Book Review: The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True

Wednesday, January 18, 2012 - 17:01

The Editor offers a review of Simon Lack's The Hedge Fund Mirage: The Illusion of Big Money And Why It's Too Good To Be True.

Simon Lack is a 23-year veteran with JP Morgan in North America, where he oversaw fixed income derivatives and forward FX trading and ultimately supervised 50 professionals and $300 million in annual revenues. He also sat on JP Morgan’s investment committee that allocated $1 billion to hedge fund managers and founded the JP Morgan Incubator Funds, two private equity vehicles that took economic interests in emerging hedge fund managers. In 1980 Lack began his career with the London Stock Exchange. He is currently a principal with SL Advisors, LLC, a Registered Investment Advisor.

The primary thesis of this volume is that if all the money that was invested in hedge funds over the history of this industry had been invested in Treasuries instead, the investor would have been twice as well off.

According to Hedge Fund Research, hedge funds will deliver their second-worst year in history in 2011, exceeded only by 2008. While hedge funds performed well in the 1990s, since 2002 they have failed to outperform the traditional 60/40 portfolio of stocks and bonds, being down 8.5 percent for the past year as compared to 2 percent for the U.S. stock market, reports Lack. While the hedge fund industry created an immense amount of wealth, very little of that wealth drifted back into the hands of the investors.

Unlike the early years when hedge funds were fewer in number and investors did well owing to their scarcity, today’s hedge fund investors have received meager payouts owing to high fees (in 2009 25 hedge fund managers earned $25.3 billion), complex legal structures, poor disclosures and return chasing. The industry has grown from $100 billion in assets under management in the early days to $1.6 trillion today, partly owing to the presence of institutional investors.

One of the most interesting chapters is entitled “Hedge Fund Fraud.” Here Lack reveals startling frauds attempted by hedge fund managers who played games in order to attract JP Morgan funds as seed capital. He describes one candidate for funds who, while highly connected politically, had misappropriated $350 million of his former employer’s funds and was found out through very clever questioning by a colleague. Equally fascinating are other stories about how those seeking the bank’s capital to start their funds were unmasked.

However, there are still opportunities in the hedge fund arena. The author advises on how to identify good hedge funds that generate better returns for their investors. Look for smaller funds that are generally not so well followed and that use some unorthodox strategies. Use careful due diligence in demanding better terms, transparency, liquidity, lower fees and reliable and frequent good information.

Questions that Lack poses to the industry are

  • Why have overall results for clients been so poor?
  • What is an appropriate fee model that is fair to clients but appropriately rewards high-decile investment performance?
  • What rights over transparency, liquidity and governance should investors demand for their hedge fund investments?
  • Are these results likely to persist into the future?

While Dodd-Frank is demanding more forthcoming information on hedge fund results and disclosures regarding their portfolios, will the law be so implemented once the regulations are filled in to allow hedge funds to continue to becloud their results from investors? Will the disclosures required by the SEC ever rise to the level of those required for other public companies since the funds are custom-made for sophisticated investors?

Besides Lack’s standards for openness and disclosure, will there still be ways for some hedge funds to elude the critical eye of the due diligence experts?

While Dodd-Frank has many detractors, it may be on target in requiring some measure of accountability and disclosure in the instance of hedge funds.

For those readers who would like to sample Simon Lack’s excellent treatment of hedge funds as one well schooled in their history as an insider, we recommend this small volume published by John Wiley, January 2012. ISBN:978-1-11816431-0, $34.95. It is available in both hardcover and ebook formats.