Sep 5 2012 | 10:24am ET

Simon Lack knows there are hedge fund investors who have done well on their investments—he just thinks they’re the exception, not the rule.

“There are great hedge funds, there are happy clients,” the author of The Hedge Fund Mirage: The Illusion of Big Money and Why it’s Too Good to Be True. says. “But I have to tell you that, when I think about the people I know that are happy with their hedge fund investments, they don’t have that many of them. They haven’t got a conventional, institutional, diversified portfolio. It’s a high net-worth investor who’s got a couple of funds where he knew the manager well and invested a long time ago and it’s worked out really well.

That’s not what the Alternative Investment Management Association would like to have clients do, but I think that that’s the best way to access some undoubtedly highly-talented people running hedge funds.”

The AIMA mention is pointed: The hedge fund lobby has taken exception to Lack’s book, going so far as to issue not one but two responses; the most recent came on Aug. 6 and was billed as a “comprehensive rebuttal to The Hedge Fund Mirage .”

“Many of us in the industry looked at the arguments in the book with initial interest, and then growing skepticism,” AIMA CEO Andrew Baker said. “Many of the most sensational claims appeared not to be backed up by any figures. Where there were figures, the methodology was flawed. We noticed that no one praising the book appeared to have actually checked the numbers behind it. We began to wonder if The Hedge Fund Mirage was itself an illusion.”

AIMA raises a number of issues with Lack’s book (one of which is the result not of flawed methodology but of a typographical error), but the crux of its case against The Hedge Fund Mirage. says Lack, is that he uses dollar-weighted figures to evaluate hedge fund performance.

“The internationally accepted Global Investment Performance Standards strongly advocate the use of time-weighted data for assessing hedge fund performance,” AIMA wrote in its rebuttal. “Dollar-weighted figures tell us more about investor behavior than manager performance.”

Time Versus Money

Harvard Business School’s Gwen Yu tells FINalternatives the difference between dollar-weighted and time-weighted (or buy-and-hold) returns is simple.

“Buy-and-hold returns are returns of the fund’s performance and dollar-weighted returns are returns the investors experience,” Yu says. “That’s one way to conceptually distinguish the two. Theoretically, what buy-and-hold return does is just take a simple geometric average—it doesn’t consider any of the capital flows coming into the fund or going out of the fund.

“The dollar-weighted return does weight the investor’s experience by weighting the assets under management over time. It actually considers when the fund’s assets were getting bigger and when they were getting smaller, and by considering that weight you can actually see how well the investors were timing—when they were getting into the fund at the right time, when future returns were going up and when they were getting out at the right time, when the future returns were going down. It’s a subtle distinction but it makes a big difference.”

What it boils down to, Yu says, is, “What do we mean by hedge fund performance?”

“If you mean the experience of the investors, dollar-weighted returns will be a good way to assess the investor’s experience. If it comes to the fund’s performance, buy-and-hold return will be a good way to measure this. But when people vaguely say ‘performance,’ it boils down to whether the hedge funds are free to take in new capital and who is making that decision; if hedge fund managers are actually free to take in new capital, in other words, if they have a lot of control on the capital inflows and the outflows, the restrictions on redemptions, they can actually control the difference between the dollar-weighted return and the buy-and-hold return.”

Yu and a colleague, Emory University’s Ilia Dichev, compared the dollar-weighted and buy-and-hold returns of nearly 11,000 hedge funds from 1980-2008 and published their results in a 2009 paper, “Higher risk, lower return: What hedge fund investors really earn.”

“We were actually expecting the hedge funds to do much better because they’re market timers and they’re hedging,” Yu says. “Hedge funds, since they have these contractual provisions where you can just lock in the assets under management, I was predicting that would actually help the investors. A little disappointingly, we didn’t find any results there.

What they found was that “depending on specification and time period examined, dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold returns.”

‘A Huge Story’

The year Yu and Dichev published their research was also the year Lack retired from JPMorgan, where he’d worked for 23 years. Having sat for years on the bank’s investment committee and assisted in the allocation of billions to hedge funds, Lack said he’d long suspected the money was actually in the fees—so much so that in 2001 he launched a hedge fund seeding firm to negotiate a share of those fees—but it wasn’t until 2009 that he finally “did the math.”

“I sat down and figured it out and I was staggered,” Lack says. “I thought ‘Oh my god, look at this, the clients have actually done really badly.’”

Lack read Yu and Dichev’s work. They’d already got there before me and they’d already done a pretty thorough job on the subject and I thought, ‘This is just a huge story. People ought to know this.’”

He wrote an article for AR magazine and, encouraged by the response, he decided to expand his thesis into a book.

The Hedge Fund Mirage

That book, published earlier this year by John Wiley and Sons, has been well-received in the financial press and Lack, writing in April on his blog, In Pursuit of Value, claimed that many industry insiders “readily acknowledge the disappointing results of the past with little surprise.”

In his opening chapter, “The Truth About Hedge Fund Returns,” Lack makes his case for looking at hedge fund performance from the investor’s perspective:

The hedge fund industry routinely calculates returns based on the value of $1 invested at inception. And it’s true that, based on the HFRX Global Hedge Fund Index, if you had invested $1 million in the average hedge fund in 1998 you would have earned 7.3% annually. But hedge funds did best in the early years, when the industry was much smaller. Just as small hedge funds generally outperform large ones, a small hedge fund industry did better than a large one.

