WSJ reviews Simon Lack's 'Hedge Fund Mirage'

I am not an economist by training, and certainly not a Wall Street aficionado, yet I find that I have a more informed understanding of the discipline that the average man-in-the-road in the environs here about the area of Burnt Woods (not all that far from Packsaddle), who in turn has a more common-sense approach than the Sophisticati who dwell about the major university in the nearby ‘big city’.

Yet I will readily concede that some of the more arcane aspects of the risk-driven get-rich-quick schemes (which can easily turn into get-very-very-poor just as rapidly) are just so much smoke and mirrors to me.  But I now find that I am reassured of the topic, but not through a better understanding of the methods – rather a more confirmed doubt about its transparency (so much more smoke, not so many mirrors – though strategically placed at acute angles).

It would seem that a good introduction to the topic (we are always delighted to find a source that confirms our suspicions) is addressed by George Melloan, a deputy editor of the Wall Street Journal editorial page and author of The Great Money Binge: Spending Our Way to Socialism (2009).  He in turn (the reason for this particular posting) has written a brief review of the recent The Hedge Fund Mirage: the Illusion of Big Money and Why It’s Too Good to Be True, by Simon Lack.  If you have any interest whatsoever in the topic, then the first few paragraphs should be enough to whet your appetite:

The Federal Reserve policy of holding interest rates low to minimize the cost of federal profligacy is giving managers of pension funds a multi-billion-dollar headache.  The return-on-investment targets of 7% to 8% that are structured into pension plans are beyond reach in today's artificial environment.  To redeem their promises to retiring teachers, firemen and the like, managers are risking more money with hedge funds in hope of yields higher than those on safer investments.

But that may not be a good answer.  Simon Lack, who managed a hedge fund "seeding" operation for J.P. Morgan from 2001 to 2006, certainly doesn't think so. In "The Hedge Fund Mirage," he asserts what he calls – with some justification – an "amazing" finding: "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."  In other words, don't count on hedge funds to save those pensions.

The author's facility with numbers no doubt served him well when he was scouting for hedge-fund managers who could make money for themselves and J.P. Morgan.  He provides plenty of numbers to back up his central thesis that hedge funds have been highly overrated in public discourse, mainly because a few operators like George Soros have built famously huge fortunes.  The reason that operators sometimes get filthy rich, he writes, is that they reserve for themselves the lion's share of the profits.  He asks that sardonic Wall Street question, "Where are the customers' yachts?"

Part of the value of this book is that Mr Lack provides some real numbers in an area where SEC reporting requirements are exempt, this in an industry that has grown from $143 billion in assets in 1998 to $1,694 billion in 2010, even after the crash in 2008

. . . the seeds for which were planted by federal housing policies that polluted the market with toxic mortgage-backed securities.  "In 2008 the hedge fund industry lost more money than all the profits it had generated during the prior 10 years," Mr. Lack asserts.

Melloan here cites Lack’s example of the highly personal risk in hedge funds in the case of Long Term Capital Management (LTCM) and its “Nobel laureates” (here he is referring to Robert C Merton), which crashed to the tune of some $4.6 billion in 1998 after Russia defaulted on its bonds.  (The fact that LTCM was bailed out by the Federal Reserve Bank of New York led many to warn that such action would only encourage large financial institutions to assume more risk, a prediction of which Cassandra would be proud.)

Yet investors concluded that LTCM's failure was merely a case of "very smart people with oversized egos" and continued putting money into hedge funds, fueling the industry's rapid post-1998 growth.

Oversized egos and a reliance on a white knight just begin to explain the risk:

This can be a highly personalized game, involving a bet of millions of dollars on the stock-picking ability of an individual.  There is always the danger of latching onto a fraudster like Bernie Madoff.  To avoid this hazard, Mr. Lack hired an investigator he refers to as "Magnum" to run background checks.  Magnum seemed to have an uncanny ability to lay his hands on personnel files.

A healthy streak of paranoia, Mr. Lack notes, can be important when you are picking hedge-fund managers.  That sounds like good advice for the pension-fund directors seeking an escape from their current predicaments.

Indeed.  ‘Read the whole thing’, then avail yourself of the books.