Taking Stock / As Lack would have it
Emulating America isn't always wise: Read the story of hedge funds and shiver .
His colleagues seemed remarkably unsurprised by the thesis of his book, writes Simon Lack at its end. Confronted by his hypothesis that people were better off putting their money into bonds than entrusting it to investment managers, they didn't twitch. Financial market professionals know the situation intuitively, Lack writes. Some of his colleagues were mad that he was going to write a book and blow the whistle.
There's an entire industry of investment fund managers, brokers and advisers living off capital coming into the system, he says - and there's very little demand for advisers with a skeptical outlook.
Simon Lack worked in the money-management establishment in the United States for 23 years. His book, "The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True," is the first up-close, inside look at what has become a vast global industry, and a cold look it is.
Lack spent years at the giant American institution JPMorgan, and he knows the financial industry inside and out. He knows about the clever financial instruments and mainly, he knows about hedge funds.
Two years ago he decided to examine whether hedge funds really do create wealth for investors. His intuition did not fail him: The main beneficiaries of the funds, if not the only ones, were their managers. His numbers are eye-popping.
From 1998 to date, 84% of the profits made by hedge funds went straight to their managers. Investors got the remaining 16%.
And what about that 16%? His second conclusion is that the investors would have been better putting their money into good old government bonds.
In other words, the hedge fund industry creates value for fund managers and destroys value for investors.
Lack is a financier, not an economics professor. His book is devoid of judgments about the deeper meanings of his findings, which boil down to a few hundred hedge fund managers taking home hundreds of millions or even billions of dollars a year while giving their investors nothing.
Readers with a broader perspective, however, can grasp the book's deeper significance.
Hedge funds, which manage some $1.5 trillion in assets around the world, are a machine that fleeces millions of investors for the benefit of a few thousand individuals.
Lack's findings are particularly relevant in light of developments in the Israeli and global capital markets in the past few years.
Psst! Hot tip: T-bills
First, it is simply astonishing that few people have thought to inquire into the actual performance of this gargantuan global industry. As Lack implies, brokers, advisers and even finance professors have no interest in exposing the naked truth, that hedge funds as an industry make fortunes only for their managers.
The public sees hedge funds as magical investment vehicles that handily beat the market, making much more money for investors than direct investment in the market or "safe" financial instruments such as bonds. Yet that turns out to be true only for specific hedge funds at specific times, not for the industry as a whole. On average the industry destroys wealth, or as Lack put it: "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."
His findings about hedge funds also utterly disprove the argument making the rounds that executive pay should be linked to performance.
The claim is that pension and mutual fund managers produce poor results over time because they have no incentive to do better: It won't affect their remuneration. They get their management fees whether they make you a fortune or take the shirt off your back.
The accepted model for hedge funds is a fixed management fees (usually around 2% of the managed assets each year ), plus a bite of the profit - usually up to 20%. That last part, the share in profit, is supposed to align the interest of the managers with that of investors: The managers make a lot of money if the investors do.
But that's only in theory. In practice, the managers of most hedge funds turn out to have excelled at making money only when the amounts involved were small, or the market was bullish. Their good results make them attractive. They manage to raise huge sums of money, and this is where all too many of them start racking up huge losses, especially if the market has turned bearish.
The chasm between the glittering image of hedge funds and their tatty performance is emblematic of the money management industry as a whole. Hundreds of millions of people entrust their life savings to managers at banks, insurance companies and investment funds - and hedge funds - but most have no idea if these people really will create wealth for them.Insurance executives have feelings too
One would think it the government's job to make sure the financial industry generates wealth for the public. But commonly, and certainly in the United States and in Israel, the financial industry has taken over government and tamed its watchdogs - the politicians, the regulators and the press too.
Finance Minister Yuval Steinitz and capital markets commissioner Oded Sarig seem completely indifference to the issue. Last week they met with the heads of Israel's insurance companies, a small group of people who manage hundreds of billions of shekels, all belonging to the public.
This small group had a bone to pick with the finance minister and the capital markets commissioner: They don't like being criticized for how they manage the public's money.
Instead of demanding that the insurance executives explain how they invest the public's money, or provide proof of wealth creation, Steinitz and Sarig nodded in sympathy. Steinitz may have roared like a lion to increase the government's take from the gas and oil industry, but in confronting the infinitely more powerful financial industry he hasn't so much as growled.
Israel's banking and finance sector has always had economic clout and political influence. These have become all the stronger in recent years thanks to the increase in the amount of money under management and intensified economic concentration: the domination of the economy by the few.
The United States is a particularly bad model for emulation. In 2009, the 25 best-compensated U.S. hedge fund managers earned $25.3 billion collectively.
No, that isn't a mistake. A couple of dozen men divided up a take of $25.3 billion in a single year, equivalent to the average income of half a million Americans. The superstars, like Steve Cohen, David Tepper and John Paulson, each took home up to $4 billion that year.
There's a Wall Street chestnut about a group of tourists visiting Lower Manhattan that is taken to the nearby marina, where they ogle the gorgeous yachts. "That one belongs to a bank manager," says the guide, pointing, "and that one belongs to the head of an insurance company." "Nice," one of the tourists says, "But where are the customers' yachts?"
Simon Lack's story about hedge funds, which are touted as the most sophisticated financial-management vehicle ever invented, proves once again that the customers will never have yachts. The Occupy Wall Street movement has revealed the truth in all its starkness: just now much of the total wealth is in the hands of the 1%, most of whom are in the finance business.
Yet here in Israel we are yearn to emulate that model. If we don't come to our senses now, we could reach the same straits as America, where the government, the regulators and the watchdogs are tamed, muzzled and drugged into a stupor by the guys with the yachts.