7 Reasons Hedge Funds Suck

The following is a summary of points I found in ‘The Hedge Fund Mirage by Simon Lack. Simon spent an entire career on Wall Street as a trader or providing ‘Seed Funding’ to Hedge Fund managers. The goal of his book is to inform investors and provide some transparency to the Hedge Fund Industry.

Feds and Vets, thank yourself that the TSP prevents you from stepping in these Hedge Fund land mines below:

Disclosure: At the time of this writing I hold a small position in a Merger-Arbitrage mutual fund.

1. Hedge Funds are the ideal business structure for fraudulent managers.

Since Hedge Funds are unregistered with the SEC, the SEC cannot inspect or audit them (since SEC does not have regulatory jurisdiction) (Lack, 146).

2. Up to 3 Percent of Hedge Funds are fraudulent in their reporting.

Let me re-iterate that – Not inaccurate, but deliberately Fraudulent (Lack, 130). This statistic is not at all surprising considering point #1. For further reading, go grab a copy of Bruce Johnson’s The Hedge Fund Fraud Casebook – where Mr. Johnson identified some $80 Billion in Hedge Fund Fraud (and note the $80B in fraud statistic pre-dates Bernie Madoff)!

3. Reported Hedge Fund industry performance statistics are juiced.

Hedge Funds self-report their results in the Hedge Fund Return Index (HFRI). Self-reporting incentivizes only the better managers to report results (Lack, 4). Furthermore, extinct funds are not reported at all (the dreaded ‘survivorship bias’ which omits extinct fund performance). This results in industry performance statistics that are way over-inflated.

4. The ‘Absolute Return’ promised by the funds is a mirage.

Hedge Funds are sold on the concept that they will move contrary to the market during downturns and shield investors from losses. However, during the 2008 crash, the Hedge Fund industry failed to perform to its sales pitch – The HFRI lost more in 2008 than it made during the preceding decade (Lack, 12).

5. The fee structure of Hedge Funds has taken over half of the clients’ profits over the last 10 years.

The common fee structure of ‘2 and 20′ (2 percent of annual assets and 20% of annual performance) has gobbled up most of investors’ returns over the last decade (Lack, 75). This is because the fee structure is set up to reward the manager, not the investor. One of Simon Lack’s favorite cocktail party questions is to stump hedge fund managers with, “Name an Investor who got rich investing in Hedge Funds”. The managers typically name George Soros, John Meriwether, or Bernie Madoff. Unfortunately, none of them count, as they are hedge fund managers- not investors.

6. Bigger is definitely NOT better.

Statistics in the Hedge Fund Return Index (HFRI) show that early-stage Hedge Funds significantly outperform larger established funds (Lack 14, 162).

This is easy to explain. Say you decided to run an Arbitrage Hedge Fund with a strategy to buy-up Closed-End Mutual Funds that are trading at a value less the market value of the shares of stock that they hold. You can get away with this for a while, but when your fund gets to the size where institutional money is flowing in (Billions of dollars) you can’t fly ‘under the market’s radar’. You’re a victim of your success- Any trade you make will ‘move the market’ and you can’t buy bargains without moving the prices upward.

Indeed, the Golden Age of Hedge Funds was in the 1990’s and is long-gone. In 1998 there were $143B in Hedge Fund Assets Under Management (AUM)- This grew to $1.7B in 2010 (Lack, 10). Returns since the ‘Golden Age’ have been abysmal – to the point that many investors would have been better off investing in T-Bills (depending on the year starting in this century).

7. Your money is essentially locked-up.

Your ‘Partnership Position’ in a Hedge Fund means you are are illiquid, and it’s hard to get your money out or perform a trade (Lack, 128). Don’t believe me? Just ask investors in Long Term Capital Management, or Bernie Madoff’s investors.

In the end, Mr. Lack recommends the Hedge Fund Industry look itself in the mirror and ask the following questions (Lack, 173):

  • Why have overall results for Investors been so lousy?
  • What’s an appropriate fee structure that is both fair to customers and provides incentives to effective Hedge Fund managers?
  • What transparency rights should investors demand?
  • Are the Hedge Fund results we’ve seen in the past going to repeat in the future?

 


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