Lack, The Hedge Fund Mirage

In The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True (Wiley, 2012) Simon Lack draws on a long career in the hedge fund industry. The result is a chatty, personal history of hedge funds and a critical look at what they offer (and mostly don’t offer) investors.

The very first sentence of the book is a stunner: “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.” Contrast this stark reality with the money earned by hedge fund managers. In 2009 the top 25 hedge fund managers collectively earned $25.3 billion. No wonder one of Lack’s chapters is entitled “Where Are the Customers’ Yachts?” referencing the classic book of that title.

Lack set up JPMorgan’s incubator funds that provided early stage funding, or seed capital, to new hedge fund managers. Typically, they would offer $25 million of capital in exchange for 25 percent of the business. “The business share would come, not through a direct equity stake in the manager’s company, but through carving off 25 percent of the fees earned from all the other clients.” (p. 40) That is, they would earn a share of the top line, before expenses, and be at least in part protected from investing losses.

Even JPMorgan occasionally suffered from hedge fund practices that, though presumably legal, are detrimental to investors. Transaction costs, for instance, can be substantial when the fund invests new money. Some hedge funds claim to value their holdings on the bid side to be conservative. But “this should be false comfort because it also means that new investors come into the fund at a ‘conservative’ (which means low) NAV. Since the new capital received will have to be deployed, the manager will either have to buy more of the securities already owned, incurring transaction costs shared by all the investors, or use the cash for new opportunities which has the effect of diluting the existing investors’ share of current holdings at the bid side of the market. In effect, existing investors sell a pro-rata share of their holdings to the new investors at the bid side of the market.” (p. 110)

Moreover, Lack encountered a firm that played fast and loose with the valuation of its portfolio. When Lack’s group decided to exercise its escape clause in the face of a deteriorating convertible bond market and withdraw half of its capital, the fund switched from valuing its holdings at mid market to using the “Bid NAV.” The group felt they’d been had. “Fortunately,” Lack writes, “we were able to turn the trick back on them two months later” when the fund managers artificially boosted their performance as the market bounced back by using the “Ask NAV” to value their bond portfolio. Lack’s group cashed out the rest of its holdings at the higher valuation.

In this book Lack names names—the good, the bad, and the slouches. He offers pointers on how to invest wisely in hedge funds, his best idea being to opt for a small, new hedge fund. And, of course, do lots of due diligence.

Lack’s experience shines through on every page of The Hedge Fund Mirage. Hedge fund investors, and anyone who is even contemplating investing in a hedge fund, would do well to take advantage of it.