What would we think of doctors who deliberately hurt patients by prescribing dangerous and unhealthful products in order to make more money? Fortunately, the medical profession is set up in such a way that such things virtually never happen. This is not so in the financial services industry, where hazardous products are routinely sold to unsuspecting consumers.

Why are there tens of thousands – perhaps hundreds of thousands – of financial advisors who deliberately harm their clients’ financial health in order to earn more money?

The doctor analogy arises repeatedly in a new book, “Wall Street Potholes: Insights from Top Money Managers on Avoiding Dangerous Products” by Simon Lack, the author of “The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True” (which I earlier reviewed).

Perhaps the most important use of the doctor analogy in the book is this one: “Suppose a minority of doctors was prescribing medication known to be harmful? Would the rest remain silent?”

Lack’s book is partly a campaign to call out those financial advisors and consultants who prescribe financial products known to be harmful. These are the “potholes” referred to in the title. Lack does not identify the culpable advisors by their individual or corporate names, but he and his coauthors do identify a few of the products. (Several of the chapters are written by others besides Lack.)

The hedge fund pothole

Wall Street is laden with potholes, but Lack and his coauthors cover only a few generic ones. One of the most astonishing – in keeping with Lack’s previous book – is the hedge fund pothole.

Most readers of financial news must have noticed something inexplicable. For years, average hedge fund returns have been abysmal. Lack notes that the average fund and the universe as a whole has underperformed a 60/40 stock/bond portfolio since 2002 not only over the whole time period, but in every single year.

And yet, over that time period, net flows into hedge funds have been huge. They have been growing even in recent years as their underperformance has been widely publicized (not least in Lack’s earlier book).

How can this be? Whether it is an advisable practice or not, investors’ money tends to move into market segments that have performed well and away from those segments that have performed poorly. Why hasn’t this happened with hedge funds?

I knew the reason before reading Lack’s book. But I did not know it with the up-close confirmation that he provides. The Economist magazine has also been on this case for a while, though seemingly with little practical effect.

Lack points out that prior to about 2002, hedge funds were a very small investment market segment. Their investors were mainly high-net-worth individuals and families. At that time they had performed quite well.

But then, institutional investors, such as pension funds and endowments, were enticed to become hedge fund investors. I saw this process in motion when I attended a conference on hedge funds in the spring of 2005. It took place at a posh hotel on the banks of Lake Geneva in Switzerland. I wrote about this in my 2007 book, The Big Investment Lie.

At this conference a number of institutional investors were in attendance, for example an administrator of a British pension fund who gave a talk. He said that he, like other institutional investors, was evaluating hedge fund investing and “dipping a toe into it gradually.” He expressed reluctance and caution. But it came off to me more as though he were saying, “Treat me to a few more posh conferences and expensive dinners, and talk to me in Greek letters so I can impress my bosses. Then we’ll see.”

Sure enough, institutional investors did start piling into hedge funds. And they kept piling.

In the present day, a large segment of the investment money in hedge funds comes not from high-net-worth individual investors but from United States public pension funds, the kind that promise benefits to retired firemen, police and other city and state government workers.

The Economist points out that these public pension funds – unlike private pension funds, which are increasingly an endangered species – use an unusual accounting procedure dictated by the Governmental Accounting Standards Board (GASB) rules. Instead of discounting future liabilities (future pension payments) at the rate of interest on a safe bond, they discount them using the pension fund’s investment portfolio’s expected return.

Most public pension funds hire a consultant, such as Towers Perrin, Cambridge Associates or one of several others. These consultants typically assume a 7% expected rate of return on hedge fund investments. (If you want to know where they get this number, read this 2010 Advisor Perspectives article, as well as this one; hint: those consultants may not reveal its source.)