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Why Hedge Funds Destroy Investor Wealth

August 7, 2012

by Michael Edesess

Mr. Lack’s other enlightening insights

Because of Mr. Lack’s once-central position in the hedge fund industry, he is able to shed light on some interesting questions. There are too many to relay them all here, but I will highlight one – the central position of large banks like JPMorgan and why they are able to make so much money.

Mr. Lack’s job at JPMorgan, during the period he recounts in the book, was to select promising hedge fund managers for JPMorgan to invest in. The process is called “seeding” a hedge fund – if a hedge fund manager wants to start a fund, or accumulate more assets for a small fund that is already launched, the manager can go to JPMorgan (and other seed-funders) to try to get one of them to seed the fund with a substantial investment. In the case of Lack’s operation, the seed funding was $25 million, which it would invest to help a fund get started with a pool of assets. In return, JPMorgan would receive 25% of the fees levied by the fund. If the fund was successful, JPMorgan’s share of the fees often dwarfed whatever it earned in investment returns on its $25 million seed investment.

Meanwhile, a large bank that seeds a fund can introduce the fund to its clients and prospects – thus lending the fund an imprimatur that enables it to attract investors much better than it could without the backing of the bank’s brand.

This introduction process that some banks practiced, known in the industry as “cap intro,” has to be handled with great discretion. Lack says in his book: “The regulations around hedge fund marketing and the legal liability for the banks are both so onerous that everybody involved signs forms agreeing that no actual marketing is going on, that nobody’s recommending anything, and that hedge funds are very risky.”

As long as it abided by the legal restrictions on hedge fund marketing, a bank can leverage its brand to sell hedge funds that it has seeded to its clients, then reap enormous fees in return. (Few are aware that Harvard’s endowment fund, managed by Harvard Management Company, also benefits from similar seed-funding practices.)

It should be readily obvious what a conflict of interest this represents, as well as what enormous profits.

Then what should investors do?

Lack believes that, although to invest in hedge funds you need to be an above-average selector of managers, consistently picking good managers is extremely difficult – not least because there is so little return persistence. He says he can’t really offer any “formula” for that, though he says smaller funds are generally better, and investors should be willing to invest in less-common strategies. He also believes diversification among hedge funds does not make sense, because it dilutes results.

“Selecting simply the best 2-3 funds one can find may well be the best approach,” Lack told me when we spoke. “In response to the obvious charge that this is far too concentrated and therefore foolhardy, the response is that the overall hedge fund portfolio must be correspondingly smaller. Rather than 10% of an institution’s portfolio in 20 hedge funds, they should be thinking in terms of 2% in just two or three. This fits in with the notion that the industry is just too big to generate the returns today’s investors expect.”

Lack’s account is of a hedge fund industry containing many extraordinarily smart people. His indictment is not of the intelligence of the participants, or their ethics, just of the results. “It’s tempting to condemn hedge fund managers as representing the worst excesses of Wall Street,” wrote Lack in his book. “Few would argue that the efficient allocation of capital requires the creation of today’s hedge fund fortunes in order to be carried out effectively. But that philosophical question is for others. Investors are all voluntary clients. Hedge funds are meeting a clear demand from the market.”

The emphasis is my own, not Lack’s. I would argue that, quite the contrary, those who meet the market’s demand have a responsibility to debate that very question, and to inform their clients if what they are demanding is not in their interest. Consultants who are supposed to have their clients’ interests at heart too often tell the clients what they expect to hear – that they should invest in hedge funds, for example – even though they may know that their advice is unlikely to benefit the client. But, as Lack writes, “There’s little demand for consultants or advisers who profess skepticism, and no doubt those individuals who do simply make their careers elsewhere.”

Perhaps the industry needs to reform itself en masse and agree to start telling clients the truth.

Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment and sustainable development fields. He is a Visiting Fellow at the Hong Kong Advanced Institute for Cross-Disciplinary Studies, as well as a partner and chief investment officer of Denver-based Fair Advisors. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler.