business model, but the consequence is that investors are stuck with the mediocre average as a result.
Simon Lack worked at JPMorgan for 23 years and founded the firm's seeding platform. He is the author of The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True. He now runs Westfield, NJ asset management firm SL Advisors, which invests client capital through separately managed accounts.Related: To use a fund of funds, or go direct? That is the question for institutions | Would you invest grandma's money in hedge funds or stocks? Authors Lack, Schwager and Zuckerman debate | Simon Lack responds to AIMA's hedge fund cheerleading