The author of a controversial new book on hedge fund investing has warned UK pension funds that the real money in the asset class lies in fees for the industry rather than returns for clients 

Simon Lack, an independent asset manager formerly of JPMorgan, has hit the headlines in the financial press with his scathing analysis of hedge funds' real value. He suggests that the annual return figures promoted by hedge funds disguise poor overall returns weighted by each asset as smaller hedge funds perform much better than larger ones (the latter being more accessible to institutional investors).

Lack's analysis has in turn been sharply rebutted by the Alternative Investment Management Association. The body claims that Lack's analysis would be equally critical if applied to other asset classes and point to the increasing numbers of institutional investors putting money into hedge funds being a vote of confidence in the industry.

Pension funds have been upping their appetite for hedge funds in recent years since the financial crisis reduced the attractiveness of traditional assets. For the wider public and many pension fund members though, hedge funds remain a virtual by-word for financial greed.   

Lack recently shared his views with Pension Funds Insider from his New York office.

Pension Funds Insider (PFI): When did you first become sceptical of the value of hedge funds?

Simon Lack (SL):  I was an investor in hedge funds with JPMorgan and I always used to have a feeling that the fees were really where the money was. I never felt very comfortable going to the big hedge funds of the time where you almost had to ask "please take me on as a client!"

Then I set up a private equity fund ten years ago to take a venture capital stake in hedge funds, providing seed capital to a hedge fund in exchange for some of their fees (we were seeing a lot of interest of institutional investors in hedge funds after the dot-com bubble). But it turned out that most of our returns from that strategy came from fees rather than investment themselves.

Only when I started my own business two years ago and sat down to do the maths did I realise that, unbelievably, the clients of hedge funds haven't made much money. I wrote an essay on this topic for my company and what's more found out that the asset-weighted returns from hedge funds are far lower than the average annual returns, so in looking at the latter investors have a false proxy for the asset class's performance.

Hedge funds did very well in the 1990s, as did their clients – there just weren't too many funds or clients at the time. As the industry has grown, the returns have gone down fairly steadily. It turns out there is a pretty clear correlation between the size of the industry and returns. Any hedge fund you look at did better when it was small and the same goes for the industry as a whole.

Amazingly, investors don't appear to apply the same test in making the decision to allocate assets to the hedge fund industry that they would do when picking individual managers.

The overall rate of return from the hedge fund industry is lower than if the money had been invested in treasury bills. In writing an essay for Absolute Return magazine on this I realised there is some academic research which supports my point. That's when I thought 'man, this is a huge story!'

PFI: How have people you do business with reacted to your controversial research?

SL: When I've spoken to people in the hedge fund industry and tell them that treasury bills have actually outperformed hedge funds, they aren't surprised by this at all. Then you talk to people who are not in the hedge fund business but are in financial circles and they are surprised. I feel there's a huge gulf of misunderstanding, and if those close to the hedge funds know it, isn't that something that the investors should know?

It doesn't alarm me that I'm one of only a few people who have dedicated themselves to looking at hedge funds negatively. If you don't agree with what hedge funds are doing it's difficult to make a living out of that position – you can't short hedge funds.

PFI: Are you saying that pension funds should avoid hedge funds entirely?

SL: Well, in my view, all institutional investors who have money in hedge funds are rich enough to know better. I think pension investors have been poorly advised, with the consultants (who promise them good returns and a better sharpe ratio with hedge funds) guilty of sloppy analysis.

It's bold to say that the $2 trillion invested in the global hedge fund industry is all in the wrong place. There are some fantastically gifted hedge fund managers, there always will be, and there are happy clients – it's important to stress that it isn't all bad.

I would say though that, in the overall picture, that is not typical.

Hedge funds have been fantastic investments, it's just that the profits have mainly stayed within the industry rather than going back to the clients.

PFI: What advice would you give to pension funds who do decide to invest in hedge funds?

SL: Frankly, every pension fund should consider the asset-weighted returns in my view and ask from that if hedge funds have a useful role in their portfolio or not. There are some great hedge funds but it's a huge challenge to build a portfolio out of them.

The analysis shows that hedge funds performed well in the past when small. Pension funds just aren't going to get the results that they want in these massive industrial strength $20 - $30bn funds.

I asked people at a roundtable event recently what returns they expected from hedge funds and 7%, the figure the industry likes to promote, was a popular view. Well, if you want those kind of returns the industry would need to post record returns year-on-year. And as an investor I wouldn't count on that.

Having said all that, it's true a couple of well-selected hedge funds could benefit a pension fund.

Important things to do in any hedge fund selection process are negotiating for optimal returns, lower fees and transparency. All that should ensure investors get better outcomes and better rights in their dealings with hedge funds.

PFI: UK pension funds on the whole have increased their exposure to hedge funds from 1.8% to 4.1% in the last two years (according to the National Association of Pension Funds), as part of a general rise in 'alternative' asset investments (up from 10.3% in 2010 to 17% in 2011 according to Pension Funds Online). Does that not indicate that many hedge funds are doing well and impressing pension fund investors?

SL: There are some great hedge funds out there but in general it seems to me that pension funds have been won over by the fairly simplistic analysis of average annual hedge fund returns beating those from fixed income and possibly equities.

I'm sceptical whether the absolute return industry really has that much absolute return to deliver.

PFI: What alternative would you recommend to pension funds that have become interested in allocating to hedge funds when looking for some alpha in recent years?

The equity risk premium is very wide at the moment in the US, and I imagine that the same would be true in the UK. There is a pretty strong case for investing in public equities – the fact that they have underperformed for ten years just means that they have generally grown book value without going up in price.

So as a pension fund trustee I would be at the upper end of my allocation band for equities. I'd be underinvested in fixed income because bond yields in every industrial country are grossly distorted by central bank activity.

It's a challenge of course, especially for all the pension funds that are seeing their funding deficits widen. Pension funds are investors with some of the longest time horizons though and they are supposed to look for the best long-term returns possible.

dbillingham@wilmington.co.uk