The Hedge Fund Mirage?

The jury is still out on whether they perform.

December 5, 2012

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palm treeFor at least a decade, institutional investors have been encouraged to move beyond a traditional 60/40 stock/bond allocation, in search of both alpha, and better beta.. In part, they were encouraged by the outstanding returns Yale University’s chief investment officer, David Swensen, produced..

But Swensen himself, essentially, told investors “don’t try this at home.” Indeed, he advised retail investors, and by implication, smaller pension plans, to cleave to the basics of low-cost diversification using indexed investments.

Useful wisdom to ponder, as Ontario proposes to sweep up many small institutional pension plans into bigger entities that have the same investment capacity as AIMCo, CPPIB, OMERS or OTPP. The argument is that, apart from economies of scale, such arrangements would “broaden access to additional asset classes and enhance risk management practices.”

Not to pick on a particular sector, but the brightest minds in the financial industry are graduated from the universities – this isn’t any Bernie Madoff doing a hustle. And yet, as the New York Times reports:  “data compiled by the National Association of College and University Business Officers for the 2011 fiscal year (the most recent available) show that large, medium and small endowments all underperformed a simple mix of 60 percent stocks and 40 percent bonds over one-, three- and five-year periods.”

True, perhaps. Until one gets to this stunning statement, from Simon Lack: “’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 asserted. And he maintained that nearly all the hedge funds’ gains had gone to hedge fund managers rather than clients.”

Well, there is the perception. Indeed, many think hedge funds blew up the financial system in 2008. Not investment banks packaging up mortgage-backed securities to slake the thirst institutional investors for every yield at the margin. Of course, some of those investment banks did run or fund hedge funds that did bet on MBS movements. And some of them lost badly.

It’s the nature of risk, no matter how quantified it has become. Risk regimes change, and upset all the quantifications.

Back to Mr. Lack. Is he right? Would institutional investors have been better off with money-market securities than hedge funds? (Of course, be careful about your money-market securities: the Lehman Brothers bankruptcy broke the buck on at least one money market fund, sending institutional investors to the hills.)

Interestingly, the London-based Alternative Investment Management Association was prompted to write a rebuttal of  Mr. Lack’s assertions. It’s quite fiery.

“Claim: ‘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. When you stop for a moment to consider this fact, it’s a truly amazing statistic.’

“These are the opening lines of ‘The Hedge Fund Mirage’. But to paraphrase, what is really ‘truly amazing’ is that nowhere in the subsequent 174 pages is this “statistic” actually supported by clear figures or working.

In fact even the academic paper (by Dichev and Yu) cited in the book to support this view contradicts it and says the opposite – i.e., that hedge fund returns have been higher than those for T-bills.

“What our own calculations, using the same core data and time period, show is that investors allocated $1.24 trillion to hedge funds from 1998-2010 and had $1.78 trillion to show for it, a 44% return, while the same amount invested in T-bills over the same period would have produced $1.52 trillion, a 23% return.

So to paraphrase the book’s opening line, if all the money that had been invested in hedge funds had been put in T-bills, the results would only have been half as good.”

There are good hedge funds and bad ones. Unsuspecting investors have been burned. There are also good hedge fund books and bad ones. Without judging a book as yet unread, what we seem to have here, to borrow from the old movie, is a “failure to calculate.”

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Scot, I am the author of The Hedge Fund Mirage. I am sorry you didn't have time to read my book before commenting on it, but you may want to go to the book's website ( where there are links to the mainstream financial press coverage it's received. With respect to AIMA, Felix Salmon memoraby commented that, "...the AIMA paper has convinced me of the deep truth of Lack’s book in a way that the book itself never could." His commentary is here ( You might find it interesting.

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