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Hedge fund wizards
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.
Posted by Tyler Cowen on March 15, 2008 at 06:55 AM in Economics | Permalink
Comments
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.
Posted by: infopractical at Mar 15, 2008 8:20:50 AM
You always get better returns by adding funds extorted from the government.
Posted by: Ron Hardin at Mar 15, 2008 8:35:14 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.
Posted by: Anthony at Mar 15, 2008 8:59:43 AM
There is a lot of good to the hedge fund world,
Maybe, but are you sure? Let's say there's some improvement in the allocation of capital because of hedge funds. Is there enough to justify the risks the funds seem to impose on non-participants?
What would the conomy look like without hedge funds, or with their activities restricted to reduce the chance of creating problems? Would the country really be worse off?
Posted by: Bernard Yomtov at Mar 15, 2008 9:09:38 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.
Posted by: Anthony at Mar 15, 2008 9:27:57 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.
Posted by: Bob Murphy at Mar 15, 2008 9:43:43 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.
Posted by: Bob Murphy at Mar 15, 2008 9:44:13 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. (The 2% management fee could cover fund operating expenses and provide current income to the manager and his staff.) With such a provision, the hedge fund manager puts his capital at risk to the same investment strategy he is providing to investors.
After the first year, the hedge fund manager will no longer have a costless "trader's option" on the return to his strategy. (You could eliminate it in the first year by having the manager invest his own capital alongside investors at the start, as well.) This will not eliminate managers and funds who undertake risky strategies, but it should mitigate against managers taking complete flyers with other people's money. It should also reduce the opportunity for fraud.
There are variations on this idea which can reinforce positive fiduciary behavior in the manager, like maintaining a "high water mark" for the fund, in which the manager's performance fees do not kick in until the investor has achieved a minimal level of return and/or recovered previous losses. You could also stipulate that managers cannot withdraw their invested capital before investors do: they could be locked in for the life of the fund, or they could only withdraw capital pro rata with other investors. Such provisions should also discourage irresponsible risk taking.
Investors could still sign up with a manager who runs a fund that places stupidly risky bets (with the hope of stupidly high returns if he is right), but at least they will feel more confident that the manager's interests are more fully aligned with their own.
Now, how you regulate this effectively is beyond me. But there is a simple solution: investors themselves should demand such provisions. If they do not, or they sign up with a manager so popular he does not have to offer such terms, then they do indeed deserve whatever they get. (Do not forget these are qualified--i.e., rich or institutional--investors, not moms and pops.) Interestingly enough, many of these features already exist at some funds. Perhaps there is less of a misaligned incentive problem here than some people think.
Such provisions, however, would do nothing to address the potentially harmful or dangerous externalities that aggressive risk taking by hedge funds might be generating in the markets. At some point, if lots and lots of funds and money are chasing similar strategies (like the picking up pennies in front of steamrollers example in the Brookings article), does that skew the proper assessment of risk for all investors? This, in the end, is the more interesting question to me, not whether investors should be protected against their own irresponsibility in handing out free options to their investment managers.
Posted by: The Epicurean Dealmaker at Mar 15, 2008 9:52:34 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.
Posted by: The Epicurean Dealmaker at Mar 15, 2008 10:07:27 AM
Sorry: one last clarification. The "set it and forget it" strategy Foster and Young describe is not only lazy but wasteful. A real active hedge fund manager would actively manage his potential option exercise liability by committing only the probability-adjusted amount needed ($110 million haircut by the probability the option is in the money) into his escrow account. He could then use the balance of his investor's funds to invest in other strategies or trades while he waits for the option term to expire.
If the trade moves against him (the probability of exercise goes up), he would have to commit more funds to the escrow account; it it moves in his favor, he could withdraw funds and commit them to other trades. This is what is known as dynamic hedging, and this--among a great number of other things--is the "work" that investors presumably pay their hedge fund managers and employees to do.
So my comment above was not strictly true. Dynamic hedging is not fraudulent or irresponsible. In fact, it is quite the opposite. It just requires careful attention, quick reflexes, and constant vigilance.
Posted by: The Epicurean Dealmaker at Mar 15, 2008 10:17:34 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?]
Posted by: Chuck at Mar 15, 2008 11:08:29 AM
Back when there was portfolio insurance, in 1987 as I recall, it became apparent that if there's no way anybody can lose money, then some assumption will be violated and they will lose money.
In that case, the assumption that you can make simultaneous trades.
The rule remains true though. Assumptions take up the slack when reality kicks in.
Gall's law, fail-safe systems fail by failing to fail safe.
Posted by: Ron Hardin at Mar 15, 2008 11:13:47 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.
Posted by: infopractical at Mar 15, 2008 11:24:40 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.
I, at least, suggest no such thing. I do ask whether the pros outweigh the cons.
