How to run a hedge fund

Via Mark Thoma, this nice summary of how to run a hedge fund, taking advantage of the fee structure and the asymmetry of compensation and risk. If the fund goes up, the manager gets paid. If the fund goes down, the manager still gets paid the management fee, if not the performance component. This means he is incentivized to take asymmetric bets like selling insurance policies, which have a high probability of a decent return from the premium, but a small chance of blowing up due to a rare event. In the latter case the investors lose their money but not the manager. What looks like a decent return by the fund might in fact reflect crazy risk taking -- it's hard for investors to know.

But don't be too critical. These people are making our economy more efficient ;-)

Most managers don't behave this way, although it's an example of the more general agency problem, which arises whenever the incentives and interests of a principal differ from those of an agent (e.g., hired to manage a company or financial portfolio owned by the principal).

Washington Post: ...It is extremely difficult to tell, based on past performance, whether a fund is being run by true financial wizards, by no-talent managers who happen to get lucky or by outright scam artists.

To illustrate how easy it is to set up a hedge fund scam, consider the following example. An enterprising man named Oz sets up a new fund with the stated aim of earning 10 percent in excess of some benchmark rate of return, say 4 percent. The fund will run for five years, and investors can cash out at the end of each year if they wish. The fee is the standard '2 and 20': 2 percent annually for funds under management, and a 20 percent incentive fee for returns that exceed the benchmark.

Although he has no investment track record, Oz has a smooth manner, a doctorate in physics and many rich acquaintances. He raises $100 million and opens shop. He then studies the derivatives market and finds an event on which the market places fairly long odds, say 9:1. In other words, it costs $.10 to buy an option that pays $1 if the event occurs and $0 otherwise. The nature of the event is unimportant: it might be a large fall in the stock market, Florida getting hit by a Category 5 hurricane or Russian President Vladimir Putin dying before the end of the year.

Next Oz writes some covered options on this event and sells 110 million of them in the derivatives market. This obligates him to pay the option holders $110 million if the event does occur and nothing if it does not. He collects $11 million on the options. To cover his obligations in case the 'bad' event occurs, he uses the investors' money plus the proceeds from the options to buy $110 million in one-year Treasury bills yielding 4 percent, which he deposits in escrow. This leaves $1 million in "pocket money," which he uses to lease some computer terminals and hire a few geeks to sit in front of them, just in case his investors drop by.

The probability is ninety percent that the bad event does not occur and Oz owes nothing to the option holders. With a gross return (before expenses) of $15,400,000, the investors are thrilled, and so is Oz. He collects $2 million in management fees (of which he has only spent $1 million), plus a performance bonus equal to 20 percent of the 'excess return', namely, 20 percent of $11,400,000. All in all, Oz nets over $3 million for doing absolutely nothing.

Oz can then repeat the same gambit next year. When the fund terminates after five years, the chances are nearly 60 percent that the unlucky event will never have occurred. Oz looks like a genius and gets paid like a genius. ...