Hedge fund wizards

by on March 15, 2008 at 6:55 am in Economics | Permalink

By Dean Foster and H. Peyton Young.  They fear that hedge fund managers can write a series of naked puts with high probabilities of above-average returns and low probabilities of extreme disaster.  Most of the managers will establish track records and attract more funds.  They gain on the upside but don’t lose that much on the downside.  The key problem is that investors judge investors on the basis of observed past performance, not the entire probability distribution they have created.  Yet the latter is what we all end up having to live with.

infopractical March 15, 2008 at 8:20 am

This problem was being discussed a decade ago during the LTCM collapse. Some of the funds that blew up in its wake were put sellers.

There are two possible solutions:

(1) An oversight body that looks at every hedge fund portfolio (even constantly as it changes) and applies its own subjective probabilities. (Sounds like nothing but an invitation of gross government corruption), or

(2) Do something about the primary flaw with the hedge fund system: incentives are extremely top-heavy, meaning that all you need is a single unethical jerk capable of hiring underlings who don’t know, don’t yet fathom, or aren’t yet close enough to the problem to care about the ethics involved.

The barriers of entry that require investors to be rich, and that the hedge funds have X amount of money in order to make certain kinds of investments (regulation T for instance) keep traders from competing with their hedge fund bosses. This makes the primary skill for running a hedge fund…knowing rich people. Quickly, an incumbent system develops with some very bright fund managers, and some who just want to make big bucks like their bright rivals.

And there’s no downside for the fund managers. In fact, there is little flat side. Do well one year and you have enough money to live on for the rest of your life.

There is a lot of good to the hedge fund world, but to ignore this aspect of the system is crazy and encourages the worst kinds of politics and ethics to dominate more and more.

Anthony March 15, 2008 at 8:59 am

“Eliminating such scams through regulation is not going to be easy due to the unusual nature of the product. Yet, some steps toward protecting investors can — and should — be taken.”

Nah, no steps need to be taken to protecting investors. If a bunch of stupid greedy rich people want to throw away their money on excessive management fees, that’s their problem. I don’t care how smart the hedge fund manager is, you can’t justify a “2 and 20″ fee arrangement, especially not in today’s low interest rate environment. As far as I’m concerned, I’d support “a rising tide of failed funds [which] cause a collapse in [hedge fund] investor confidence, putting both the good and the bad wizards out of business.”

If a hedge-fund manager is providing a legitimate research service, there’s no reason not to start a normal corporation and sell the service. Well, except for the tax loophole where hedge-fund managers can report their “carried interest” as long-term capital gains. So I guess I was wrong that no steps need to be taken to protecting investors. One step needs to be taken. Close the hedge-fund manager tax loophole.

Anthony March 15, 2008 at 9:27 am

“What would the [e]conomy look like without hedge funds”

It wouldn’t look any different. Arbitrage and efficient allocation of capital would still happen, it just wouldn’t happen through hedge funds. Rich people would just hire smart people to find arbitrage opportunities and to manage their money directly.

Of course, those smart people would now have to pay ordinary income taxes and payroll taxes on their earnings, instead of long-term capital gains taxes, so in that sense I guess the economy would be improved, because either the tax rate on everyone else would go down or the budget deficit would.

Bob Murphy March 15, 2008 at 9:44 am

Are we all agreed that the single worst thing the government can do, if indeed these skewed incentives exist, is to bail out firms when the “low probability” events occur? That seems an obvious way to make investors learn to care about more than simply past performance, regardless of risk.

The Epicurean Dealmaker March 15, 2008 at 10:07 am

Oh, and Tyler, the strategy Foster and Young outline cannot properly be described as writing “naked puts.” Their downside due to option exercise is strictly defined, not unlimited, and their hypothetical manager has actually provided funds to cover the full amount required by potential option exercise by putting T-bills in escrow. If they lose the bet, at least they can cover the fund’s obligations.

As strategies go, this is not totally insane or completely irresponsible. An irresponsible or fraudulent manager would not put (all of) those funds in escrow but would instead commit them to other strategies, like leveraged investing in CDOs. Whoops.