Note that I am talking in social terms. The existence of profitable strategies for bond trading is interesting, but that existence in itself may not create any more value than the existence of profitable strategies for playing blackjack or poker. Now, we shouldn't care about that if people want to do it and the results only affect the traders and their backers. But what we are seeing is that there are huge interdependencies in the financial system, so these kinds of misfires are not isolated. Indeed, the traders seem to have a sort of one-way payoff here. Heads they win, tails they break even or, if they are CEO's, they win anyway.
Let the hedge funds play with their own money and their investors' money as much as they want. But why do they get to play with other peoples'? On what basis is it possible to argue that their activities are so valuable that they should be allowed to do things that will create financial crises if they make mistakes?
Ron Hardin, above, says
You always get better returns by adding funds extorted from the government.
There's clearly something to that. I wonder whether some of the huge trading profits available don't depend, in an indirect way, on the fact that the government has a few choices when a firm like Bear Stearns is in danger of going under. The expected bailout certainly reduces the information cost and risk of making big trades.
Posted by: Bernard Yomtov at Mar 15, 2008 12:21:06 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.
Posted by: st4rbux at Mar 15, 2008 5:02:34 PM
"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."
Or maybe government spending would increase, the economy would be better off, and my least favorite politician will lose their seat when one of those Rich Evil Hedge Fund Managers stops making soft-money donations to his political party. Even that scenario seems more likely than the one you presented.
I'm all for lower taxes, but leaving in a tax loophole which provides an almost $2 billion/year tax break to just 25 individuals isn't the way to do it.
Posted by: Anthony at Mar 15, 2008 6:53:20 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.
Posted by: Paul N at Mar 15, 2008 9:47:17 PM
This is exactly Nassim Taleb's point in Fooled By Randomness.
Posted by: David at Mar 15, 2008 9:53:47 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.
Posted by: eccdogg at Mar 15, 2008 10:37:01 PM
Guys, I think we've really seen in the past 6 months the real core of the problem : the massive problems of agency caused by the rise in mutual fund savings.
The huge tide of 'lazy money' of recent years: pension funds, mutual funds; has led to a situation where we have whole layers of people : fund managers, hedge fund managers, who dont actually do anything or create any wealth. They are paid because the money paying them is lazy and the spenders (you and me) are not controlling it. Same as for corporate CEOs.
This is also the cause of the dramatic rise in income inequality. Who are the new rich? Corporate CEOs and financial market 'professionals' (people who do very little being paid with other people's money).
The market has failed. We need a new breed of mutual/retirement funds, ones which are tough and tight with cash. The CEOs and financial market professionals (if there are any left after this happens) would actually have to justify their earnings.
The real cause of massive income inequality in the US is not the free market : its the failure of the free market.
Posted by: Dave at Mar 17, 2008 1:27:16 AM
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.
Posted by: Johan at Mar 17, 2008 12:50:10 PM
It is certainly true that hedge funds have an incentive to take risks which their clients don't want them to. But that is only a problem for the clients as long as it is restricted to hedge funds. They are meant to be unregulated funds for rich people who either know what they are doing or have enough money to afford a loss.
The problem comes when the same attitudes percolate the rest of the financial system and affect institutions which can't be allowed to fail. It is why the Glass-Steagall act in the US separated ordinary banking from investment banking. It was repealed in 1999. Not only did this allow ordinary banks to take greater risks; it positively induced them to go seeking them in an effort to get the profits big risk takers were making.
In the 1994 crisis many banks were afraid Goldman Sachs would go bust; they cut off its credit. If it had failed the impact wold have been bad but not a catastrophe for the system. This time around all the banks are so up to their neck in worthless securities that the whole banking system might have collapsed.
Thatg is what really needs to be unwound.
Posted by: Daphne Millar at Mar 18, 2008 3:33:21 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.
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.
Posted by: michael e sullivan at Mar 19, 2008 12:39:11 PM
It's up to investors to do the due diligence and find out how much the manager's have of their net worth invested in the fund and only invest with those that are willing to invest a substantial amount alongside you. Also you need to diversify across funds. I think the U.S. restrictions on investment in hedge funds are silly. You can lose your money much more easily and faster trading options.
Posted by: moom at Mar 24, 2008 5:04:46 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.
Posted by: Yuan at Apr 11, 2008 2:20:31 AM
As long as the SEC and federal regulators are fearful of having to confront Mr. Goldmiddlefinger and those of his ilk who want unlimited freedoms to solicit funds outside of ordinary safeguards and regulation, then fraud will continue to occur and hurt the most vulnerable. Gambling should be exposed for what it is so that anyone who wants to play knows the risk and rules of the game, and not be presented as something more respectable and part of ordinary investment strategies, and most egregious, under the guise of legitimacy behind front custodial institutions.
Posted by: 007 at May 6, 2008 1:30:38 AM
