I agree with Jim Manzi that this sounds kind of crazy.
Now imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.
The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money.
The immediate response may be that so naked a scam is inconceivable. Well, imagine a fund that leverages investors’ money by borrowing massively in short-term money markets in order to purchase higher-yielding paper. Assume, again, that the premium gives a correct estimate of the risk. With sufficient leverage, this fund, too, is likely to make profits for years. But it is also very likely to be wiped out, at some point. Does this strategy sound familiar? It certainly should by now.
Not the basic underlying point, which I thoroughly endorse: there were a lot of people over the last decade or so who decided that they were geniuses because they made money for a few years. What they were really doing was levering up and massively underestimating the risk of failure.
This is, in my opinion, a general truism about human nature: if our decisions have good outcomes, we tend to assume that this is due to our native genius. We entirely discount the role of luck, aka random chance. The more our decisions pay off, the more confident we come, and the bigger bets we are willing to make--and then, the deluge.
But while I agree that many money managers were foolish and overconfident in their rather modest abilities, I don't see how you can cast it as a morality play. The only hedge funds I'm familiar with structure the compensation so that it is very hard to make much money if your clients lose it. That's not really surprising, since the clients of hedge funds are generally not gullible widows investing their meagre savings with a smooth-talking stockbroker; they're very rich people, or institutional investors. Those people tend to be at least somewhat familiar with the incentive problem created by guaranteeing that your fund manager makes money regardless of whether you do.
Also, most of the hedge fund managers I've met have a substantial portion of their own wealth tied up in the fund--it's very hard to get people to invest in your fund if you won't. They not only aren't minting money off a fund that blows up; they're likely to lose a considerable portion of their net worth.
Now, it's not as if I've done a representative survey of hedge funds or anything, so I'm open to being told I'm wrong. But I'd be very surprised to hear that it was so.
I work closely with hedge funds, and not only are you right Megan - in general they are very purposefully structured so that it is difficult for managers to make significant money if the fund suffers losses (or even disappointing returns), and most actually require managers to keep their money in the funds - but furthermore recent market events have had a Darwin on steroids effect on the hedge fund industry. Investors are pulling their money out at the first whiff of trouble, and pushing back harder than ever on the "2 and 20" structure. Hedge fund investors are not fools, and they know that right now they hold all the cards. We are probably going to see significant consolidation among hedge funds over the next two years since only the largest and most successful funds can draw new money (and keep it). But even these funds are going to have tough time of it since leverage is significantly harder to obtain at sensible cost these days.
Actually, you're not quite right, MM. Or at least you mixing two issues: mgr competence vs gaming the fee structure. On point 1 you're right: most managers suck and can't beat their benchmark in a given year let alone over several years.
Point 2, however -- the point Manzi makes -- is not that the HF in his example is not going to make money. It *is* going to make money, possibly for a long time. And during this time the manager is going to be paid a ton of fees. Over the long haul, odds are good that the fund will blow up, but at that point the investors lose, not the mgr (he's already banked years of fees) -- he can fold his tent, go on vacation for awhile, then just start another fund under another LP.
Also, I'd dispute that all or most managers keep a significant portion of their wealth in their fund. Law requires that 1% of the fund be the manager's money. That's it. Some keep more, some keep less. Certainly a savvy investor should ask, but in ten years, very few have asked me.
Another thing no investor has ever asked me is how much leverage I employ. (Ans: almost none). However, most of the HF's I've looked at employ a fair amount, and some between 15x - 25x. I think these guys are insane, but they've made a fortune over the past 5 years.
Some managers believe their primary objective is to make $$ for their investors. Some believe it's to make $$ for themselves. Those in second group who are massively leveraged are so not because they've misunderstood the risk of ruin, but because they've accurately assessed the risk in terms of time -- ie, I have a 60% probability of generating great fees for at least 5 years before the sh*t hits the fan. It is in this sense that this story *is* a morality play.
this:
"Another thing no investor has ever asked me is how much leverage I employ. (Ans: almost none). However, most of the HF's I've looked at employ a fair amount, and some between 15x - 25x. I think these guys are insane, but they've made a fortune over the past 5 years.
