Hedge funds employ a variety of management strategies but share some common characteristics – they are structured as limited partnerships frequently marketed to “sophisticated investors”, have a fee structure of a management fee plus a share of the profits (Warren Buffett derisively calls them the 2-and-20 crowd) and are poorly regulated and secretive about their investment strategies. Their fee structure alone is enough in the eyes of many critics to recommend that retail investors stay well clear of these exotic products. But despite the high-profile blowups of Long-Term Capital Management, Amaranth Advisors and numerous others, there is wide spread belief that hedge fund managers can get excess returns because they are “smart”. But, are they?
The authors of a new paper titled The Hedge Fund Game: Incentives, Excess Returns and Piggy-Backing argue that it is difficult for investors to tell the smart managers apart from unskilled ones and it is easy for a con artist to generate “fake alpha” and give a simple example of one such gambit. A more accessible version of the paper is available through Knowledge @ Wharton.
The authors say hedge funds are analogous to an automobile “lemons” market in which lemons can be manufactured at will.
Indeed, it [the hedge fund market] is analogous to a car market with the following characteristics: i) every car is one of a kind; ii) the car’s engine is locked in a black box and no one can see how it works (it’s not protected under patent law); iii) anyone can cobble together a car that delivers apparently superior performance for a period of time and then breaks down completely.
Would you buy such a car?