Tuesday, April 16, 2013

Chance Rewarded: “Sophisticated” Investors Let Hedge Fund Managers Win Big

Chance Rewarded:  “Sophisticated” Investors Let Hedge Fund Managers Win Big

Every year at this time, we get some informed guess about how much money some of the top hedge fund managers made in performance bonuses in 2012.  Mere mortals find these figures hard to comprehend.  For example, David Tepper of Appaloosa Capital took home $2.2 billion, Raymond Dalio of Bridgwater earned $1.7 billion, and Stephen Cohen, despite all his legal problems, brought in $1.6 billion.[1]

Everyone Wants Fund Flows (1999)
Rather than getting upset at the money managers for their outsized financial windfall, I am becoming more upset at the investors who permit this to happen.  Investors freely enter into an arrangement with hedge fund managers that permit the managers to reap huge annual rewards, even though exemplary annual performance is, most likely, the result of dumb luck.

Here’s how the reward system works in simplified form.  Imagine investing $100 with a hedge fund/coin flipper.  If the coin comes up heads your money doubles, but the coin flipper gets 20% of your profits.  If the coin comes up tails you lose half of your money.  So if things turn out well, you make $80 and your manager/flipper takes home $20.  After a year, your account has $180, before the coin is flipped again.  If the coin comes up heads in the second year, your account is worth $324, (180 times 2 less 20% of the gain) and the manager/flipper earns a $36 bonus.  If it comes up tails in the second year, you lose $90, and the manager/flipper loses nothing.  He doesn’t have to reimburse the $20 bonus from year one.  Even though you won one and lost won, you’ve lost money, instead of coming out break-even.

The annual profit-sharing model in hedge funds rewards luck more often than it rewards skill.  In any given year, a hedge fund manager’s results are more likely to be the result of rising markets, some other external factor, or just dumb luck.  Yet sophisticated investors agree to contract terms that reward hedge fund managers without respect to their skill for playing an annual game of chance.  In the next few months, you’ll read about some hedge fund manager who is acquiring a large yacht or the latest executive jet.  He ought to name his latest acquisition “serendipity” or “good fortune.”

There’s a solution to this problem.  Hedge fund managers should only get paid their performance bonus when an investor withdraws her capital or the fund winds up its affairs.  It would be like settling a hotel bill at the end of a stay. With the passage of time, investors would have some idea if they were rewarding the manager for luck or skill. 

You can already hear the complaint that hedge fund managers wouldn’t take on the burden and pressure of managing without annual rewards.  I doubt this threat is true.   However, if hedge fund managers are correct, it would have the added benefit of reducing the number of people pursuing a career in money management. That would be a great thing for the economy and society as a whole.

I am ashamed to admit that I’ve signed my share of agreements with hedge fund management with annual profit-sharing provisions.  I guess I’m not at a terribly sophisticated investor after all.

[1] http://dealbook.nytimes.com/2013/04/15/pay-stretching-to-10-figures/

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