The End of Black-Box Investment Funds December 17, 2008Posted by federalist in Finance.
Foster & Young’s paper “The Hedge Fund Game” is getting renewed attention. I covered this earlier this year, but the more the game unwinds the more astonished I am that so many people failed to see the hazards inherent in the traditional hedge fund structure, namely:
- Lack of transparency into strategies and actual investment activity
- Ability to trade derivative securities
- Steep incentives for short-term gains
Together these characteristics make it impossible to determine whether a successful hedge fund is (plausibly) generating alpha — which is what investors believe when they commit money — or whether it is instead gambling on a portfolio with strong negative skewness — i.e., one that makes steady positive returns with high probability, but with low probability eventually “blows up,” taking massive losses.
Alpha is worth paying for, and there any number of ways sophisticated managers can generate returns on capital that are uncorrelated to the market and that have attractive expected return characteristics — arbitrage; market making; astutely harvesting premiums on liquidity, information, and risk. The problem Foster & Young rigorously demonstrate is that a “mimic” can either intentionally or naively (e.g., Victor Niederhoffer) sell options to create a negatively skewed stream of returns that with high probability is hard to distinguish from positive alpha … until it suffers a catastrophic loss.
Naturally, the more you pump up returns by these methods, the higher the probability that the fund will crash. As previously shown, however, the probability of crashing is not all that high on an annual basis for excess returns that look very impressive. Furthermore, if you are risk-averse, there is a simple way to spread the risk: Just start several funds under different names and run them in parallel, using independent piggybacking strategies. The probability is high that at least one of them will survive, yielding performance fees that make up for poor results at some or all of the others.
Under the traditional three rules of the hedge fund game it is so easy for an fund manager to make a fortune as a mimic that hedge fund investors who did not break one of those rules should have simply assumed they were paying someone else to gamble with their money. Indeed, it is hard to distinguish the results of many hedge fund investors from that scenario.
Foster & Young go one step further with a formal argument that there is no plausible incentive scheme that can mitigate this hazard. They summarize:
Essentially, we have shown that the industry is vulnerable to entry by managers who have no particular skill but whose lack of ability is difficult to detect, based solely on their track records. In short, the hedge fund industry has a potential “lemon” problem. This term was coined by economist George Akerlof to describe the used-car market, where sellers tend to have much more information about the reliability of their cars than do potential buyers. This leads buyers to insist on lower prices to compensate for their risk. But then the owners of cars that actually are of high quality will withdraw them from the market, which means that the remaining cars will be, on average, even riskier. The result is a downward spiral in prices and a situation where no one can sell a car at a reasonable price.
I.e., breaking the third rule of the game is not enough to remove the hazard! If you break the second rule you are effectively restricting the game to the mutual fund world, where it is much more difficult to create portfolios with large skewness. (Granted, mutual funds have seen their own gaming in the form of “actively managed funds,” which have proven to be nothing more than a means for investors to pay higher fees to gamble on managers, who in aggregate have been unable to outperform the market indices investors can buy more cheaply.)
When it comes down to it, the only practical way to remove the hazard from the hedge fund industry is to break the first rule. Foster & Young conclude,
[T]he root of the problem is lack of transparency. Skilled managers need to find a way to distinguish themselves from the low-quality entrants. Here the analogy with the used-car market provides some clues to the solution. Just as a buyer can hire a mechanic to look under the hood of a possible purchase, so hedge fund managers may have to allow professional intermediaries (acting on behalf of potential investors) to have extensive access to their books and trading strategies, not just once but on an ongoing basis. Alternatively, individual fund managers may find it advantageous to operate under the umbrella of a large organization that can guarantee the product, just as the owner of a used car may prefer to sell it through a dealer rather than try to market it himself.