A friend who worked for a while as an executive at a very large and famous hedge fund told me, "Most of the shareholders in this industry are lost. These are multi-billion dollar institutio
ns, and they think they're getting alpha [i.e., extra returns garnered due to insights from the portfolio manager] when they're really getting leveraged beta [i.e., extra returns garnered due to risk-taking by borrowing money and buying more overall exposure to a particular financial market]. This year, they didn't know what was in their portfolios, and they didn't know how much leverage they had."
Contrast the Madoff affair with the well-publicized problem of the Reserve money-market fund Stateside, which "broke the buck" by dropping from $1 to $0.97 due to holding Lehman Brothers paper. The reaction was vociferous, with redemptions and finger-pointing and newspaper headlines. The retail investors were unaware of what had occurred with a small portion of the Reserve portfolio, which cost them 3 cents on the dollar. The institutional investors were unaware of what was occurring with the entire Madoff portfolio, which cost them 100 cents on the dollar. Which investor base seems more sophisticated?
Pick Pockets
Here's another example. Hedge fund buyers permit the big hedge funds to set up "side pocket" deals--arrangements whereby certain shareholders are given better terms than other shareholders. One such term might be liquidity, whereby a particularly important shareholder that demanded better liquidity might be permitted to redeem shares more rapidly than would a standard shareholder.
This looks, smells, and tastes like the mutual fund market-timing scandal that hit the U.S. as few years back--a deal whereby certain shareholders receive better performance because they are granted redemption privileges that other shareholders are not. With mutual funds, the benefiting shareholders made daily trades that took advantage of temporary fund mispricings. With hedge funds, the benefiting shareholders got out early, before the vicious cycle of redemptions and asset sales pushed down the prices of the funds' holdings. In either case, the privileges effectively enabled them to siphon off monies from the remaining shareholders.
But where in the hedge fund industry is the scandal? Yes, there are mutterings. Rumblings. But push come to shove, most institutional investors who were ill-treated by that process will line up to be ill-treated again.
Readying the Sheep
The reason that these institutional investors are willing to work off handshakes, and to accept rotten deals, is that they believe that the managers who demand so much from their investors possess true and rare insight.
They believe because they have been set up to believe. In The Hedge Fund Game: Incentives, Excess Returns, and Performance Mimics, Dean Foster of Wharton and Peyton Young of Oxford and Johns Hopkins show that hedge funds have a powerful ability to deceive. The authors demonstrate that the unholy duo of options-related payoff structures and a lack of transparency about actual investment tactics gives "an unskilled trader" a strategy that emulates "the return sequence being generated by the skilled trader with a high probability (and blows up with a small probability). [The unskilled trader] therefore earns fees and attracts customers just as if he were skilled until the fund blows up."
Great--a nobody who sits on a time bomb of a fund, and a somebody who actually has skill, are indistinguishable until the markets act strangely, then one of them explodes. Sounds like a game of Stratego. Is the opposing piece a colonel--or a bomb? Don't know, can't tell, both pieces look the same from my perspective.
The authors conclude, "Essentially we have shown that the market is vulnerable to entry by managers who have no particular skill, but whose lack of skill is difficult to detect based solely on their track records. In other words, the hedge fund industry has a potential lemons problem."
To address the lemons, they recommend improved transparency, which in their view would not only prevent the obvious Madoff-style frauds, but which would also assist with the larger problem of managers who have no special insight to offer, but who act as if they do.
You Don't Say
Appearing in Monday's e-mail was the teaser: "Fund Bonuses Likely to Disappoint in 2008." I wasn't much teased.
