Poor Academics Grouse at Wealthy Hedge Fund Managers (again)

Hedge Fund managers are greedy robbers who don't deliver? Surprised? That's what these people think: only two weeks after Martin Wolf gives a big thumbs-up to the Wharton "hedge funds are lemons" paper published by Dean Foster and Peyton Young, the same paper and the Wharton puff piece summarising it get another airing courtesy of the Journal's DealBook blog.

Spare yourself the agony of reading the paper. Yet another hashed out explanation of the age old "trader's option" with some sparkly mathematics thrown in for academic credit. The trader's option is the incentive to take extended, but largely unintelligent, short gamma and/or leveraged beta bets with other people's money in the knowledge that success will be rewarded handsomely and subsequent failure will not result in clawback.

Wharton finds the potential for this skulduggery a startling revelation. The paper goes on to describe the hedge fund world as a "lemon" market, akin somewhat to the used car market: you have no idea if you purchased a bad one until it is apparent you purchased a bad one, and by then, well, tough.

Why is this newsworthy? Yves Smith picked this up a while ago, and poses one for Martin Wolf:

First, [Wolf] seems shocked, shocked that investment managers can make a lot of dough while delivering mediocre returns. Where has he been? It's almost a truism that active managers don't earn their fees; numerous analyses have found that ones that outperform don't sustain it over time. It's just that hedge funds have elevated the fee extraction to unimagined levels.

Indeed so. In reality of course there are both lemon managers as well as competent managers. I don't begrudge the General Partners of either type their loot one iota. What the academics fail to understand (choose to ignore?) is that for lemon strategies the General Partners' business model is "to raise money at 2+20", not "to deliver alpha". Theirs is a sales job at which they have been particularly proficient. Congratulate them for it, at the expense of investors gullible enough not to carry out appropriate due diligence before investing. Whether alpha accrues is of secondary importance, whatever is claimed. If, in applying their business model, General Partners have earned super normal returns, this speaks more to the limited negotiating capability of hedge fund investors generally. Herein lies the rub. The academics (and Martin Wolf of course) want to gnash teeth at those who made easy money with lemon strategies, not question the motivations of the chumps who funded them based on a powerpoint presentation and confident smile.

Indeed, the Wharton paper makes a number of suggestions to redress this balance: (a) assess payments based on final returns after an extended period, (b) require General Partners to invest alongside or (c) assess penalties for underperformance. Astute readers will recognise this as exactly the same old mulch trotted out in response to egregious investment banking pay. Come on now, if you're the type of entity or person who invests in investment banks or hedge funds, don't be moaning that you weren't aware of the nature of the game.

**EDIT 8 Apr** For the avoidance of doubt, this post is an attack on those who cheaply malign hedge funds, not an attack on hedge funds. I'm agnostic as to the prevalence of sustainable alpha, but I do believe the adaptive markets hypothesis is the right framework to explain why temporary alpha is widely available.