When You Have Lemons, Make Lemonade

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.

In contrast, if hedge funds lose the "profits" or even principal on which they have already charged fees, managers are not required to refund fees. Indeed, we are now seeing managers just close up shop and start new funds, perhaps first waiting until market conditions are favorable and investors have forgotten their previous failures. This way, the managers can more quickly earn the 20% incentive fee again. John Meriwether of Long Term Capital Management is the classic perpetrator of this ruse.

Failed hedge fund managers who don't shutter can stay in business with redemption gates, a fine-print provision that forces investors to remain in the fund and pay management fees until the fund manager feels that it is the right time to meet redemption requests. Investors may wait years to fully redeem, as the more illiquid assets are sometimes siphoned off into "side pockets" for an indeterminate period of time.

How We Got Here
Institutions are to blame for these misaligned incentives, for they allowed hedge funds to gain the upper hand in the first place. Over the last few years, pension funds and endowments have poured money into "absolute return" investments, which include hedge funds and other private investment vehicles, with few strings attached. One of the primary reasons for this negligence was that hedge funds were actually (at the time) outperforming the market, and pension and endowment managers didn't want to underperform relative to their peers.

It turns out that many of these "absolute return" funds were anything but and had achieved their outsized returns frequently through the use of leverage and high-risk investments. Take Bear Stearns Asset Management, for example, whose motto was "Risk Managed, Value Added." It took subprime CDOs and levered to the hilt, calling this strategy "capital markets arbitrage." We all know how the Bear Stearns story ended.

Funds of hedge funds were probably the biggest disappointment of all. These funds charge investors an extra layer of fees, typically 1% management and 10% incentive fees, to diversify manager risk and conduct due diligence for those who lack the resources, while promising smaller institutions access to "elite" hedge funds managers. The proof is not in the pudding--funds of hedge funds performed worse than the average hedge fund over the last five years, as measured by the Morningstar Hedge Fund of Funds and Morningstar 1000 Hedge Fund Indexes.

Furthermore, the Bernie Madoff scandal showed that some funds of hedge funds, Fairfield Greenwich and Tremont, for example, failed to conduct even basic due diligence, relying entirely on Madoff's reputation rather than investigating his strategy, investment team, and operations before investing billions. These funds also failed to follow the basic portfolio-management tenet of diversification, putting all of their eggs into one fraudulent basket.

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