When You Have Lemons, Make Lemonade
It's not time to give up on hedge funds. Rather, it's time to make them better.
You can't blame investors for wanting to throw in the towel on hedge funds. Too many of them have turned out to be lemons. Dean P. Foster of the University of Pennsylvania and H. Peyton Young of the University of Oxford published a working paper in March 2008 describing the "lemons" problem with hedge funds. Because of information asymmetries between hedge fund managers and investors, low barriers to start a hedge fund, and fee structures that favor the hedge fund manager over the investor, hedge fund investors are faced with an industry of used cars. These used cars tend to run well for a while during favorable market conditions, making the investors think that they procured a skilled "alpha" manager. Sooner or later, though, the transmission goes out alongside the market, revealing the "beta," or market-driven nature of the hedge fund manager and strategy (or nonexistence, in the case of Bernie Madoff), and costing the investor a good chunk of change.
The lemons story ends with a deep discount for used-car buyers because there is no good way to eliminate the risk from information asymmetry. Similarly, hedge fund investors are now selling partnership interests in top-name funds secondhand at substantial discounts on platforms like Hedgebay Trading. The hedge fund story can't end here, under the yellow lights of a used-car parking lot. First, there are skilled hedge fund managers, and second, the institutional market needs their services. Hedge funds need to be fixed, not discarded. We think that increased transparency and realigned incentives are the answer.
The Incentive Problem
Hedge funds are typically structured as a "heads I win, tails you lose" proposition for the fund's management. Managers get larger-than-mutual-fund monthly fees whether they make or lose money, and each year that they earn any "profits," realized or unrealized, they take a 20% (or more) cut of the gains. In years when most financial assets are rising, these performance fees can become very large for even ordinary performance. Hurdle rates, which require hedge fund managers to earn a minimum return (such as the risk-free rate or a more appropriate benchmark) before taking a cut, have steadily declined since 2005. Furthermore, claw-back provisions, forcing managers to return past fees, have never really become mainstream.