the real mirage

Last week, I finally got around to reading The Hedge Fund Mirage. It was published in 2012, so I’m only two years behind, and the book’s main message is just as valid today as it was when it was written. Namely, the average hedge fund is the last place you should even think about putting your money. The very first sentence of the book makes this point quite persuasively:

“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.”

Ouch. The book’s author, Simon Lack, goes on to explain this sorry record by proving and reproving an obvious yet little-acknowledged law of money management. I discuss it in my book, as well (available now for pre-order!): asset size is the enemy of return. Hedge funds produce much better investment results when they manage a relatively small amount of money, but those returns shrink toward mediocrity (or worse) as a fund’s assets increase.

Put simply: the more capital you’ve got under management, the poorer your investors are probably going to be.

It’s not that most hedge fund managers don’t do a good job. In one sense, they do an excellent job. They usually make themselves a whole lot of money by way of the exorbitant fees they charge. Of course, that’s not supposed to be their first priority. They’re supposed to earn their limited partners great returns in good markets and bad ones. But that gets harder and harder to do as you take in more assets under management.

It’s not rocket science. It’s a simple liquidity issue. You can’t put hundreds of millions or billions of dollars to work in smaller, less efficiently priced stocks. The only places to deploy those kinds of assets are in massive market-cap companies that are already efficiently priced, and thus unlikely to bring large returns.

Think about it: if your money manager has sucked in so many assets that he has no choice but to invest in highly liquid blue chips like Microsoft or General Electric, why should you be paying him huge fees to do so? You might as well buy those stocks yourself or, better yet, buy index funds. That’s the best way to “hedge” these days.

Of course, plenty of gigantic hedge funds have managed to post major returns over the years. You read about them all the time in the press–either for the lavish lifestyles their general partners enjoy or, increasingly, for the legal troubles they eventually get themselves into. An old money manager friend of mine used to say, “Show me somebody who manages more than $500 million and I’ll show you someone who checks his ethics at the door every morning.” That was quite a while ago. These days, he’d probably up the limit to a billion, but his argument still applies: it’s damn near impossible to ethically earn high returns on that many assets. The recent raft of insider trading and expert network cases prove my old friend’s point.

I’ve made a conscious effort to keep the size of my hedge fund relatively modest, in the $100-200 million range.  This decision has probably prevented me from earning more in fees over the years, but it’s allowed me to continue to do what I love: find and invest in smaller, less scrutinized companies. I mentioned one of these hidden gems in my last post, LGI Homes. I’m writing a longer piece on the company for Seeking Alpha, but it’s a perfect example of the kind of stocks larger hedge funds bar themselves from investing in by overgrowing their assets. It only has 21 million shares outstanding, which puts its current market cap under $400 million. Large funds simply can’t buy enough shares in a company that small to make their investments worthwhile. But these are the exact kinds of stocks that we hedge fund managers should be putting our investors’ money into.  I think LGI Homes has a good chance of doubling in the near future. Hedge funds have an obligation to bring in those kinds of returns. How else can we justify the enormous fees we charge?

I’m not saying I’m positive that LGI Homes will double, or that I’ve always succeeded in making the right investments. I’ve made plenty of mistakes. But by keeping my fund lean and capable of investing in smaller, faster-growing companies, I can wake up every morning and look myself in the mirror knowing that I have at least tried to do right by my LPs. Unfortunately, too many of my peers in the industry can’t say the same.

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