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Opalesque Futures Intelligence

Opalesque Exclusive: An Academic Response to the "Hedge Fund Mirage" (Part I)

Thursday, December 13, 2012

Mr. Schneeweis answers hedge fund critic Simon Lack with a new white paper. The first of a two part series.

Editor's Note: In our last issue of Opalesque Futures Intelligence we conducted an interview with Simon Lack, who authored the book Hedge Fund Mirage (Wiley, 2012).‚  Mr. Lack made the assertion that hedge fund stated performance may not be all that it appears.‚  In this article, Mr. Schneeweis and Mr. Kazemi essentially argue that the alternative investment industry has been growing and is a viable method for investors seeking returns uncorrelated to the performance of the stock market.

By Thomas Schneeweis and Hossein Kazemi


While it is impossible in a short synopsis to convey all the pros and cons of hedge fund investment, every three or four years, an article or book appears which attempts to paint the hedge fund industry with a broad brush of poor performance and that the rise in assets under management (AUM) in the hedge fund industry could therefore only be accomplished through a range of investment scams or marketing trickery. Given the sophistication of the investment industry, even in an imperfect information market, the very fact that over the past twenty years estimated AUM in the hedge fund industry has reportedly grown from under $100 billion to over $2 trillion is indicative that many investors view the strategies which are included under the hedge fund umbrella as beneficial in their expected return/risk management decisions.

Despite the seeming demand by investors for hedge funds, critics of the hedge fund industry still attempt to prove that hedge fund investors have been sold a product that has not provided real benefits. A recent attempt is "Hedge Fund Mirage" by Simon Lack (2012). The author maintains that the picture of hedge funds benefiting the average investor is biased by the fact that the relatively higher performance of hedge funds in the 1990's had fewer investors at least as measured by industry AUM. He maintains that if we used performance measures which considered hedge fund industry AUM, the average investor's relatively poor performance in recent high AUM years would dominate the relatively superior hedge fund performance in earlier low hedge fund AUM years and that hedge fund's benefits to the average investor may even have disappeared. He also emphasizes the performance fees charged by hedge fund managers as a potential source of poor hedge fund returns and compares the yearly 'real' net profits by investors to estimated gross profits by hedge fund managers.

In this brief report, we provide additional analysis of the benefits of hedge funds over the period of analysis. It is shown that 1) if one uses any of the more traditionally used hedge fund indices (including both Equal Weighted and Asset Weighted Hedge Fund Indices) while using the IRR method and benchmark comparison (risk free rate) suggested by Lack, the results shows that the Internal Rate of Return (IRR) of all of these more traditionally used hedge fund indices are greater than the comparison risk free rate and 2) if‚  one uses any of the more traditionally usedmeasures of performance and uses more traditional hedge fund indices (including both Equal Weighted and Asset Weighted Hedge Fund Indices) as well as the book's own preferred HFRX Global Asset Weighted index, hedge funds are shown to be‚  beneficial additions to a traditional 'diversified' stock and bond portfolio in almost every year of analysis (e.g., regardless of the level of estimated hedge fund industry AUM).

In short, using the author's suggested return methodology and benchmark, results based on traditionally used hedge fund indices show benefits to the average investor and moreover, if one has concerns as tothe book's methodology for judging the benefits of hedge funds, results also show that looking at hedge funds on a year by year basis further indicates the benefits of hedge funds over the period of analysis regardless of the level of AUM; that is, a hedge fund benefit 'win/win' under either analytical approach.

