The Hedge Fund Mirage
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. So claims Simon Lack – a former JPMorgan executive whose job was once to help steer billions into hedge funds – in his recent book, The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True. You’d think hedge fund advocates would immediately pounce on this and refute it; but it’s irrefutable. Before taking up his approach, let me first briefly summarize some of the more blatant errors in hedge fund performance reporting that others have previously explored. An often-cited study is “The ABCs of Hedge Funds” by Roger G. Ibbotson, Peng Chen, and Kevin X. Zhu. In it, the authors find that when biases inherent in the hedge fund databases are corrected, average performance during the period 1995-2009 falls by more than 7% annually. But they consider only survivorship bias and backfill bias. Survivorship bias stems from the fact that performance data for funds that were later closed are not among the database figures. Backfill bias stems from the fact that funds that try out their strategy for a while before deciding that their numbers are good enough to go live backfill their trial performance into the database once they do. Back-end bias can also be a problem if hedge funds stop reporting after a bad month. Selection bias is difficult to assess because all the major databases, of necessity, allow hedge funds to report their performance numbers only if they want to. This means that the average performance numbers reflect only averages of self-selected, willing reporters of their own performance. However, another study (“Out of the dark: Hedge fund reporting biases and commercial databases,” by Adam L. Aiken), which used a data source untainted by self-selection found that self-selection bias alone slices 4% off of hedge funds’ average performance. When combined with the biases already mentioned, that’s enough to wipe out any trace of alpha. And yet Mr. Lack’s assertion about the relative merits of hedge funds and Treasury bills is not even based on any of these database flaws. Instead, it is a result of the fact that most hedge fund investors put their money in hedge funds only after the funds’ performance – or at least their apparent performance – was good; but funds’ performance often becomes awful after they are bloated with that new money. Lack writes, “In the first three years of the new millennium, the compounded return on the S&P 500 was -37 percent, while hedge funds (as measured by HFR Global Hedge Fund Index [HFRX]) generated a compound return of +30 percent.” We need to adjust the HFRX number way downward to account for all those biases, but it still seems justified to say of hedge funds that “from 2000 to 2002 they genuinely added value. In the years 2000-2002, however, the total dollar amount invested in hedge funds, according to BarclayHedge, averaged only about $300 billion. By 2007-2008, the amount invested was more than six times that, just in time for a negative 23% return in the year 2008. Much more money was invested in hedge funds when they performed poorly than when they performed well.