The Trouble With Hedge Funds

James Surowiecki notes that the performance bonuses for hedge fund managers have absurd results: "Fund managers get bonuses at the end of each year, and they keep those performance fees even if the fund eventually goes south. So if a billion-dollar hedge fund rises twenty per cent in its first year and falls twenty per cent in its second, its investors will have lost money, while the fund’s manager might earn forty million dollars in performance fees." Consequently, a strong incentive exists to take advantage of this quirk and of financial markets' general upward trajectory, by just investing the money in ways that generates more noise -- bigger up and down swings -- some of which can be translated into bonuses.

Tyler Cowen has more thoughts on this, conceding that the recent explosion of new investment schemes "has brought us new products" but "it all seems to be new mortgage products" whereas "the junk bond revolution of the 1980s involved some "excess" risk-taking, but I believe those risks were more closely connected to the real economy, and more likely to bring real economy benefits, than the recent spate of mortgage-related risks."

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