Author and former JP Morgan Director of North American Fixed Income Derivatives and Forward FX trading, Simon Lack has been providing institutional investors counsel regarding transparency, fees and avoiding the wrong alternative investments for some time. In this interview, Mr. Lack overlay's his hedge fund knowledge on the managed futures industry.
In his book The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True (Wiley 2012), author and industry practitioner Simon Lack mentions many unmentionables as he reviews the industry with a critical eye.‚ In this article he discussed his views on the hedge fund industry.‚ As a former leader of JP Morgan's alternative investment efforts, having allocated over $1 billion to various hedge funds, Mr. Lack knows the industry from the inside.‚
Mark Melin / OFI: So first off I have got to tell you I loved your book in terms of its frankness and its honesty. Do you sometimes find a little difficult to speak out on Wall Street?
Simon Lack: Well, no, I did not find it difficult at all, although I could not have done it when I was at J.P. Morgan (Mr. Lack is now independent). I did not have the time to do the research first of all and of course, they would want to approve anything that I wrote. If it was controversial I am sure it would not have come through the process. But I never thought about writing the book when I was working there anyway.
But no it is not that difficult to hold what seems like a controversial view. Especially because I have the numbers. I have the facts to back me up. So I have been pretty comfortable delivering the message and I have had just a lot of very positive feedback. I have had all kinds of people tell me I am performing a public service. Many have said "It is about time somebody told us the truth." Hedge fund managers often contact me, people I do not even know and say, "You are right, there is a lot of mediocrity in the industry." Of course, they add, my fund is different.
Mark Melin: That is always the case, "this time it's different." You wrote a great book, no doubt and you broke some ground.
Simon Lack: Well I do not need paid employment so I am not going to be looking for a job working for a hedge fund. I have financial freedom to do that; I could not have done it probably 20 years ago.
Mark Melin: If there was one central message your book was delivering to readers, in your own words what is that message in a couple of sentences or so?
"Hedge fund investors should be far more discriminating in terms of why they are investing in hedge funds and the terms on which they do. They should look for lower fees, much greater transparency and information rights and much better access to their cash, to their assets."
Simon Lack: Hedge fund investors should be far more discriminating in terms of why they are investing in hedge funds and the terms on which they do. They should look for lower of fees, much greater transparency and information rights and much better access to their cash, to their assets.
Mark Melin: Right. So side pockets you would avoid, what else would you tell investors to avoid when looking at a hedge fund?
Simon Lack: I would compare hedge funds with other things they invest in. Hedge funds provide less transparency than anything else. Investors have far greater transparency with traditional assets like equities and fixed income, particularly through separate managed accounts. Clearly with real estate funds you see what buildings you own, and in private equity the manager will tell you what companies you have invested in.
While the transparency that hedge fund investors receive is the lowest of anything else they could invest, fees are also an issue. I think that the fees particularly in a world of zero interest rates in the developed world are just ludicrous.
If the fees were cut in half, I am not sure we would miss too many hedge fund managers while investors would get a better deal. And I think that the limited partnership structure through which many investors access hedge funds is not always appropriate. For investor's accessing strategies that use public equity, separately managed accounts can definitely work. They obviously work for futures and the managed futures business. I recognize that you can't use separate managed accounts in every area; this is clearly more difficult if you are using bonds or need to use derivatives agreements. But I think that for public equities it is fine and investors then have complete access to their capital as well as complete visibility around what is being done with it.
Mark Melin: Okay well you just hit on a key point. You mentioned the managed futures direct account. Now Simon, honestly, not many people on Wall Street understand the intricacies of a direct managed futures account. I am going to be impressed if you know the structural differences between a direct account, a limited partnership fund account and a managed futures mutual fund. You would be a rare person on Wall Street even among sophisticated hedge fund managers.
Simon Lack: Well I would not go as far as to say that. I don't have much direct experience with the managed futures segregated account. I know people who are CTAs who run groups of separate managed accounts but it is not an industry I have spent a lot of time in so I could not tell you what the norm is.
