Bastiat’s Bastions

The last real job I had (before I entered the academic realm) was in a consulting firm that did research on hedge funds. I came across an interesting article in Slate on hedge funds. It seems another hedge fund has gone belly up. Not exactly LTCM, but still a meaningful chuck of investor cash.

The article highlights a potential incentive problem for hedge fund managers.

For those of you who don’t know, hedge funds resemble mutual funds to a large extent. Both take investments from investors, pool them, and invest in stocks, bonds, and other financial securities (derivatives, options, etc).

There are two notable differences between hedge funds and mutual funds. First, hedge funds are typically limited to what is called “high net worth individuals”. A typical minimum investment for access to the fund would be on the order of $500,000.

Second, hedge funds managers earn compensation for their efforts in a very different fashion than their mutual fund counterparts. While a mutual fund manager (and their staff) would typically receive a percentage of the assets under management as a fee, a hedge fund manager will typically receive a fraction of the hedge fund’s profits. Typically, this “incentive fee” is on the order of 20% of profits, usually only earned on the profits above and beyond some benchmark. However, these terms vary considerably across funds. (Regulations concerning mutual funds prohibit managers from receiving a portion of the investment profit.)

The differing compensation gives the managers different incentives, hence the article. The appeal of the hedge fund would be that because the manager has a large monetary incentive to do well, he or she (and their staff) will put forth a large amount of effort. As the manager earns a large chunk of the profits, the incentives are said to be alligned. These incentives will attract top investment talent into the hedge fund sector.

But often, the hedge fund manager has relatively little of their own equity in the fund. It’s not too difficult to come up with a situation where the manager may make very risky investments. The thought would be if they pan out, the manager has just earned a large incentive fee. It if doesn’t work out, the manager will lose his/her job.

How much is too much? Difficult to say. If there is no profit sharing, there is less incentive to put forth effort. But too much, and the manager may be too risky. Does this sound similar to the story you’ve heard about in your finance classes about debt holders vs. equity holders?

Where the article misses a crucial point is in regard to what happens if a fund does poorly. It seems to suggest that if the managers of a firm lose investors money at Fund A, they’ll just move to Fund B or start Fund C. I think this gives hedge fund investors too little credit. You can’t make a career out of betting the farm (actually other people’s farm) and losing it half the time.

–CT

This entry was posted on Monday, September 25th, 2006 at 3:19 pm and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.