Thursday, May 3, 2012

Simon Lack's Hedge Fund Mirage?

Last week, I spoke with Simon Lack, author of The Hedge Fund Mirage and founder of SL Advisors, a Registered Investment Advisor which started operating in 2009.

I have already discussed Simon's views on hedge funds in earlier posts (see here and more recently here) but wanted to interview him for my blog which he graciously agreed to.

I asked Simon the following questions:
1) Can you give us a brief background on you and your firm?

Our bios are posted on our website (see here). I traded derivatives for many years, and have been investing in hedge funds since 1994. I began seeding them in '01.

SL Advisors was set up in '09 to manage my money - a brief history is in this month's newsletter under the Business Update section (read here).

2) Please discuss the investment strategies you offer. Are they liquid, transparent and scalable? What are the fees for investing and how is alpha produced?

Our strategies are described on our website (read here). Everything is kept in separately managed accounts (SMAs) so is totally transparent to clients, easily accessible and independently valued. We only invest in publicly registered securities in the U.S. Our Philosophy page may also be helpful. We charge 1% p.a. and no incentive fee.

3) Your book,
The Hedge Fund Mirage, is controversial in the hedge fund community. Can you discuss its main conclusions and address some of the criticism that AIMA recently leveled at it?

I think the main message is that you can only evaluate hedge fund returns by considering the size of the industry. Returns were good when the industry was small. Investors did very well in the 90s but they weren't that numerous. As assets flowed in returns fell. Essentially the debate comes down to whether you believe that's simply a coincidence, or is caused by the industry's size. I firmly believe the latter. The industry's supporters reject that connection.

With respect to the KPMG/AIMA report, I wrote about that on my blog last week (read Simon's blog comment here). You may find some of the other blog posts I have written under the "Hedge Funds" section to be of interest.

Towers Watson, a consultancy which advises institutional investors, recently leveled criticism at the high fees hedge funds charge and urged them to cut their take on gains on assets they manage (read article here). Would you agree that past a certain level of assets under management (AUM), hedge funds should only charge performance fees?

Clearly fees are too high. I have calculated that fees have consumed all of the profits earned in excess of T-bills in the history of the industry. I found this to be the case through 2010 with fairly conservative assumptions. 2011 just made it worse.

Others may use different return series and torture the data somewhat, but there's no getting away from the fact that fees have taken anywhere from most to more than all of the "real" profits (that is, in excess of the risk-free rate). Fees could be adjusted down in a number of ways.

Clearly large firms could charge lower management fees since the business is so scalable. Incentive fees really ought to have a hurdle, perhaps over a minimum expected return (6-8% is not uncommon in Private Equity). But this will only happen if investors start pushing back on current terms.

5) What are your main concerns about hedge funds going forward?

I think it's going to be very hard for a $2 trillion industry to generate expected returns of 7%. Hedge funds are over-capitalized. To my mind, mediocre performance, probably no better than very low single digits, is the more likely outcome.

6) Please discuss the most important aspects of due diligence that you feel are being neglected.

The impact of size. Small hedge funds outperform big ones; big hedge funds did better when they were small. Investors don't appear to modify their return expectations much as size increases, and in fact many institutions are drawn to the larger funds because of their robust infrastructure.

In effect, the returns of a small industry gained their attention but they then invest in a way that doesn't reflect the history that drew them in.

I also think the notion of a diversified HF portfolio is itself deeply flawed. Modern Portfolio Theory holds that a diversified portfolio is the most efficient way to achieve the systemic return, and that investors don't get rewarded for taking concentrated bets. But in HFs, the systemic (or average) return is pretty poor. The only way to succeed is to be better than average at manager selection.

Consequently, in my opinion the smart way to use hedge funds is to invest in a very small number of funds where your conviction about manager skill is high.

Diversification runs the risk of diluting the advantage of whatever manager insight you have. You need to get as far away from the average return as you can. That naturally means that a 5% HF allocation that would have gone to 15 managers needs to be scaled back to, say, 1-2% across 2-3 managers. It's not what the industry wants investors to hear, but is in my opinion the most likely way in which investors will achieve acceptable results.

7) What are your thoughts on seeding hedge funds? What is the best way to seed, direct or through fund of funds? What terms should investors negotiate?

Seeding is a good structure that experienced HF investors should be prepared to adopt. I think that seeding vehicles are not such a great idea. At times there aren't many good deals to be done and a dedicated pool of capital needs to be doing deals.

Dedicated pools can also hinder subsequent growth. At JPMorgan if we seeded a hedge fund that precluded the manager from receiving a subsequent allocation from any of other other discretionary pools of capital at JPMorgan, because it would create a conflict of interest.

8) Please discuss your performance and why you don't charge performance fees. Please explain your thoughts on this as most institutions are deeply distrustful of any fund that doesn't charge performance fees (after clearing a hurdle like T-bills).

That's an interesting question. I think in many cases fees are too high. It's not that we're not commercial, but over the long run our business will prosper as long as our clients do well. The 2 & 20 is short run greedy for the manager, but over the long run it represents quite a performance headwind.

It's my belief that fees in the HF industry will need to moderate. Indeed, I note in my book that all of the investor profits in excess of t-bills have gone in fees. Under those circumstances it would be strange for me to charge HF fees.

Investors should be suspicious of managers that charge fees they can't realistically justify through their results. And if anybody wants to pay us a bonus fee following good performance we would naturally be happy to accept!
I thank Simon for taking the time to answer my questions. You'll find lots of information on the web about their thoughts on different investments. Old newsletters are on their website, you can read their old blogs and they have published research on Seeking Alpha for nearly two years (read articles here).

I agree with Simon's observations on hedge funds. The bulk of the managers are delivering mediocre results and more worrisome, institutions keep pumping billions into hedge funds, most of which are nothing but glorified asset gatherers primarily focused on marketing their Malakia Capital Management, perfectly content on collecting 2% on the billions they manage (less focused on the 20% performance fee).

Meanwhile, smaller hedge funds outperforming their larger rivals are being shunned by institutional investors suffering from the 'placebo effect' of large hedge funds. While there are exceptions to this rule, and it's true that large institutions can't bother investing in smaller funds, the reality is that they're better off hiring and properly compensating qualified managers to produce alpha internally. Or they can allocate to guys like Simon Lack who won't take them for a ride on fees.

I will, however, disagree with Simon on two points. One is the concentration risk on hedge funds he is recommending. He's right that overly diversifying in too many hedge funds (or private equity funds) is silly and will only produce mediocre returns, as well as eat you alive on fees. But if you are only allocating 2% of your portfolio in 2 or 3 managers, you're wasting your time investing in hedge funds, even if you are investing with Bridgewater, Brevan Howard or any other "elite" hedge fund. You're also not diversifying your operational risk.

As for seeding hedge funds, I understand Simon's arguments on the constraints of dedicated pools for such ventures but as I wrote in a recent comment, there are a select few funds of funds that are experts in seeding alpha managers and some funds of funds deserve another go.

Once again, I thank Simon for this insightful interview and urge investors to contact him directly at SL Advisors for more information on his advisory services. His contact information is available here.

Below, Simon Lack talks with Deirdre Bolton on Bloomberg Television's "Money Moves" about his book and the reasons investors should avoid hedge funds. Also, AlphaClone CEO, Maz Jadallah, discusses the recent underperformance of hedge funds with Jeff Macke at Yahoo's Breakout.

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