Friday, January 20, 2012

Where Are The Customers’ Yachts?

Earlier this week, a wise and skeptical senior Canadian pension fund manager sent me this Bloomberg article, Hedge Funds Buy Ferraris, Clients Often Get Phantom Gain:

Hedge-fund managers treat themselves to absolutely fabulous toys: Ken Griffin is fond of Ferraris, Steve Cohen is known for his Damien Hirst pickled shark and ice rink outfitted with its own Zamboni in a gabled cottage.

So where are the customers’ yachts?

“Who can name even one hedge fund investor whose fortune is based on the hedge funds he successfully picked?” asks Simon Lack in his stinging expose, “The Hedge Fund Mirage.”

If anyone is qualified to pose that question, it’s Lack, whose Wall Street career lofted him through the multiple mergers that begat JPMorgan Chase & Co. His answer ought to drive many hedgehogs -- and their investors -- into hibernation.

Sitting on JPMorgan’s investment committee, Lack helped to allocate more than $1 billion to promising hedge-fund managers, the book says. His conclusion about the broader industry, stated baldly on page 1, can be boiled down to one statistic.

“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,” he writes.

Lack isn’t saying that hedge funds never reap superior returns for investors. Far from it. He clearly admires John Paulson’s bet against the U.S. housing bubble and George Soros’s wager against the Bank of England. And the industry did perform well and preserve capital during the 2000 to 2002 bear market, which is why so many institutional investors threw money at them, driving assets under management to more than $1.6 trillion, Lack says.

Flood of ‘08

Yet the star performers are outliers. Research shows that “a few dozen have produced most of the investors’ returns,” Lack says. And don’t forget the “thousand-year flood” of 2008, when the hedge-fund industry “lost more money than all the profits it had generated during the prior 10 years,” he writes. So much for the “absolute, uncorrelated returns” they promised: Investors would have done better by shoveling their money into T-bills, earning 2.3 percent, Lack says.

Shunning simple average annual returns, Lack measures hedge funds with an index weighted by assets, just as the stocks in the Standard & Poor’s 500 Index are weighted by their market value. This gives a better sense of the returns, he argues, because investors in aggregate have invested more in the bigger funds. Then he turns his attention to the real profit killer: fees.

He starts with two data sets: annual assets under management (as tracked by BarclayHedge since 1998) and returns as measured by the HFR Global Hedge Fund Index (HFRXGL), which is weighted by assets. Next, he estimates fees using the standard “2-and-20” formula -- a 2 percent management fee and 20 percent incentive fee.

Real Profit

This involves a few simplifications. Some managers, for example, charge more than 2 and 20, some less. Yet the methodology does reveal a clear picture of the total profit hedge-fund investors received minus fees and the return they could have gotten by parking their money in Treasury bills.

From 1998 through 2010, these “real investor profits” totaled $70 billion, compared with fees of $379 billion, Lack estimates. Adding the fees back in, hedge fund managers salted away 84 percent of $449 billion in total profits, leaving 16 percent for their investors, he says.

And that’s not the worst of it, Lack says. HFRX index doesn’t account for factors such as “survivor bias,” meaning that only surviving hedge funds report returns (just as the victors write history, he says). Adjusting for those biases, the annual fees sink to $324 billion, while the real investor profits plunge to a negative $308 billion, he says.

Consider, too, the fees charged by funds of hedge funds, used by roughly a third of hedge-fund investors, Lack says. Throwing that into the mix, investors were left with $9 billion, while the industry amassed $440 billion in fees, or 98 percent.

So Much, So Little

The risks and rewards are so cockeyed that Lack can’t resist paraphrasing Winston Churchill’s encomium about Royal Air Force fighter pilots during the Battle of Britain: “Never in the history of Finance was so much charged by so many for so little.”

If Lack’s calculations are wrong, he can kiss his career goodbye. If he’s right -- and I think he is -- pension funds have a lot of questions to answer.

