how do you adjust hedge fund returns for survivorship bias?
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.
