The Hedge Fund Mirage, by Simon Lack, discusses a variety of topics regarding hedge fund investing. Given the increased allocations to alternative investments (including hedge funds) by pensions and other institutional investors in recent years, this is a timely book. As a good friend and industry colleague recently said, to write a book, a person must be part entertainer. Simon Lack does not disappoint. His book is an easy read, informative in many parts, and with his obvious wit and good humor maintains the reader's interest throughout.

Mr. Lack seems to have two primary objectives with this book; to provide experienced insights about hedge fund investment, and to challenge the return profile of hedge funds. With regard to the first, Mr. Lack provides a useful overview of various aspects of hedge funds, including the pros and cons of investing with small or new managers versus larger, more established firms. He outlines industry research finding attractive return profiles for smaller managers and funds, relative to the stronger organizational infrastructures and established business models frequently found with larger managers. This potential trade-off is often debated among investors, and Mr. Lack outlines the issues well. No surprise, given his experience as a seed investor in hedge funds. The seeding business is active today, and his discussion provides a valuable summary of the rationale and economics of investing in start-up and smaller firms. I also found the discussion, spread among several chapters, regarding due diligence issues informative. However, he could have said more concerning recommended approaches to a variety of due diligence topics, including the best use of consultants and fund of funds in light of the skills or resources of different investors.

Much of the media coverage about the book relates to Mr. Lack's return analysis. Early in the book (consistent with being an entertainer), Mr. Lack states that ‘if all the money that's ever been invested in hedge funds had been put in (US) Treasury bills instead, the results would have been twice as good’. A provocative statement and a clever way to grab readers’ attention.

Having worked in financial markets for over 25 years myself, including time at the IMF, a data-intensive organization, I know that numerical analysis can be greatly influenced by the selected dataset, key assumptions, and time period chosen, so a dose of skepticism is often healthy. Mr. Lack relies in part on the work of Professors Dichev and Yu (2010) to argue that asset or dollar-weighted returns since the mid-1990s are lower than the time-series returns typically used by hedge fund managers and indices. He argues that since returns in the 1990s were often higher than in recent years, and because the industry is much larger today, fund managers should use dollar-weighted returns to better reflect the ‘average investor's’ returns.

A few thoughts. First, I generally find it worthwhile to consider a variety of methods to analyze risk/return profiles, and each tends to provide some information. However, in the asset management industry, including hedge funds, time-series returns are considered ‘best practice’ when presenting or evaluating a manager's or a fund's performance, and is in compliance with the Global Investment Performance Standards (GIPS), developed and published by the CFA Institute. The Hedge Fund Standards Board in the UK (with global investor and manager membership) and the President's Working Group on Financial Markets in the US also recommend the performance reporting standards outlined by the GIPS and the CFA Institute.

An important rationale for time-series rather than dollar-weighted data is the desire to evaluate a manager's performance record, and not the timing decisions of investors, which decisions are outside the control of the investment manager. In another recent study, sponsored by KPMG and the Alternative Investment Management Association (AIMA), where I am currently Chairman, the Centre for Hedge Fund Research at London's Imperial College found that hedge funds outperformed traditional asset classes in the period from 1994 to 2011, and did so with lower levels of volatility. This work also found that a portfolio including hedge funds and other alternative investments with traditional equities and bonds outperformed the 60:40 equity to bond portfolio of many pensions.

While I also question some of Mr. Lack's calculations and do not agree with his analysis of the 2008 market crisis, there are other points to be made about hedge fund performance and increased pension allocations to alternative investments. First, during what the book describes as the ‘golden age’ of hedge fund investing in the 1990s, high net worth individuals were the primary investors, and typically seen as seeking ‘absolute returns.’ Today, with the majority of industry capital from institutional investors, the risk/return goals are usually described as ‘higher quality, lower volatility returns,’ with active portfolio management designed in part to ‘preserve capital’ during market downturns and ‘outperformance’ realized over economic or market cycles. In addition, such investors now demand greater transparency, and more aligned portfolio liquidity and redemption terms. Mr. Lack touches upon these developments, but does not discuss them in depth, including the increased use of segregated accounts (or similar fund structures) designed to provide investors with greater transparency and control, as well to reduce co-investor risks. Finally, consistent with the ‘institutionalization’ of hedge funds, today we also witness a growing convergence of alternative investment techniques and styles (hedging, short selling, derivatives and reduced correlations) among traditional asset managers. I believe this trend is driven by investors’ desire for lower return volatility, and outperformance over multi-year investment horizons. This trend also reflects the superior business model of hedge funds and ‘hedged’ products, a conclusion I believe Mr. Lack would likely agree.

The Hedge Fund Mirage is an easy read. While I do not agree with his return analysis, which has attracted criticism from industry analysts and some academics, many parts of the book are informative of industry practices and trends. In my own reading, I frequently search for writers with views or analysis different from my own, and as noted above, such books often provide an entertaining read.