Lastly, the author also raises the issue of hedge fund manager profits as a source of market concern. To some, the positive benefit of hedge fund as additions to a sample stock/bond portfolio in every year of this analysis makes the gross profit of individual hedge fund managers moot. This is up to one's personal opinion. Regardless of the product, (financial, consumer, manufacturing), if an investor is receiving a positive benefit from owning a product, the net profit to the creators of the product may be regarded of secondary concern.‚  More importantly, what is presented in the book is not 'net profit' to hedge fund managers but 'gross profit'. Any discussion that concentrates on the gross profit of hedge fund manager s relative to the net profit of an investor is somewhat meaningless. Gross profits are a measure of gross revenue. In order to determine actual net profits to a hedge fund, one must remove all costs (operational, research, staff, travel, research...). Only then can one compare net profits to investors with net profits to hedge fund managers and the relative returns to each. This is impossible to do without detailed fund operational cost data. Again, gross profits as a measure of returns to hedge fund manager does not and cannot represent the actual profits to a hedge fund manager any more than gross revenue to a corporation represents the net profits to the firm. The author of "Hedge Fund Mirage" does not have the net profits to hedge funds but such data is required before true comparisons between net profit to investor and net profit to hedge fund manager can be made.

Hedge Fund Research: A General Review

Before getting into several of the specifics of issues raised in "Hedge Fund Mirage", we all should be reminded that:

  1. Hedge funds are generally regarded as investments vehicles that offer risk and return opportunities not easily obtained through traditional long-only stock and bond investment vehicles. Such unique investment opportunities are made possible primarily through the ability of hedge funds to participate in a wide variety of financial instruments and global markets not typically available to the traditional investor, as well as through the hedge fund managers' ability to take both long and short positions in a wide variety of security markets. Lastly, since they are not designed to directly track any individual long only investment benchmark (e.g., S&P 500), hedge fund managers have greater flexibility in both internal asset allocation as well as investment strategy and are therefore capable of benefiting from a broader universe of profit opportunities within various economic environments. They are often structured as privately pooled investment vehicles that employ varying degrees of leverage and often charge a performance fee.

  2. Most hedge fund strategies there are not absolute investment products that are designed to make money in all market environments. As discussed below, each hedge fund strategy has unique security exposures (equity long short is often exposed to equity market movements and distressed security based hedge funds are exposed to changes in credit risk). What most hedge funds do (depending on the strategy involved) is offer the potential for downside protection in equity/bond market declines while offering upside participation in periods of positive equity/bond market movement.

  3. Results based on a single historical time period is a sample of one and should not be used as a simple case for/or against investment in anyasset class or investment strategy. I never invested in a manager who could not tell us the simple basis for the construction of his current portfolio (and if that construction process differed from the past) and in what market conditions his current portfolio would lose money even if it never lost it in the past. In regard to past data, what was important (especially for funds for which I did not have daily positions) was that the fund lost money when it should and made money when it should. It has always amazed us to the degree that some academic research promotes the idea that hedge fund managers have daily or even monthly flexibility to change their portfolio's composition dramatically as if they were active 'daily' discretionary traders.

  4. Composite hedge fund indices may offer little as to the actual or expected performance of any individual investor. The hedge fund industry has evolved dramatically over the past twenty years. While discussed in greater detail later in this presentation, focusing on the returns of a composite index for which the underlying strategies and investment in those strategies have changed dramatically, offers little evidence as to the underlying benefits of the "universe of hedge funds' over time except under the most restrictive of assumptions as to investor behavior and investment. In short, most hedge fund indices reflect the performance of a "non-investible portfolio of hedge fund strategies". An equal weighted index assumes that the investor holds a hedge fund portfolio which reflects the number of reporting funds and that the investor can rebalance consistent with the measurement period of the index (e.g., monthly). An asset weighted index assumes that the investor holds a hedge fund portfolio weighted to reflect the AUM of the underlying managers and can adjust his/her portfolio to match incoming cash flows to each strategy. There is no single investor who can meet the above. What composite hedge fund indices do provide is an estimate of a "composite return' to a wide range of strategies within the hedge fund industry at a particular point in time. Individual fund of funds or individual funds will reflect the returns of the composite index only to the extent that the fund of funds or the manager's strategy reflects the composition of the historically derived hedge fund composite index.

  5. Emphasis on individual strategy based indices which more closely reflect the actual performance of a particular focused fund of funds or hedge fund manager may provide a more realistic portrayal of expected rates of return and risks across an array of market environments. However, even in this case strategies do change over time. What is necessary is to understand the conditional factors driving individual hedge fund strategies and to ensure that particular hedge fund strategies returns are consistent with the historical factors (e.g., Equity long short managers generally make money in up equity markets and Distressed Security hedge fund managers perform well in declining credit spread conditions).

