Why Today’s Hedge Fund Industry May Not Survive

An interesting take on money managers in general, and hedge fund managers in particular.

March 18, 2008
Financial Times
Why today’s hedge fund industry may not survive
By Martin Wolf

Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap.

Getting away with producing adulterated milk is hard; getting away with an investment strategy that adds no value is not. That was the point made by John Kay, in a superb column last week (this page, March 11). With the “right” fee structure mediocre investment managers may become rich as they ensure that their investors cease to remain so.

Two distinguished academics, Dean Foster at the Wharton School of the University of Pennsylvania and Peyton Young of Oxford university and the Brookings Institution, explain the point beautifully*. They start by asking us to consider a rare event – that the stock market will fall by 20 per cent over the next 12 months, for example. They assume, too, that the options market prices this risk correctly, say at one in 10. An option costs $0.1 and pays out $1.

Now imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.

There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.

The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. 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 immediate response may be that so naked a scam is inconceivable. Well, imagine a fund that leverages investors’ money by borrowing massively in short-term money markets in order to purchase higher-yielding paper. Assume, again, that the premium gives a correct estimate of the risk. With sufficient leverage, this fund, too, is likely to make profits for years. But it is also very likely to be wiped out, at some point. Does this strategy sound familiar? It certainly should by now.

We can identify two huge problems to be solved. First, many investment strategies have the characteristics of a “Taleb distribution”, after Nicholas Taleb, author of Fooled by Randomness. At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.

Second, the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit.

Professors Foster and Young argue that it is extremely hard to resolve these difficulties. It is particularly difficult to know whether a manager is skilful rather than lucky. In their telling example, the chances are more than 10 per cent that the fund will run for 20 years without being exposed. In other words, even after 20 years the outside investor cannot be confident that the results were not being generated by luck or a scam.

It is also tricky to align the interests of managers with those of investors. Obvious possibilities include rewarding managers on the basis of final returns, forcing them to hold a sizeable equity stake or levying penalties for underperformance.

None of these solutions solves the problem of distinguishing luck from skill. The first also encourages managers to take sizeable risks when they are close to the return at which payouts begin. Managers can evade the effects of the second alternative by taking positions in derivatives, which may be hard to police. Finally, even under the apparently attractive final alternative it appears that any clawback contract harsh enough to keep unskilled managers away will also discourage skilled ones.

It is obviously best not to pay the manager, as a manager, at all, but rather to invest alongside him, as at Berkshire Hathaway, Warren Buffett’s investment company. But we still have the challenge of knowing whether the manager is any good. We know this today of Mr Buffett. Fifty years ago, that would have been very hard to know.

What we have then is a huge “lemons” problem: in this business it is really hard to distinguish talented managers from untalented ones. For this reason, the business is bound to attract the unscrupulous and unskilled, just as such people are attracted to dealing in used cars (which was the original example of a market in lemons). The lemons theorem states that such markets are likely to disappear. The same may happen to today’s hedge-fund industry.

Now consider the financial sector as a whole: it is, again, hard either to distinguish skill from luck or to align the interests of management, staff, shareholders and the public. 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.”

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 next time and the time after next?
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5 thoughts on “Why Today’s Hedge Fund Industry May Not Survive

  1. I believe the hedge fund industry is so diverse in strategy and geographical focus that it would take a total financial meltdown to seriously threaten their existence and because of their low regulatory hurdles and ability to trade quickly they would probably survive longer than many investment banks could.

    The press has always predicted the demise of hedge funds, and we might see a bit of a run on them this fall/winter but I believe they will always be around.

    – Richard
    Richard Wilson

  2. Hi Richard,

    I think the article was talking about “today’s” hedge fund industry. I.e., the way it is “today.” I.e., in its current form.


  3. Financial Times article:

    “US hedge fund suffer heavy withdrawals”
    By Deborah Brewster and Henny Sender in New York

    Investors pulled at least $43bn from US hedge funds in September as market turmoil led to unprecedented withdrawals, an analysis by a leading research house shows.

    The data from TrimTabs Investment Research – which was to be sent to clients late on Wednesday – come as hedge funds are working to prevent far bigger redemptions by the end of the year, when many funds give investors a chance to take out money.

    Withdrawals can lead to a vicious circle in the markets, as funds sell holdings to return money to clients, depressing prices and prompting further redemptions.

    To prevent such an outcome, some hedge funds had offered to suspend fees if investors kept their money in until March, said Marc Freed, of Lyster Watson, which invests in hedge funds on behalf of institutional and private clients.

    “Every investor fears other investors will pull their money and so they worry they will be at the back of the line if they don’t also pull,” Mr Freed said.

    “Nobody will invest in anything illiquid because they think they may not survive long enough to see them rise in value.”

    A fundraiser for a major hedge fund said the period “between now and December 1 is a sort of death march” for the industry.

    The chief executive of a leading alternative investment manager said he expected the hedge fund industry to shrink by 50 per cent in coming months – with half the decline coming from withdrawals and half coming from investment losses.

    Conrad Gunn, chief operating officer of TrimTabs, said the $43bn in September withdrawals would mark “the beginning of what we expect to be a series of outflows for the remainder of the year. We expect October outflows to be larger”.

    Mr Gunn said the September outflows were based on an analysis of preliminary data and that the final tally would probably be higher because funds with heavy redemptions tended to report data later.

    The industry, which manages close to $2,000bn, has experienced outflows during only a handful of months previously, including a small outflow in April of this year.

    JPMorgan Chase has estimated that hedge fund outflows could total up to $150bn over the coming year. As investors take their money out of hedge funds, the funds have to sell assets.

    But because they use so much borrowed money, the amount of potential asset sales is far larger. For example, JPMorgan expects that an outflow of $150bn will lead to sales of about $400bn.

  4. Oct. 25 (Bloomberg) — Hedge funds are aggravating the worst market selloff in 50 years as they dump assets to meet investor redemptions and keep lenders at bay.

    U.S. hedge-fund managers may lose 15 percent of assets to withdrawals by year-end while their European rivals shed as much as 25 percent, Huw van Steenis, a Morgan Stanley analyst in London, wrote yesterday in a report to clients. Combined with investment losses, industry assets may shrink to $1.3 trillion, a 32 percent drop from the peak in June.

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