Mark Melin: Okay, well, if you do not mind I would like to engage in an analysis of managed futures based on what you know and what you have available. I will outline a couple of key points and then I would like you to overlay your message in your book relative to what is known as a direct managed futures account.
Simon Lack: Okay.
Mark Melin: First let us talk transparency. In a direct managed futures account you can see the exact positions that the managers have, you can look at the margin to equity exposure and all the fees are visible, have you ever seen anything like that in an equity-based hedge fund investment?
"You can get transparency, but it is clearly not the normal model."
Simon Lack: You can get transparency, but it is clearly not the normal model. When I invested in hedge funds as the seeding business (for JP Morgan) because we could negotiate preferential terms, we really did get that type of information. But that is rare in the hedge fund industry. It would exist for big institutional clients that insist on it, but I do not know what percentage of assets in hedge funds are invested that way. But it would be, I am guessing it would be below 10% a minimum, it will be a small percentage.
Mark Melin: They get transparency. Now it is interesting because managed futures is primarily a pension fund professional investor game, I mean if you look at the distribution of assets under management, it heavily favors the institutional CTAs. So it is interesting where the CTAs who offer the direct accounts, the transparency, and most importantly the risk management are the ones that have been shown favor among the institutions. But it is not a game that at this point retail has really embraced any significant degree.
Simon Lack: Yes those institutions who invest in managed futures and get that kind of transparency might well ask themselves why they do not get the same level of disclosure with the hedge fund investments.
Mark Melin: Right now there is a debate going on about allowing investors transparency into the strategy, some want to keep it a black box others want to open up the strategy so sophisticated investors can understand where the risk is and how they can understand how performance is generated. I have been advocating is that a basic level of strategy understanding, with the knowledge of when the strategy might experience risk should be disclosed to the investor. You don't have to tell them the exact algorithms and exactly why and how trades are executed, but they should understand the strategy as it relates to market environment and macro strategy risk. What is your experience relative to hedge funds disclosing strategy risk?
Simon Lack: Well it varies a lot by hedge fund. I do not know that there is a common standard. Typically when you meet with the hedge fund manager you will review the strategy that drivers, the performance, the security selection, how a portfolio is constructed and maybe that sort of qualitative dialogue. The investor will try as best they can to derive expectations, about returns and risk, about what it is going to look like and will obviously ask that question directly. But I think that each case is probably handled in its own way. I think that that type of information is absolutely vital to investors and they should definitely have it.
The opposite reaction that you have got - a lot hedge fund managers fall into this camp ˘â‚¬â€ś brings forth many arguments against transparency.
One argument (against transparency) is managers do not want investors front running trades or even hedging out some of the trades. Such actions can be at the detriment of other investors. And of course in a transparent vehicle I can understand that is theoretically a concern.
One issue is that even sophisticated investors, when offered transparency, might not know what to do with it; it is too much data and they do not have the resources to basically manipulate the data to get any useful information out of it. And while that might very well be true, that is not a reason for not providing the transparency and I think that investors certainly have the capability should they choose to devote the resource to do analysis on set of securities and look at what the return drivers were.
Investors should be demanding and then using transparency to better understand the performance drivers of their investments.
Mark Melin: Right, great point. What are some of the other reason people give for not providing transparency?
"Fund managers are concerned because if they provide transparency to some clients everybody might expect to be treated equally. They worry about assets in short positions if their hedge strategy becomes known."
Simon Lack: Fund managers are concerned because if they provide transparency to some clients everybody will expect to be treated equally; they also worry about assets in short positions if their hedge strategy becomes known. There is always a concern about reverse engineering of the strategy since most managers feel this is proprietary.
Mark Melin: Do you find that those who are trading illiquid markets are a little more concerned about transparency than those trading liquid markets?
