EUROPE - A book reviewed by the London Financial Times' chief leader writer as a "devastating exposé" of the hedge fund industry and "required reading for pension fund trustees" has had its "methodological, mathematical and factual errors" severely criticised in a paper from the Alternative Investment Management Association (AIMA).

"The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to be True", by Simon Lack, a former JPMorgan hedge fund seeder and founder of investment management boutique SL Advisors, was published earlier this year to what AIMA chief executive Andrew Baker called "uncritical and gushing reviews".

"Many of the most sensational claims appeared not to be backed up by any figures," said Baker. "Where there were figures, the methodology was flawed. We noticed no-one praising the book appeared to have actually checked the numbers behind it."

The new paper, written by AIMA's research committee in conjunction with "leading academic experts on the industry" such as Thomas Schneeweis, professor of finance at the University of Massachusetts-Amherst and founding editor of the Journal of Alternative Investment, sets out to rebut six of Lack's major claims.

One of the central claims of Lack's book is that 'dollar-weighted' returns are a better measure of performance than 'time-weighted' returns - and that 'dollar-weighted' returns make hedge fund performance since the late 1990s look much worse than what investors see in the published indices.

But while these numbers go some way to illustrate one of Lack's major themes - that hedge funds find it difficult to maintain returns as they grow larger - they distort the picture much more significantly by telling us more about hedge fund investors' 'buy-high, sell-low' habits than about the skills of hedge fund managers themselves.

As AIMA points out, Lack's methodology directly contradicts the recommendation of the Global Investment Performance Standards (GIPS), which strongly advocates 'time-weighted' returns to remove the effects of cash flows, which GIPS guidance notes are "generally client-driven".

Lack himself lays blame at the feet of hedge fund investors for "performance chasing".

Lack's book opens with the claim that the investors who had put their money into hedge funds would have achieved twice the level of returns if they had simply parked it in US Treasuries.

AIMA's paper observes that the claim is never supported by "clear figures", and, using the same core data and time period of 1998-2010, which includes 'dollar-weighting', finds that hedge fund investors ended up 44%, while Treasury buyers would have ended up 23%.

AIMA further claims that Lack unfairly understates hedge fund returns by picking one of the worst-performing hedge fund indices (HFRX) and "arbitrarily" cutting an additional 3% from annual returns to account for various index biases - despite what AIMA characterises as recent academic consensus suggesting these biases tend to cancel one another out.

A further claim in the book - that hedge funds failed to beat a simple 60/40 portfolio - is criticised by the AIMA paper not only for understating hedge fund returns, but for assuming that investors treat hedge funds as a standalone investment rather than a portfolio diversifier.

An equal-weighted equity, bond and hedge fund portfolio "significantly outperformed a conventional 60/40 strategy between 1994 and 2011, and did so with a lower tail-risk", the paper argues.

The book's claim that "almost all the profits" of investing go to managers rather than investors is criticised for confusing profits with gross revenues and for excluding the risk-free rate from hedge fund returns when calculating fees.

A previous study from AIMA and Imperial College London calculated that investors keep 72% of returns while 28% goes to managers.

But perhaps the most devastating rebuttal is of a section of Lack's book that claims hedge fund managers report positive returns even as their investors lose money.

The example given is of an investor who puts $1m (€810,000) in a fund that has a +50% return in a single year, and then adds another $1m in year two, when the fund is down 40%.

Net, the investor has lost 25% of his money, and the fund will report a compound average annual growth rate of -5.13%.

"But the book says that the fund will report +5.13% and bases its whole case against hedge funds on this figure," the AIMA paper observes.

When head of risk at AQR, Aaron Brown, pointed this out in a detailed Amazon website review in January, Lack blamed an "unfortunate typographical error".

On the website of SL Advisors in July, Lack claimed that "most of the feedback I've received from the industry has been positive" and that "even those who disagree with me (such as the London-based lobbying group AIMA) have struggled to produce a convincing rebuttal involving numbers".

Baker at AIMA said: "We are not of the view that the industry should not be criticised. There are many legitimate grounds on which to do so, and indeed AIMA itself has worked since its inception in 1990 to raise industry standards through its sound practices work.

"All we are saying here is that the main claims made in 'The Hedge Fund Mirage' do not stand up to rigorous examination."

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