Lack does more than crunch numbers in this book. He recalls a chance JPMorgan had to invest with Bernie Madoff (they passed) and an “opportunity” to do a tricky trade with Long-Term Capital Management LP. LTCM’s Myron Scholes, of Black-Scholes Option Pricing fame, offered to help price the deal. Lack declined.

“Trading options with Myron Scholes didn’t sound like a poker game I should join,” he says.

As damning as his analysis is, Lack ultimately concludes that hedge-fund managers aren’t the villains of this sad story. The real fault lies with the “supposedly sophisticated investors” who fling so much money at funds with so little skepticism and critical analysis.

“The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True” (Wiley, 187 pages, $34.95, 23.99 pounds, 28 euros). To buy this book in North America, click here.

Simon Lack is absolutely right, most hedge funds, including Canadian hedge funds, are terrible and investors are better off investing in T-bills. And don't get me started on fund of hedge funds, the biggest scam of all, charging an extra layer of fees for mediocre results.

And hedge funds aren't the villains. Too many institutional investors are lazy and sloppy, listening to the advice of brainless pension consultants who've never invested in hedge funds. Remember the famous quote from Tom Barrack, the king of real estate, on why he cashed out before the downturn. "There's too much money chasing too few good deals, with too much debt and too few brains."

In a recent interview with Pension Funds Online, Lack was quoted as saying pension funds investing in hedge funds are "rich enough to know better":

The author of a controversial new book on hedge fund investing has warned UK pension funds that the real money in the asset class lies in fees for the industry rather than returns for clients.

Simon Lack, an independent asset manager formerly of JPMorgan, has hit the headlines in the financial press with his scathing analysis of hedge funds' real value. He suggests that the annual return figures promoted by hedge funds disguise poor overall returns weighted by each asset as smaller hedge funds perform much better than larger ones (the latter being more accessible to institutional investors).

Lack's analysis has in turn been sharply rebutted by the Alternative Investment Management Association. The body claims that Lack's analysis would be equally critical if applied to other asset classes and point to the increasing numbers of institutional investors putting money into hedge funds being a vote of confidence in the industry.

Pension funds have been upping their appetite for hedge funds in recent years since the financial crisis reduced the attractiveness of traditional assets. For the wider public and many pension fund members though, hedge funds remain a virtual by-word for financial greed.

Lack recently shared his views with Pension Funds Insider from his New York office.

Pension Funds Insider (PFI): When did you first become sceptical of the value of hedge funds?

Simon Lack (SL): I was an investor in hedge funds with JPMorgan and I always used to have a feeling that the fees were really where the money was. I never felt very comfortable going to the big hedge funds of the time where you almost had to ask "please take me on as a client!"

Then I set up a private equity fund ten years ago to take a venture capital stake in hedge funds, providing seed capital to a hedge fund in exchange for some of their fees (we were seeing a lot of interest of institutional investors in hedge funds after the dot-com bubble). But it turned out that most of our returns from that strategy came from fees rather than investment themselves.

Only when I started my own business two years ago and sat down to do the maths did I realise that, unbelievably, the clients of hedge funds haven't made much money. I wrote an essay on this topic for my company and what's more found out that the asset-weighted returns from hedge funds are far lower than the average annual returns, so in looking at the latter investors have a false proxy for the asset class's performance.

Hedge funds did very well in the 1990s, as did their clients – there just weren't too many funds or clients at the time. As the industry has grown, the returns have gone down fairly steadily. It turns out there is a pretty clear correlation between the size of the industry and returns. Any hedge fund you look at did better when it was small and the same goes for the industry as a whole.

Amazingly, investors don't appear to apply the same test in making the decision to allocate assets to the hedge fund industry that they would do when picking individual managers.

The overall rate of return from the hedge fund industry is lower than if the money had been invested in treasury bills. In writing an essay for Absolute Return magazine on this I realised there is some academic research which supports my point. That's when I thought 'man, this is a huge story!'

PFI: How have people you do business with reacted to your controversial research?