Chuck March 15, 2008 at 11:08 am

“There is an easy and effective way to guard against such behavior: simply require the hedge fund manager to reinvest the bulk of the 20% profit sharing returns he (or she) earns back into the fund.”

Most funds already do this voluntarily.

” (The 2% management fee could cover fund operating expenses and provide current income to the manager and his staff.)”

Most funds already do this.

“There are variations on this idea which can reinforce positive fiduciary behavior in the manager, like maintaining a “high water mark” for the fund, ”

Most funds already do this.

“You could also stipulate that managers cannot withdraw their invested capital before investors do: ”

Most funds implement some variation of this.

Interestingly, whether this last feature is actually good for investors is far less clear than you make it sound. [To take an extreme case, would you want every CEO to be invested 100% in his own company while the investors hold diversified portfolios? Wouldn’t the investors want the CEO to be willing to take *some* risks?]

infopractical March 15, 2008 at 11:24 am

I think that those responders who are suggesting that there are no pros to weight against the cons of the hedge fund world have probably never seen a spreadsheet for a hedge fund strategy from a good quantitative fund. The success of a strategy depends on many variables, and outside of hedge funds, legality prevents other investment vehicles from meeting those variable requirements.

For instance, without a certain amount of leverage, many large bond box trades (long vs. short bond swap spreads) could not be carried profitably.

Granted, we could solve this problem by relaxing some regulations on other types of funds, removing the need for hedge funds. But regulators have been unwilling to do that historically because of “risk to investors who cannot afford it.”

It’s almost never the case that a story is one-sided. Whether hedge funds stay or go, there are some aspects of them that should be preserved because they are valuable.

st4rbux March 15, 2008 at 5:02 pm

Anthony “…I guess the economy would be improved, because either the tax rate on everyone else would go down or the budget deficit would.”

Or government spending would increase, the economy would be no better off, and your least favorite politician would secure their seat for life having cut the Evil Hedge Fund Managers down to size.

Paul N March 15, 2008 at 9:47 pm

The authors echo exactly the point I have always made about hedge funds.

I feel no pity for people who think they can beat the market by picking the right hedge fund. And when the hedge fund craze is over it’ll be the next big thing, same old story.

eccdogg March 15, 2008 at 10:37 pm

Actually, I think the interest of hedge fund managers and thier clients is much better aligned than that of traders in banks.

As others have mentioned many in hedge funds are required to hold a large portion of thier bonus in the fund so they no longer own the hypothetical put.

In fact both the economist and the wall st journal have pointed out that hedge funds have weathered the recent storms rather well. Their was a the hiccup in the quant funds earlier, but for the most part the industry has done well. One reason that both articles pointed to is that the interest of hedge fund managers are BETTER aligned than those of investment banks.

Johan March 17, 2008 at 12:50 pm

Do Foster and Young cite Taleb as a reference? Because if they don’t I think they owe him an apology. Fooled by Randomness was a bestseller, and this is possibly the most central point of that book.

Taleb talked about risk exposure in financial markets with poorly defined performance-based pay in general, and not about hedge funds specifically, but I do not see how that adds anything to the analysis.

michael e sullivan March 19, 2008 at 12:39 pm

Oh, and Tyler, the strategy Foster and Young outline cannot properly be described as writing “naked puts.” Their downside due to option exercise is strictly defined, not unlimited, and their hypothetical manager has actually provided funds to cover the full amount required by potential option exercise by putting T-bills in escrow. If they lose the bet, at least they can cover the fund’s obligations.

yes, but this still is at least skating around defrauding the investors. How many investors would sign onto this plan and payment schedule knowing the details of how these high returns are being achieved, and that the real expectation of the strategy is only the 4% baseline.

Yuan April 11, 2008 at 2:20 am

The only reason that hedge funds are unregulated and blatant fraud is allowed to continue is because of the lobby money and cozy relationships that hedge fund interests have on Capitol Hill. That’s all there is to it. Protecting investors, enforcing entry barriers or even existing laws do not apply if it interferes with the cash flowing into hedge funds. Everyone else is expendable.

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