Postscript to Part Two: Are Hedge Fund Returns a Mirage?

As this book was entering its copyediting phase, I came across the following startling quote:

If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good.

—Simon Lack

This opening line from Simon Lack’s book, The Hedge Fund Mirage (John Wiley & Sons, 2012), may well be the most damning sentence ever written or uttered about hedge fund investment. But is it true? Well, it’s a true statement about the wrong question. The question that Lack chose to focus on was: How many total dollars have investors earned in hedge funds? The appropriate question, however, is: How much would an individual investor have earned assuming hedge fund index returns?1 Measuring the performance of hedge funds based on total dollars earned, as Lack does, is deeply flawed for two reasons:

1. Investors are terrible in timing and redeeming investments, and measuring performance based on cumulative dollars earned by investors blames managers for the poor timing decisions of investors. Lack reaches his conclusion because hedge funds’ worst-performing year by far, 2008, occurred with hedge fund assets under management (AUM) at a relative peak. Lack states that “in 2008, the hedge fund industry lost more money than all the profits it had generated during the prior 10 years.” But whose fault is that? Who is to blame for investments in hedge funds peaking right before the industry’s worst year? If an individual investor had been invested in a fund of funds with index-like returns all along, would the 2008 loss have wiped out the investor’s returns of the prior 10 years? Of course not. The returns would not be impacted by the fact that a lot of new investors chose to allocate to hedge funds in the year preceding the funds’ large decline.

Imagine if equity returns were based on equity investor returns instead of equity index returns. We don’t have to imagine. Every year Dalbar, Inc. releases a report that compares investor returns with the S&P 500 index return. Dalbar’s 2012 report showed that for the 20-year period ending in 2011, equity investors earned an average annual compounded return of 3.49 percent versus 7.81 percent for the S&P 500 index—a 4.32 percent per annum difference. Should we therefore conclude that equity returns for this period were over 4 percent lower than reported? Of course not. Any individual investor or institution could have achieved the index return with an index investment. The fact that investors as a group fared worse because of their poor timing of additions and withdrawals is irrelevant to the individual index investor.

2. Since there has been dramatic secular growth in hedge fund assets under management (AUM), the more recent years have undue weight. This could cut both ways, but since the biggest AUM year until very recently was the extremely poor-performing 2008, it creates a downward bias by measuring results in cumulative dollars.

So how have hedge fund returns fared compared to Treasury bills? Using the same hedge fund index Lack used, the HFRX Global index, and the same starting year, 1998, the average annual compounded return through the end of 2011 would have been 5.49 percent for the hedge fund index versus 2.69 percent for T-bills. Thus the statistics show that hedge fund returns were more than double T-bill returns, not half as much as Lack contends. Admittedly, beating T-bill returns by 2.8 percent per annum is not terribly impressive. But consider that during the same period, the S&P 500 generated an average annual compounded return only 1.0 percent above T-bills with far greater volatility and drawdowns.

Although I believe Lack’s evaluation of hedge fund performance is based on faulty assumptions and hence is incorrect, I do not want this commentary to be construed as a broad-based criticism of his book, The Hedge Fund Mirage. On the contrary, with the exception of the measurement of hedge fund performance—which admittedly is a pretty big exception—I am in general agreement with many of the other opinions Lack expressed in his book, which include:

• Hedge fund fees are too high relative to the value they deliver to investors (albeit this is an inevitable consequence of the laws of supply and demand).
• The early history of hedge fund returns is irrelevant to current investors because those returns were achieved when the hedge fund industry was much smaller. Now that hedge funds have grown so much, and there is much more competition to exploit the same inefficiencies and many hedge funds are too large to take advantage of less liquid trading opportunities, it is highly unlikely that the industry will again approach the returns of those earlier years.
• Although institutional investors almost invariably invest only in large hedge funds, the available data tends to suggest that small hedge funds perform better than large hedge funds.

1By hedge fund index we assume a fund of funds index that would not be subject to the multiple biases of an index based directly on manager returns (as was explained in Chapter 14).