Hedge funds: heads I win, tails you lose?

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.