Hedge Fund Wizard or Scam Artist?

Hedge funds are risky, and ought to be transparent. Here's an example to illustrate "how easy it is to set up a hedge fund scam":

Hedge Fund Wizards, by Dean P. Foster and H. Peyton Young, Brookings Institution, Commentary, Washington Post: Scarcely a day goes by without another story of some large hedge fund blowing up due to bad bets. While many of the latest hedge fund casualties are linked to the subprime mortgage crisis, investors should not be lulled into thinking that the problem will be solved once the mortgage mess is mopped up.

Hedge funds are risky for another reason. It is extremely difficult to tell, based on past performance, whether a fund is being run by true financial wizards, by no-talent managers who happen to get lucky or by outright scam artists.

To illustrate how easy it is to set up a hedge fund scam, consider the following example. An enterprising man named Oz sets up a new fund with the stated aim of earning 10 percent in excess of some benchmark rate of return, say 4 percent. The fund will run for five years, and investors can cash out at the end of each year if they wish. The fee is the standard '2 and 20': 2 percent annually for funds under management, and a 20 percent incentive fee for returns that exceed the benchmark. ... [...continue reading...]

Comments

[hari]

This is absolutely crazy...like parasites these hedge funds are mushrooming all over the sectoral divide and hoodwinking innocent people (who certainly don't understand the underlying value of the fund).

EU considered (under German chairmanship) to regulate Hedge Funds operating in EU markets. But it didn't fly!
The British opposed any control what-so-ever on funds.

UK also UK originates/manages a lot of these (offshore) funds...

At some point in time, as new cabals emerge and create havoc in the operations of the orderly market, some action against unwarranted marketing gimmicks may be in order. Or they'll will have to finally institute regulatory regime on Hedge Funds & Operations - transparency is an absolute must for the individual investor if he/she can follow what's on offer, etc.

[ken melvin]

Krugman's @ Google 14 Dec.

http://calculatedrisk.blogspot.com/2007/12/video-krugman-speaks-at-google-dec-14th.html

[Eyal Bar]

The conclusions of the article are wrong for America and for the world. Containing the hedge fund industry in further layers of regulation is futile. When will these people learn??
The right direction for our country is to have hedge funds blow up, scare the common man who naively invested in them, scare the pension funds and endowments who invested in them, and leave behind an unregulated industry for sophisticated/accredited investors, people who are wealthy and who have a lot of life/business experience. Those people are more than capable of viewing IN ADVANCE when there is a hedge fund scam like the one theorized in the article. If we regulate the industry, hedge fund managers will find new scams, because no regulation is perfect. How come the Investment Act of 1940 didn't prevent the scams of the 60's and the scams described by this article? After new scams occur, we will one day have to regulate even more. It's not a question of how much you regulate, it's "the client base, stupid"! Instead of registering and having layers of mutual-fund-like compliance expenses, hedge funds must remain a low-cost operation whose client relationships are based on good old trust.
What will transparency give?? It's not as if the simpleton clients don't know what they're investing in!! They may or may not, but even if they do, they won't understand it!! And the converse also holds. That is to say: when a sophisticated investor is approached by a hedge fund, even if the hedge fund has a no-disclosure policy, the investors is going to scrutinize the manager so much that there will be a very, very, very small amount of hedge fund managers who actually lie to such sophisticated people in a face-to-face meeting, get all the trust they want, and run away with a scam as described by the article.
Hedge fund managers are usually very far from being street gangs. Clearly the authors of the editorial have never invested in hedge funds. If anybody is responsible for all the credit-stuff that's blowing up right now, it's professors like them. There lies the biggest problem. If we all just remained old-school businesspeople, old-school "consumers" and old-school investors, things would be quite stable now.

[nocountry]

Interestingly, it turns out that lots of common investment strategies have returns that are strongly correlated with the option-writing strategy described in the article. For example, here is a paper showing that this is so for merger arbitrage:

http://www.blackwell-synergy.com/doi/abs/10.1111/0022-1082.00401

[calmo]

Eval, I have to ask following thisClearly the authors of the editorial have never invested in hedge funds.clearly have you invested in hedge funds? Can you spare the time away from your other investment obligations to comment here as if you had the minimums to participate in HF ventures?
Can we assume that your knowledge of HFs means that you lost serious money (I'm sure you will be joined by many shortly) and are reduced to current misfortunate circumstances that allow you to guide our investment behavior?

It is a variety of the Black Market Economy, yes? There might be serious constraints on the credibility owing to proprietary information, practices, partners, times, places, payoffs, favors, promises...threats...

[phyron]

Would you be as incensed if instead of a "put".. he sold a Put Spread.. or an Arrow Debreu..

No risk of blowup then?? and the same Probability math applies..

Then it seems like exactly what everyone in the world should be doing.. and indeed does..

Flip it around.. the bet remote is that the FED tightens rates in the next year..
Buying a Two year NOTE is equivalent to selling a Put on exactly this event..
Prudent risk avoidence? or just selling the probability of a tightening?

[Hedge Fund Blog]

Have any additional articles or white papers on this topic? I would like to reference your blog and write about this in my own hedge fund blog.

- Richard
Richard@RichardCWilson.com

[Hedge Fund]

Here is my article on Hedge Fund Ethics related to this topic: http://richard-wilson.blogspot.com/2007/12/hedge-fund-ethics.html

[Dorothy]

Thanks for exposing the hedge fund structure for the scam that it really is. In spite of the smug and pompous babblemouths who endlessly defend this despicable rip-off scheme, one that has contributed to the current economic debacle, it is refreshing to see some attempt to expose the abuses and shortcoming of this type of fund.

[Richard]

Hedge funds are based daily in the mainstream media but when you interview consultants, family offices and the ultra high net worth people who invest in them - guess what? they are on the whole positive about hedge funds, even during the crisis there have been signs of UHNW individuals wanting to move away from equities and towards hedge funds.

The blame doesn't come from those investing, it comes as a spectators sport and easy scapegoat for complex market variables.

- R