March 19, 2008
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.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Christopher Miller (guest): Even though I work in the hedge fund industry, I particularly enjoyed the ironic juxtaposition of your piece next to John Kay’s. Warren Buffett’s activities in insurance have many similarities with selling options. And it is particularly ironic that you refer to Taleb, because irrespective of the sageness of the activity ex-ante, those who win are applauded, and those who lose are reviled. Would you close down the whole of Lloyds just because of a bad year? Are you saying that because some hedge funds have short option strategies all hedge funds may not survive? Luckily for the transport industry, the existence of some lemons has not changed the fact of latent demand for transport.
I read your article as I waited in the BBC to be interviewed about the effect hedge funds are having on the global economy. Because hedge funds are usually prevented by legislation from answering back, many people actually believe that this credit crisis is caused by hedge funds. The reality is of course that bank salesmen discovered that no one was stopping them from giving loans to Americans with no jobs and no money. The salesmen bank the commission. The bank sees property prices rising, and keeps some for its own book and then makes a profit from repackaging it for hedge funds or any schmuck who will buy it. When the value of the hedge fund’s assets or the bank’s capital adequacy goes down, they give the hedge funds margin calls, and the hedge funds sell whatever they can at the rapidly diminishing price.
Our hedge fund research and rating business, Allenbridge HedgeInfo, exists precisely because of the problem you rightly identify - that it is hard to identify truly good managers from the merely lucky. We particularly look for managers who have significant exposure in their fund parri passu with the clients to avoid the conflict of interest. Managers who don’t find that their business does not grow, and this is nothing new; just like Taleb’s work is brilliant not because of groundbreaking concepts, but because, like Stephen Hawking, he made complex concepts more accessible. We are not the only people who devote considerable resources and experience to such difficult work. Hedge funds of funds (some of them anyway) earn their extra layer of fees by careful qualitative selection to identify risks that are not apparent from the track record.
Professors Foster and Young assume that because some hedge funds are entirely opaque, all are. That is not the case. Commercial confidentiality is necessary and common in all industries, and providing it is proportionate, that is fine. Their conclusion in one paper is that hedge funds should be required to report their returns. I have never heard of a hedge fund that was so opaque that it refused potential investors performance information. Maybe a start would be to allow hedge funds to publish their performance openly, because that is currently illegal.
The question about fees is also interesting. It seems to me that compared with many hedge fund managers, and using the same fee levels, Warren Buffett would not stand out. Hedge fund fees do not need to be justified by anything other than demand and net returns. Some funds charge 50% performance fee and still make so much money for investors that they have to turn most away. The professors produce some compelling arguments which show that performance fee structures can encourage unskilled or dishonest managers to “fake” good returns. Their suggestions are: (a) payments should be based on final returns. This is good in theory, but it would not be possible to employ good staff without regular incentives in practice; (b) Require the manager to hold an equity stake in the fund. This already happens in practice and it is a standard question on any due diligence questionnaire; and (c) Assess penalties for underperformance. Again, to run a business with good staff, they need positive incentives.
But I find that their conclusion - that it is too difficult or impossible to differentiate between good managers and bad ones - to be defeatist and not cognisant of how the industry has worked around these issues already. Don’t take my word for it. I can point you towards hedge funds of funds who have consistently produced good low volatility performance for many years, despite the extra layer of fees.
Finally: is Carlyle Capital unregulated? Apparently not, according to their home page. And their prime broker and lending banks weren’t either. How about Peloton? No, they weren’t unregulated. The banks who did all the sub-prime lending weren’t unregulated either. So what are the regulators for and what were they doing? My personal opinion is that no one believed that property could go down as well as up, and they didn’t think there was a problem. Even if there was, who wants to spoil the party?
My conclusion here is that non-professional investors should stay clear of single manager hedge funds, but that a well managed hedge fund of funds could be a suitable part of their portfolio. At an institutional level, a professional approach should be able to discriminate between good and bad managers, and as a failsafe, diversification prevents a blow up from hurting much.
Christopher Miller is chief executive of Allenbridge HedgeInfo
Posted by: Christopher Miller | March 19th, 2008 at 4:13 pm | Report this commentAli Chughtai (guest): It is certainly true that there have been quite a few dubious business models which have worked well and are now going out the window. There are two futher inter-linked points which I think are very relevant with regards to why there are so many lemons in the hedge funds universe currently - and not necessarily becuase the managers are unskilled or overpaid opportunists.
First, the rise of fund of funds over the last few years has meant that hedge funds are judged on “how you did last month”, and if you dont make money over a few months while others do, you loose funds or fail to attract any. This short-termism has forced otherwise skilled traders/managers into the momentum mindset, no one gets points for pointing out the emperor has no clothes - the Taleb distribution is favored by those who have been allocating money. So rational, skilled managers have been playing with these rules.
Secondly, volatility has generally been declining in markets over the last few years, until last july that is. This compounded the first problem raised above with leverage - given that returns had to be made with less movement and from the same thing that everyone else was doing; which begets further low volatility - until the process cannot continue. This CDO business in the credit space is perhaps the most blatant example of trying to make money from low volatility through leverage, however there are examples in all markets of this behaviour.
A purge has certainly started of the hedge funds, I am hopeful that we will see a revision of the fund of funds model as well - so we can get back to a reasonable marketplace.
Ali Chughtai is a private investor
Posted by: Ali Chughtai | March 19th, 2008 at 4:18 pm | Report this commentMartin Wolf: I want to thank the participants in this discussion. I only want to say here that severe difficulties are inherent in the normal 2 and 20 fee structure (2 per cent management fees and 20 per cent of the return above some threshold). The average manager will earn average returns, but may still, because of these fee structures, earn more than a decent income, at the expense of clients, provided he has a run of lucky bets. Distinguishing genuinely skilful managers from the rest is just hard to do. Even a long run of good results does not prove exceptional skill. I advise those thinking of putting their money into hedge funds or funds of hedge funds to read the work of profs Foster and Young. It will make them think.
Posted by: Martin Wolf | March 29th, 2008 at 6:22 pm | Report this comment