The Hedge Fund Mirage

Bounded rationality even for the most "sophisticated" capital allocators of all: pension funds, wealthy individuals, private wealth managers. Financial services are incorrectly priced, both by sophisticated investors, and by society.

See also The truth about venture capital.

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Economist: “The Hedge Fund Mirage” attacks the Wall Street worshippers’ blind adulation. Simon Lack, who spent 23 years at JPMorgan, an investment bank, selecting hedge funds to invest in, grew tired of the free hand that investors all too often gave managers. He has written a provocative book questioning a central tenet of the hedge-fund industry: its performance is always worth paying for. The promise of superior performance is wrong, he says. Of course some investors make a killing, but on average hedge funds have underperformed even risk-free Treasury bills. This is because the bulk of investors’ capital has flooded in over the past ten years, whereas hedge funds performed best when the industry was smaller than it is now. What is more, it is hard to know how hedge funds actually fare, since indices that track industry performance tend to overstate the returns. Funds that do badly or implode are not usually included in the indices at all.  

Why would any client continue to pay for such mediocre returns? One reason is that hedge-fund managers are incredibly good salesmen. In addition, industry insiders who are all too aware of hedge funds’ shortcomings choose not to expose them, Mr Lack argues. Moreover, the common fee structure, in which hedge-fund managers keep 2% of assets as a “management” fee to cover expenses and 20% of profits generated by performance, has made many managers rich, but not their clients. Mr Lack calculates that hedge-fund managers have kept around 84% of profits generated, with investors only getting 16% since 1998. “Where are the customers’ yachts?” is the title of one chapter. What is worse, the disastrous dive of equity markets in 2008 may have wiped out all the profits that hedge funds have ever generated for investors.  

Mr Lack places a good deal of the blame for this on investors who fail to ask tough enough questions and have not grasped that they “want yesterday’s returns without yesterday’s risk”. They invest money with the biggest, best-known funds “that look nothing like those whose aggregate performance” they want to emulate. Instead investors should stand up to managers, negotiate more favourable terms and put their money into smaller funds, which tend to perform better.