The reason I asked about illiquid markets is because that is a - front running than becomes a real concern. Like for instance the people who took the other side of that JP Morgan "whale trade," when transparency is given into trading on illiquid markets it can affect the bid / offers.
Simon Lack: You just have to have investors sign a NDA and make sure they understand thatit is not really in the investors interest to be doing something that is going to adverse to one of their managers anyway. And so you have the investors sign an NDA and commit not to do anything that will be adverse to the strategy. But it is only going to happen if the investors demand it, hedge fund managers are not going to offer that. And so I think it requires institutional investors say, okay this is how I invest and if you do not meet these needs I just can't invest.
Mark Melin: Exactly. If the top 20 institutional investors say "Here is an investors' bill of rights, we demand that transparency, independent audits, full fee disclosure" ˘â‚¬â€ś go down the list - institutional investors can use this as their first hurdle, the programs will open up.
Simon Lack: I think that is true. I think that is absolutely what should happen, but it is going to take the clients to push for that. So, one of the goals of my book was to provoke debate amongst the clients to be maybe more assertive. They should say here are the things we need, otherwise you do not qualify to receive money from us.
Mark Melin: In managed futures I have spoken to some of the top funds and think they don't have a problem with a certain degree of transparency so long as it doesn't expose the intricacies of their algorithms.
Simon Lack: Well, managed futures is a more generic product in terms of the operational side and the settlement. With the hedge fund industry they are dealing with multiple different sort of forms of settlement and trading, from OTC derivatives to corporate bonds with different settlement terms, and unregistered securities so that there is a much more varied set of underlying assets that they are looking at. But I think nowadays with where technology is, these are not valid excuses anymore.
I mean there used to be an expression that transparency in hedge funds is a bit like drinking through a fire hose ˘â‚¬â€ś it can be too much information at once. You know, 15 years ago if you gave investors all of the detail they would never be able to get their hands around it. And what I found, when I was taking a look at the way we were seeding hedge funds, we did have complete daily position level transparency but you do not sit everyday looking at a risk report that takes all that data. Some boil it down into smaller components. What you do with that is look at the daily profit / loss for each fund. When the profit and loss behaves in a way that is different than what you expect, then you use the fact that you have that transparency to drill down more and understand a little bit more about the strategy.
It is pretty much the same thing you do as a trading manager, and I spent many years in trading. In a bank naturally we had all of the positions of all the traders. While I did not look at everybody's position in detail everyday, I did look at the daily P&L. It's the first thing you look at. You ask the question does it match up with roughly what you knew the market did given the position that trader had, and where there are those differences, you get interested and take a closer look. This guy made more than I thought based on what risks I thought he had, let me examine that and understand why. And so you use the transparency to drill down as and when you need to, I think that is the correct way to use it.
Mark Melin: In managed futures we look at a couple of things, first off margin to equity is a key number, so we are always looking at the leverage usage relative to the strategy. There are really four primary strategies and so you match the strategy to a market environment. If for instance the market environment is of price dislocation, you are going to expect certain strategies to do well and then you benchmark that against the other strategies in the industry. And like one of the issues that we have in managed futures is a flame out. This is the same in hedge funds, but in managed futures you can kind of keep an eye on a flame out because there is a correlation between margin to equity and flame out, it is kind of amazing.
"The flame out is an issue in hedge funds, too. It's a study bias that doesn't always appear in major indices."
Simon Lack: The flame out is an issue in hedge funds, too. It's a survivorship bias that doesn't always appear in major indices. Well I mean the main issue is that reporting is voluntary and so I do not know how true that is for managed futures.
Mark Melin: In managed futures we have a couple of different indices. The widely quoted index is the Barclay CTA Index. One problem with that index is that there are some younger managers and that is where you get into study bias, when the young manager flames out and then stops reporting, that is study bias. But what I look at in managed futures are the large cap indices, it is like somewhat of the Dow Jones Industrial.