SL: When I've spoken to people in the hedge fund industry and tell them that treasury bills have actually outperformed hedge funds, they aren't surprised by this at all. Then you talk to people who are not in the hedge fund business but are in financial circles and they are surprised. I feel there's a huge gulf of misunderstanding, and if those close to the hedge funds know it, isn't that something that the investors should know?

It doesn't alarm me that I'm one of only a few people who have dedicated themselves to looking at hedge funds negatively. If you don't agree with what hedge funds are doing it's difficult to make a living out of that position – you can't short hedge funds.

PFI: Are you saying that pension funds should avoid hedge funds entirely?

SL: Well, in my view, all institutional investors who have money in hedge funds are rich enough to know better. I think pension investors have been poorly advised, with the consultants (who promise them good returns and a better sharpe ratio with hedge funds) guilty of sloppy analysis.

It's bold to say that the $2 trillion invested in the global hedge fund industry is all in the wrong place. There are some fantastically gifted hedge fund managers, there always will be, and there are happy clients – it's important to stress that it isn't all bad.

I would say though that, in the overall picture, that is not typical.

Hedge funds have been fantastic investments, it's just that the profits have mainly stayed within the industry rather than going back to the clients.

PFI: What advice would you give to pension funds who do decide to invest in hedge funds?

SL: Frankly, every pension fund should consider the asset-weighted returns in my view and ask from that if hedge funds have a useful role in their portfolio or not. There are some great hedge funds but it's a huge challenge to build a portfolio out of them.

The analysis shows that hedge funds performed well in the past when small. Pension funds just aren't going to get the results that they want in these massive industrial strength $20 - $30bn funds.

I asked people at a roundtable event recently what returns they expected from hedge funds and 7%, the figure the industry likes to promote, was a popular view. Well, if you want those kind of returns the industry would need to post record returns year-on-year. And as an investor I wouldn't count on that.

Having said all that, it's true a couple of well-selected hedge funds could benefit a pension fund.

Important things to do in any hedge fund selection process are negotiating for optimal returns, lower fees and transparency. All that should ensure investors get better outcomes and better rights in their dealings with hedge funds.

PFI: UK pension funds on the whole have increased their exposure to hedge funds from 1.8% to 4.1% in the last two years (according to the National Association of Pension Funds), as part of a general rise in 'alternative' asset investments (up from 10.3% in 2010 to 17% in 2011 according to Pension Funds Online). Does that not indicate that many hedge funds are doing well and impressing pension fund investors?

SL: There are some great hedge funds out there but in general it seems to me that pension funds have been won over by the fairly simplistic analysis of average annual hedge fund returns beating those from fixed income and possibly equities.

I'm sceptical whether the absolute return industry really has that much absolute return to deliver.

PFI: What alternative would you recommend to pension funds that have become interested in allocating to hedge funds when looking for some alpha in recent years?

The equity risk premium is very wide at the moment in the US, and I imagine that the same would be true in the UK. There is a pretty strong case for investing in public equities – the fact that they have underperformed for ten years just means that they have generally grown book value without going up in price.

So as a pension fund trustee I would be at the upper end of my allocation band for equities. I'd be underinvested in fixed income because bond yields in every industrial country are grossly distorted by central bank activity.

It's a challenge of course, especially for all the pension funds that are seeing their funding deficits widen. Pension funds are investors with some of the longest time horizons though and they are supposed to look for the best long-term returns possible.
The interview above should be read by every pension fund trustee on the planet, it's spot on. Some analysts, notably in India, are going beyond Simon Lack's 'The Hedge Fund Mirage':

The key contribution that Lack has made is to focus unrelentingly on what can be called asset-weighted returns of the hedge funds.

The traditional way that all investment managers report their life-time returns is by a compounded average growth rate. This calculates how much an investor would have made had he invested a certain amount at the beginning of the fund's life and then held on to it till the present time.

By this count, hedge funds have returned about 7% since 1998, which is not bad for those markets.