Some managers believe their primary objective is to make $$ for their investors. Some believe it's to make $$ for themselves. Those in second group who are massively leveraged are so not because they've misunderstood the risk of ruin, but because they've accurately assessed the risk in terms of time -- ie, I have a 60% probability of generating great fees for at least 5 years before the sh*t hits the fan. It is in this sense that this story *is* a morality play."
is getting at it..
Our investors are delighted. Assume our benchmark was 4 per cent.
Huh? Why would you assume that the benchmark is 4%? You can calculate exactly what the benchmark is supposed to be.
And why would the investors be delighted? They aren't looking for return. They are looking for risk-adjusted return. And the risk adjusted return in this case is negative.
This is a pretty stupid example. Anyone investing in this fund would be a moron.
Is this story with Bear Stearns really any different from what happened with Long Term Capital Management in '98?
This is a pretty stupid example. Anyone investing in this fund would be a moron.
It's an example. It's supposed to be overly simplistic. And most funds don't disclose with that level of detail the strategy employed, lest their customers execute the identical strategy w/o paying the 2&20.
Megan,
You need to get out more.
"I don't see how you can cast it as a morality play. The only hedge funds I'm familiar with structure the compensation so that it is very hard to make much money if your clients lose it. That's not really surprising, since the clients of hedge funds are generally not gullible widows investing their meagre savings with a smooth-talking stockbroker; they're very rich people, or institutional investors."
You should have been at the last Milken Conference where Carlyle's Rubenstein, et al, all pretty much admitted that the money being invested with them was outrageous and that the bubble would pop. The hedgies, private equity etc. structured everything to make money and be protected against loss. Carlyle Capital went down but Carlyle Group did not and Carlyle Group I'm sure earned a pretty penny off of Carlyle Capital before it went bust.
Megan,keep writing like above and it will become clear even to the low IQ readers that you don't have a clue about finance.
Wow, people really like to insult the blog's author on their way to making not necessarily high IQ points.
Carlyle Capital and Carlyle Group are not good examples of standard hedge fund operating procedure, and one can look at the blow ups of any number of pure hedge funds to see that they cannot "structure everything to make money and be protected against loss." That's a simplistic view for a simplistic mind.
And admitting that the amount of money being invested is outrageous, or that the bubble will pop, is a verbal observation of reality, not any sort of self-indictment.
Then too, any comment that mixes hedge funds with private equity firms mixes two very different beasts. Private equity does in fact structure its deal funds in ways that are more open to self dealing, but the title of the post is hedge funds.
Any number of hedge funds have structures that require the managers to produce gains before additional profit participation can proceed (after a loss). It just defies reality and knowledge to imply they can avoid risk or by nature or structure are dishonest.
Large investors who choose where to put their money may not be stupid, but they can be short-sighted. If you see one fund earning its investors 10%, and another 15%, which one are you going to go with? Thus the earlier comment:
"And why would the investors be delighted? They aren't looking for return. They are looking for risk-adjusted return. And the risk adjusted return in this case is negative."
They should be looking at risk-adjusted return. But it's pretty easy to cook those figures if you base your risk estimates on trailing twelve months, which all happened to be in a bull market.
In my view, this all comes from a basic misunderstanding of market timing. Just because something has been working for a few years doesn't mean it will work forever. In fact, if something that shouldn't have worked for a "long time" seemingly has, that just means the crash is coming. If somebody can earn 20% returns over 20 years, that's where you want your money.
@ Finn of Low IQ
Wow! I have been accused of being "simplistic". The last time I recall being accused of being simplistic was when I argued quite simply that the real estate boom would collapse because mortgage holders would have trouble making their payments once the extremely low introductory rates expired. Simple concept. I guess I should have used the more complex models that Citi, Bear Stearns et al used.
I could go on Finn, but somehow my guess is that the markets are teaching you the lessons you need. My bet is that you took a whipping in the subprime crisis and my further belief is that you don't have a clue as to what the market is about to hand us next. Consequently you will get finacially stomped on again. But, hey, keep working those complex equations. Frankly, you seem the type that could expand upon Einstein's very simple euation E=MC2
wow sidney. Give some criticism but cant take it.