It’s not very often that one comes across an investment-related book that mixes solid research with a ground-breaking investigative analysis. ‘The Hedge Fund Mirage’, by an American investment industry insider, Simon Lack. As the title indicates, the book is about hedge funds. However, the ideas in the book are of huge interest and utility to anyone who is interested in any kind of investment service, be it mutual funds, portfolio or wealth management services or even stock-broking. Even though there are no hedge funds in India, anyone trying to understand investment management services should read it.
The key contribution that Lack has made is to focus unrelentingly on what can be called asset-weighted returns of the hedge funds. The traditional way that all investment managers report their life-time returns is by a compounded average growth rate. This calculates how much an investor would have made had he invested a certain amount at the beginning of the fund’s life and then held on to it till the present time. By this count, hedge funds have returned about 7 per cent since 1998, which is not bad for those markets.
However, Mr. Lack proposes an alternate measure, which is how much money did investors actually make. By this measure, hedge funds that invest in the US have earned less than 2 per cent a year over the same period. As he memorably puts it in the first sentence of his book, ‘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’. The reason why hedge fund’s returns are so much higher than what the investors made is simple. The investor’s returns are weighted by the money they have put in. If a fund has a 100 rupees and it gains 20 per cent in a year, investors have earned Rs 20. Next year, the fund has grown to Rs 200 and it loses ten per cent. Investors have lost Rs 20 and are back to even but the fund’s performance number are still positive at 3.9 per cent a year.
He has shown that larger funds systematically do worse than smaller ones. Not just that, the same funds did better when they were small compared to how they did when they became large. Even more interestingly, the entire industry as a whole did better when it was smaller. The takeaway for investors really is that the performance numbers reported by an investment manager can be accurate but still misleading and investors have to apply intelligent thought to what is being reported vs what they are actually getting.
There are a couple of other important points in The Hedge Fund that are applicable everywhere. One is that profit-linked fees which are based on annual returns (or other formulae that are currently used) are inherently unfair and result in investment managers taking a far greater share than is indicated by their stated terms. This is important to understand because similar profit-sharing schemes are used in India by Portfolio/Wealth Management Services.
The other important point is in many ways the most crucial one because it underlies all other problems and that is transparency. Lack’s main problem in writing this book was not the concepts but that the lack of information. Hedge funds are not obliged to reveal their real numbers and while many say they do, there is no way of knowing how much window-dressing or outright lying is going on. I think this is the most important takeaway of this book. No matter how attractive an investment product is made to look by those who are trying to sell it, there is no reason ever to even consider investing in something where independent, audited, third-party information and analysis is not available.