However, Lack proposes an alternate measure, which is how much money did investors actually make. By this measure, hedge funds that invest in the US have earned less than 2% a year over the same period.

As he memorably puts it in the first sentence of his book: "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". The reason why hedge funds' returns are so much higher than what the investors made is simple.

Investors' returns are weighted by the money they have put in. If a fund has 100 and it gains 20% in a year, investors have earned 20. Next year, the fund has grown to 200 and it loses 10%. Investors have lost 20 and are back to even but the fund's performance number are still positive at 3.9% a year.

He has shown that larger funds systematically do worse than smaller ones. Not just that, the same funds did better when they were small compared to how they did when they became large.

Even more interestingly, the entire industry as a whole did better when it was smaller. The takeaway for investors really is that the performance numbers reported by an investment manager can be accurate but still misleading and investors have to apply intelligent thought to what is being reported vs. what they are actually getting.

There are a couple of other important points in The Hedge Fund that are applicable everywhere. One is that profit-linked fees which are based on annual returns (or other formulae that are currently used) are inherently unfair and result in investment managers taking a far greater share than is indicated by their stated terms.

The point on large versus small hedge funds should be underscored. While there are large hedge funds like Bridgewater Associates and Brevan Howard managing billions and performing exceptionally well, there are plenty of others that are just large asset gatherers, collecting millions in fees, delivering mediocre results. That's why smart investors are chopping hedge fund fees, or shunning them altogether, bringing assets internally.

So what is it with hedge funds and private equity funds? Why are institutions piling into them? Just this week, I read an article on how the head of Florida’s $120 billion pension fund wants to double down on “alternative investments” in the future:

The official managing Florida’s $120 billion pension fund wants lawmakers to double the amount of money his agency can set aside for special investments that critics say are harder to value and carry more risk than traditional stocks and securities.

Ash Williams, reaffirmed Wednesday as the State Board of Administration’s executive director and chief investment officer for another year, said increasing the spending cap on “alternative investments” from 10 percent to 20 percent will diversify the state’s portfolio and reduce risk in a dreary market.

“It is not about struggling to get higher returns and taking on more risk in the effort,” Williams said.

But critics say just the opposite, painting the investments as secretive and potentially dangerous.

Alternative investments include hedge funds, private equity, venture funds or an investment in a portfolio company through an investment manager. They are not publicly traded.

Florida’s pension fund, the fourth-largest in the nation, was valued at about $120 billion on Monday, down about $8 billion since June.

“It’s a hell of a lot of money,” said Edward Siedle, president of Benchmark Financial Services, which investigates money-management abuses on behalf of pensions. “It’s a fifth of the portfolio.”

If approved by the Legislature, the target percentage would be 16 percent, not the full 20 percent allowed, Williams told a Senate committee mulling the cap on Jan. 9. The national average allocation on alternatives is 19 percent, he said, so the request is not “outlandish.”

Read more here:
No, itÈs in line with wha

Read more here:
No, it's not 'outlandish', especially when compared to what other US public pension funds are doing, but it is it smart? Are pension beneficiaries going to be the ones that will ultimately benefit out or will it be the fund managers charging huge fees? That is the key question.

And yes, there are excellent hedge funds and private equity funds, but there are so many charlatans and snake oil peddlers looking for dumb pension money. How do I know? I used to allocate to some of the best hedge funds all around the world and have seen my fair share of bullshitters and frauds. From a previous post of mine:

Most pension funds are absolutely stupid and clueless when it comes to investing in hedge funds. All too often, they are intimidated by charismatic managers who use "sophisticated" lingo to try to impress or intimidate unsuspecting pension fund managers.