When you adjust for the size of the hedge fund industry, the story is completely different. Rather than generating a return of 7.3%, hedge funds have returned only 2.1%. There were fewer hedge fund investors in 1998 with far less money invested, but based on the strong results those few earned at that time, many more followed. It’s the difference between looking at how the average hedge fund did versus how the average investor did.

Lack illustrates his point with the following example:

If in Year 1 you invest $1 million and the fund returns 50%, your investment is worth $1.5 million and your profit is $500,000.

If Year 2 you invest another $1 million (for a total investment now of $2.5 million) and the hedge fund loses 40%, your investment is now worth $1.5 million and your loss is $1 million.

The manager, writes Lack, will report this as an average annual return of 5%, but the investor’s actual internal rate of return is a loss of 18%.

Where Are The Customers’ Yachts?

Then there’s the question of fees.

Lack asserts that since 1998, hedge fund managers have kept 84% of the profits, making themselves enormously wealthy, while leaving only 16% for their investors. He’s calculated that as “excess profits over Treasury bills,” a move AIMA disputes.

“In its fees calculations the book also misleadingly excludes the risk-free rate from hedge fund returns, which has a similarly distorting effect on the final figures produced,” the industry group said.

But Lack defends his method. “They say you shouldn’t count returns only above Treasury bills. But, in fact, they give the example, ‘An investor who makes $10 [from hedge funds] could have made $2 from Treasuries, but it’s still $10 not $8.’ Well, what I would say is that if you could have earned $2 in Treasury bills and you made $10 in hedge funds, $8 is the value-added that the hedge funds added and not $10. That’s just an opinion, people can debate it, but why would you pay somebody 2% and 20% to give you a $2 return that you’d get in Treasury bills?”

AIMA also objects to his definition of “profits.

“What the book claims to be ‘profits’ for hedge fund managers are in fact the gross revenues they receive, which are obviously not the same thing as net profits,” the association writes.

“That’s sort of a red herring, isn’t it? Lack asks. I’m just talking about what the real investor profit is. It doesn’t really matter, when you’re an investor, whether what you pay the manager is incentive compensation or goes to pay for Bloomberg or whatever. As an investor, you just care about what it costs you to access the strategy.

Of course, I know that it’s not all operating profit for the hedge fund industry, that’s not my point. My point is, this is the revenue line of the hedge fund industry and was that revenue, which was obviously an expense for the client, money well spent or not?”

AIMA cites data from the Center for Hedge Fund Research which finds that hedge funds returned 72% of their profits to investors between 1994 and last year, generating an annualized return to investors of 9.07%

But Lack says AIMA is simply “wrong.”

“They have a 9% average annual return for hedge funds since 1994 and they say, ‘This is why hedge funds are good because they’ve made 9% since 1994.’ And that’s true, if you take the average annual return for the year and if you assume that you invested in an equally weighted portfolio of hedge funds which, in fact, you rebalance every year.

But, Lack says, “there are two issues with that. First of all, an equally-weighted portfolio is a nice concept but, obviously, everybody can’t have an equally-weighted portfolio because hedge funds are not all the same size. Second, within that 9% average annual return from 1994, you’ve got the first five years with 12% average annual return and the last five years with 2%. So, it’s true, the average annual return for that hypothetical, equally-weighted portfolio is 9%, but you had some great years in the ‘90s when there weren’t many investors. And as more people have shown up, the returns have gone down. I’d say that’s why they’ve gone down; I think AIMA would say that’s not why they’ve gone down.”

Lack takes it as a given that smaller hedge funds perform better than larger ones and says winning funds become victims of their own success because they attract more money than they can profitably invest. Fee structures being what they are, it’s tempting for managers to grow assets. The result, he wrote on his blog, has been “an enormous transfer of wealth from clients to the hedge fund industry. My analysis shows that pretty much all the profits earned by hedge funds in excess of the risk-free rate have been consumed by fees.”

How to Invest in Hedge Funds

Given that bleak assessment, it seems odd to even ask Lack if there’s any value in investing in hedge funds—but we did.

Lack says there are talented people running hedge funds and there is money to be made, but it won’t be made by people who accept the conventional wisdom that diversification is the key to successful hedge fund investing.

“With hedge funds,” he says, “the only way to win is if you’re good at picking managers. If you get the average return you’ll be a loser. The more you diversify, the more you’ll have a hedge fund portfolio that looks like the average return and the average return is not what you want. What you should do as a hedge fund investor is have a very concentrated portfolio of two to three hedge funds instead of 15 or 20.”

The caveat, he says, is that if you’re only allocating to a few hedge funds you should only allocate a small percentage of your investment portfolio to hedge funds.

“The right way for people to use hedge funds is to make a small allocation—less than 5%—and to invest in a small number of managers where your insight and your skill at manager selection has the best chance to generate a return for you. I know that that creates a problem for a pension fund that’s trying to reach an 8% return target and is relying on hedge funds to get them there. I understand that’s a problem and I’m sorry, I just don’t think hedge funds are going to do it for you.”

As for Gwen Yu, whose research focus has shifted from hedge funds to global capital flows, she says she’ll pass.

Yu would “probably not invest in hedge funds because I am a more T-bill kind of person.

However, if I had to I would carefully select a relatively new fund.”