Tuesday, November 25, 2008

Hedge Fund Conflict of Interest

Before the recent financial crisis, hedge funds were generally known as mysterious investments that make outsized returns. Now they have a reputation for flaming out. The reason why so many hedge funds have failed is easier to understand once we see that hedge fund managers maximize their expected returns by taking more chances than are good for investors.

The main differences between hedge funds and regular mutual funds are

Types of investments. Hedge funds are less closely regulated and tend to make riskier investments than mutual funds make, such as shorting stocks and using leverage.

Fees. In addition to a yearly management fee, hedge funds charge a performance fee, which is a percentage of any returns over a certain threshold. A “2 and 20” hedge fund would charge 2% of the full amount invested plus 20% of all returns above the threshold.

The performance fee is supposed to align the interests of the money manager and the investors, but it does this quite poorly. On the surface it seems that both parties make money together, but there are important differences that I’ll show with an example.

Suppose that High-power Growth Hedge fund (HGH) uses a simple leverage-based strategy: it buys stocks on margin. For a concrete example, we’ll assume that HGH can borrow money at 5% interest, the expected return on stocks each year is 10%, and the volatility of stocks measured by standard deviation is 20%, a figure that is close to the long-term average for US stocks. HGH’s fees are a 2% management fee plus a performance fee of 20% of returns above 5%.

What is best for investors?

Based on these assumptions, investors maximize their expected compound returns if no leverage at all is used. Without the performance fee, the optimum amount of leverage is only 16%. The performance fee clips the upside enough that it isn’t worth it to take on the higher risk of borrowing some money to invest. But the optimal amount of leverage is quite low even without the performance fee.

What is best for hedge fund managers?

It turns out that using leverage increases the money manager’s fees considerably. I ran billions of 3-year Monte Carlo simulations of HGH fund with different amounts of leverage, and the money manager’s highest expected compound return came with leverage at 249%! This means that if investors contribute $10 million to HGH, the fund would borrow an extra $24.9 million and invest the whole $34.9 million in stocks.

Using 249% leverage, investors’ expected compound return is reduced to -3% per year due to the high volatility. Don’t think of this as a steady -3% each year. HGH would have wildly swinging yearly returns like +70%, -60%, and +30%, with a significant risk of losing everything in a very bad period for stocks like the one we’re in right now.

These results show that hedge fund managers do not have their interests aligned with investors. In fact, their interests are so poorly aligned that hedge fund managers are effectively in a conflict of interest.

4 comments:

  1. Could you explain how an optimized portfolio for the hedge fund results in a terribly sub-optimal return of -3% for the investor?

    Seems that the more the manager makes, the more that investor should clear. What am I missing?

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  2. Gene: The answer is a variant of the fact that losing 10% followed by making 10% doesn't leave you even (it leaves you down 1%). To begin with, in an average year, stocks would return 10%. At 249% leverage, this is a 34.9% return less 5% interest on 2.49 times the amount invested (net return of about 22.5%). So, if you took a sequence of yearly returns on this fund, the arithmetic average is expected to be 22.5%. However, the actual returns would be wild. A typical two-year sequence would be +97%, -52%. (These two values are cooked to give the right average and the right result after compounding.) These two percentages add up to 45% for the required average of 22.5%. But, investors would be left with (1+0.97)*(1-0.52)=0.9456 times their original investment, which works out to about -3% per year. From the investors' point of view this is bad. However, the fund manager made a killing in the +97% year, and suffered little pain in the -52% year.

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  3. Thanks for the repsonse, Michael James. That makes sense now. Due to the wild swings, the investor will experience euphoric returns followed by catastrophic losses.

    In the up years, the investor pays through the nose, and in the down years, they pay "only" the 2%. Unless there's a highwater clause that limits compensation in the positive years following the negative years, the investor will lose money.

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