Yesterday's FT published an excellent article on the hedge fund compensation structure and the alignment of interests - or lack thereof - between investors and managers. The title? "Why today's hedge fund industry may not survive".
The argument is simple - start a hedge fund selling options against the unlikely event that the stock market (or any other asset) will fall significantly. Since the odds of a crash are slim, there is a very good chance that the hedge fund strategy will be profitable for a number of years. Eventually, though, the "unlikely" meltdown will take place and the strategy will lose most or all of its capital.
Thanks to 2 and 20, each year the strategy survives, the hedge fund manager gets the 2% management fee as well as 20% of the gain. As the FT notes, "whatever subsequently happens, we never need give this money back....In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money."
The article highlights three problems:
- Many investment strategies have a high probability of a modest gain and a low probability of huge losses in any period. This is, of course, Nicolas Taleb's Black Swan argument.
- Because of 2 and 20, money managers have a clear incentive to exploit these return distributions for their own benefit.
- Because the low probability loss event may not happen for a number of years, it is exceptionally difficult to differentiate true investment skill from sheer luck.
The FT concludes with the following remarks:
"It is in the interests of insiders to game the system by exploiting the returns from higher probability events. This means that businesses will suddenly blow up when the low probability disaster occurs, as happened spectacularly at Northern Rock and Bear Stearns.
Moreover, if these unfavourable events - stock market crashes, mortgage failures, liquidity freezes - come in stampeding herds (because so many managers copy one another), they will say "nobody could have expected this, but, now that it has happened to all of us, the government must come to the rescue."
(As an aside, conventional wisdom suggests that if a hedge fund manager blows up, there is no way back - investors will not give the manager a second chance. However, this theory is about to be tested: if a lot of managers blow up at the same time, will investors accept the argument that "well, this happened to everyone due to unforeseeable and utterly exceptional market conditions. This was an (insert large number) standard deviation event. The strategy remains fundamentally sound, though, and we won't make the same mistake twice. As such, you should give us money in our new fund which has a reset high water mark.)
Finally, the FT comments:
"The more one believes this is how an unregulated financial system operates, the more worried one has to become. Rescue from this crisis may be on the way, but what about the next time and the time after next?"
Sobering stuff.
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