I'll never forget my due diligence experience with some of these charlatans. It took me less than 15 minutes to figure out Norshield was a Ponzi scheme. Johnny "X" (John Xanthoudakis) walked into the boardroom sporting a tan, wearing a fancy Italian suit, smiling with his bleached white teeth, flaunting his "incredible risk-adjusted returns," a perfect 45 degree line. When I told him they are "too good to be true," he asked me if there was anything he could do to "facilitate an investment" (code for "how much to bribe you?"). That meeting was over fast. Amazingly, municipal pension plans in Quebec invested hundreds of millions in this joke of an outfit (too many of them are on the take; you better believe it is time to take action on municipal pensions).

I also dealt with my share of arrogant assholes in the hedge fund industry. Guys like "von Muffins" (our pet name for him) who was threatening us that if we do not invest with him, we will "never have access to his fund". Or another condescending jerk who was talking down to me telling me "Soros taught me risk management, you guys don't get it" to which I replied "is that why Soros fired you?" (don't ever get cute with me in a meeting, I'll rip your balls off and shove them down your throat!).
As you can see, I'm not impressed with hedge funds or private equity funds. I've gone toe-to toe with Ray Dalio, one of the few hedge fund managers I respect, but I don't think he's God. I don't think any hedge fund manager or private equity manager walks on water and is invincible.

Importantly, when I was investing in hedge funds and private equity funds, I treated everyone the same. I asked a lot of tough questions and if I didn't like the answers, I asked more questions and if I wasn't satisfied, I cut allocations or pulled the plug. The toughest thing investing with hedge funds is knowing when to walk away or when to pull the plug. Any dummy can write a big cheque, very few know when it's time to cut.

And I never chased after any hedge fund manager. I cringe reading silly articles on The Fabulous Life Of Chase Coleman: The World's Most Profitable Hedge Funder In 2011. Don't get me wrong, he is Julian Robertson’s 36-year-old disciple, a "Tiger cub," and might very well be the next Ken Griffin or George Soros, but my point is simply never "chase" after any hedge fund, ever. If you do, you deserve to get your head handed to you.

Finally, Bloomberg reports that R. Allen Stanford’s investors are enduring a 'living hell':

R. Allen Stanford’s investors, after waiting three years to see the Texas financier go to trial on charges of leading a $7 billion fraud, must hold on even longer before learning when they will get some of their money back.

Stanford’s customers have received nothing since the U.S. Securities and Exchange Commission closed his businesses in February 2009.

Stanford, accused of misleading people who bought certificates of deposit from his Antigua-based bank, spent their money on bad investments, sports sponsorships and a lavish lifestyle that included yachts, a fleet of jets, mansions and a private Caribbean island, U.S. prosecutors said.

Jury selection in his criminal trial is scheduled to start Jan. 23 in federal court in Houston. Stanford, who denies any wrongdoing, faces as long as 20 years in prison if convicted.

“It’s not fair that we have to be put through this living hell,” said Blaine Smith of Louisiana, who claims to have lost $1 million in life savings invested with Stanford.

I have a lot of sympathy for these investors but warn everyone, including pension funds, in this economy, there are plenty of other Stanfords and Madoffs looking to sucker you in. If it looks too good to be true, run, don't just walk away.

I can spot bullshitters from a mile away. I have a knack for that which has landed me in hot water at times. But when I see people being robbed or pensions getting hoodwinked by unscrupulous psychopaths, it really bothers me. In the case of pension funds, however, they really should know better but they too fall for all the glamor and glitz of the alternatives industry, eschewing their fiduciary responsibility. And some pension fund managers are on the take. Period.

Below, Douglas Burns, a former federal prosecutor, talks about an investigation into insider trading at hedge funds by the FBI and the Justice Department. Seven people were charged in Manhattan federal court with counts including securities fraud and conspiracy as part of the five-year probe.

I also embedded some Bloomberg interviews with Marc Faber, publisher of the Gloom, Boom & Doom report, and Nouriel Roubini, the New York University professor who predicted the 2008 financial crisis, and Ian Bremmer, president of Eurasia Group. As you know, I'm long risk assets, think the US economy will surprise to the upside, that eurozone will be a positive black swan, and reject claims that bonds are in a bubble.

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