Simon Lack: You are looking at an index of the bigger CTAs then. The problem with hedge fund indexes is you get what is called survivorship bias, so people report because they want to raise money and if your returns are bad, then there is no point in reporting. And so generally I would say the consensus is that the survivorship bias in the indices tend to overstate the returns on those indices. I would not say 100% believe that, but there is a lot of academic research to show that this is the case.
So then you get back your bias which is they put a new fund in an index and then they fill in the previous year or two of returns for the process of selection there, going on that because only good funds are going to bother reporting to the index in the first place. And then you get the size issue where this is between an equally weighted versus an asset weighted index. And if small managers outperform big ones, then an equally weighted index is going to overstate the returns for the average investor. And so if you are looking to measure how the investors have done, you need an asset weighted or a cap weighted index rather like the S&P 500 because the investors are all invested on a cap weighted or an asset weighted basis overall, and so there is that issue as well.
It is a big challenge in the hedge fund industry to get good, accurate index performance numbers because funds report voluntarily and generally the biases are that the existing indices are a little on the high side. Although I have to say in my research I did not rely on that, I just took them at face value. But there is not much evidence to say that the indices are too low really.
Mark Melin: In managed futures I think the most accurate representation can be found in the large cap indexes such as the BarclayHedge BTop 50, Newedge CTA Index and the Altegris 40. These indices only include the managers that have weathered the storm. These are the largest CTAs based on assets under management, so there is not the survivorship bias issue, they are NFA members and their returns are independently audited and regulators compare returns reported to the major indices to that which is audited. So having said that, talk to me about the indices, because there have been questions about the hedge fund indices and their legitimacy.
"The hedge fund industry could do a lot worse than take a look at how managed futures works in terms of the investor disclosure and try and emulate some of those standards."
Simon Lack: As far as managed futures clients go, I think it is an example. The hedge fund industry could do a lot worse than take a look at how managed futuresworks in terms of the investor disclosure and try and emulate some of those standards.
Mark Melin: Wait, stop, hold the presses. You mean Wall Street might want to look to what is being done in the commodity industry?
Simon Lack: I mean, why not?
Mark Melin: I have been saying that forever.
Simon Lack: The division between futures and securities is really an artificial one, imposed because of the regulators.
Mark Melin: And the political one. The US Senate Agricultural Committee does not want to let go of the futures markets, but I'm told the big banks, who are having SWAPs regulated to a degree, are working behind the scenes to ultimately try and move the CFTC under the control of the financial services committee. So funny. We are starting to talk about the inside of the industry, these are the unmentionables Simon.
Simon Lack: I know. But anyway the futures industry certainly gives a lot more information than the hedge fund industry and maybe they should be the leaders on that.
Mark Melin: The country is at an interesting point and so is the futures and options industry. I'm hoping those that have a real understanding of risk management and leverage usage are given a voice.
Thanks for your time, Simon, it's always interesting.
About Simon Lack:
Following 23 years with JPMorgan, Simon Lack founded SL Advisors, LLC, a Registered Investment Advisor, in 2009. Much of Simon Lack's career with JPMorgan was spent in North American Fixed Income Derivatives and Forward FX trading, a business that he ran successfully through several bank mergers ultimately overseeing 50 professionals and $300 million in annual revenues. Simon Lack sat on JPMorgan's investment committee allocating over $1 billion to hedge fund managers and founded the JPMorgan Incubator Funds, two private equity vehicles that took economic stakes in emerging hedge fund managers. Simon chairs the Investment Committee for Wardlaw-Hartridge School in Edison, NJ, and also chairs the Memorial Endowment Trust Investment Committee of St. Paul's Episcopal Church in Westfield, NJ. He is the author of The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True, which received widespread praise from mainstream financial press including The Economist, Financial Times and Wall Street Journal. Simon makes regular appearances on cable TV business shows discussing hedge funds and investing, and is a CFA Charterholder.
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Friday, October 05, 2012
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