  6. One should not look solely at returns of the entire industry as reflecting the pros and cons of the entire industry or that of an average investor. A wide range of individuals/institutions hold a wide range of hedge fund strategies for a wide range of reasons (to lower risk, to enhance return...).Nor should one look at the benefits of hedge funds based solely on historical returns and risk. For example, looking over a past period of superior bond or stock returns (falling bond yields or low equity volatility)tells us nothing about how a portfolio of hedge funds may benefit bond or stock investors in a ‚ forecasted period of increasing interest rates or stock market volatility. Lastly, given the varying risk exposures of any individual investor, the benefits of hedge funds in general, or a strategy in particular, is investor specific.

  7. The form of the return estimation should be consistent with the analysis conducted. If one is using monthly data to create a portfolio which is designed to reflect the actual historical conditions or to test the conditional impact of market factors on hedge fund return, then the use of monthly rates of return is generally recommended. If one attempts to estimate the return by which a $1 investment grows to its final value over a period of time, then a geometric rate of return is often used. If one wishes to reflect an investor's individual changing investment level over time, an IRR return (with a host of assumptions as to the reinvestment rate) is recommended (although the weighted risk assessment requires a different form of return measurement).

Of course, all of the issues suggested in the previous paragraphs may be one level above "hedge fund 101' and authors (academic and practitioner) often are forced to present a topic in a form which makes good theater rather than boring night time reading. In short, to get readers' attention to look at some of the issues of concern one must often transform the facts. Concerning the present book, our concerns are over some of the facts that have been transformed. There are many other issues discussed in this book, some of which, such as the benefits to investors of increased transparency, are valid concerns. It is a little disheartening that the valid parts of the book are often mixed with the fiction of hedge funds, on average, of not providing investor benefits and of obtaining excessive manager profits. In the following sections, I discuss some of the major issues raised in the book.


This is part one of a two part article.‚  To receive the full white paper on the topic, e-mail

Thomas Schneeweis Ph.D. is the Michael and Cheryl Philipp Professor of Finance and Director of the Center for International Securities and Derivatives Markets at the Isenberg School of Management, University of Massachusetts-Amherst. He is the Founding and current Editorof The Journal of Alternative Investment. He is also the co-founder of the Chartered Alternative Investment Analyst Association (, the Chartered Alternative Investment Analyst Foundation ( and the Institute for Global Asset and Risk Management ( He has published more than 100 articles in the area of investment and asset management with his current research focusing on risk based asset management and investment strategy replication. ‚ He has presented at major conferences globally, has been quoted in major financial press, and spoken on many financial news programs. He has been credited in part for the creation of asset allocation breakthroughs such as portable alpha and the development of hedge fund replication concepts.He received his Ph.D. from the University of Iowa, M.A. from University of Wisconsin, and a B.A. from St. John'sUniversity. His most recent co-authored book publications include The New Science of Asset Allocation (John Wiley and Sons, 2010) and Postmodern Investment (John Wiley and Sons, forthcoming, fall 2012).

Professionally, he has more than thirty years experience in investment management. He was associated with the creation and development of the Zurich and Dow Jones Investible Hedge fund Indices, the LMEX and Bache Commodity Indices and acted as Director of Research at Ursa Capital (one of the first managed account based hedge fund platforms). He is currently serves as an out-side trustee on the boards of several large mutual fund families. He helped found Alternative Investment Analytics (a commodity investment firm) and White Bear Partners (a hedge fund/managed futures trading firm). He is currently principal at S Capital Management, LLC ( an investment management firm specializing in asset allocation, risk management and investment strategy replication programs.

Hossein Kazemi, Ph.D., CFA, is responsible for hedge fund performance analytics and strategy replication. He is a Professor of Finance at the University of Massachusetts and is the Associate Director of the Center for International Securities and Derivatives Markets at the School of Management. He is also a Chartered Financial Analyst and has served as a consultant in the areas of asset allocation and risk management.

This article was published in Opalesque Futures Intelligence.
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