It's easy for an unscrupulous hedge fund manager to make himself look better than he is, as Foster and Young demonstrate in their paper. "We show, in particular, that managers can mimic exceptional performance records with high probability (and thereby earn large fees) without delivering exceptional performance."
An investment pool's returns come in two parts: beta, which is merely riding the coattails of a rising market, and alpha, the extra return produced by smart investment choices. Because hedge funds use leverage, or borrowed money, and invest in derivatives, it is fairly easy to produce "fake alpha," the researchers say.
In their hypothetical example, a fund manager named Oz sets up a $100 million hedge fund with the goal of earning 10 percentage points a year above the 4% annual yield of one-year government bonds. The fund will run for five years and charge a management fee of 2% of assets and an incentive fee of 20% of any profits that exceed the bond yield.
Oz creates and sells a series of "covered calls" and sells them for $11 million. Each call is a stock option that will pay the investor who bought it $1 million if the stock market rises by a given percentage. Using historical information, Oz figures there is only a 10% probability the market will rise that much. If it does, the hedge fund will be virtually wiped out by being forced to pay $111 million to the call owners. If it does not, the fund will pay nothing -- and the $11 million received from the call buyers will be profit.
Oz now has $100 million received from his investors, plus $11 million from the options sales. He invests the $111 million in risk-free U.S. Treasury bills earning 4%. After a year, the fund thus grows to $115.5 million. To his investors, this is a 15.5% return on their original $100 million.
Oz earns his 2% management fee on the $115.5 million, plus 20% of the return exceeding what came from the 4% Treasury yield -- or 20% of $11.5 million.
There's a 59% chance this process can continue for five years without a market downturn annihilating the fund, allowing Oz to collect $19 million in fees as compounding makes the fund grow larger and larger. If the market does crash, Oz can close the fund, leaving the investors with devastating losses but keeping the fees he's been paid to that point.
This simplified "piggy-back strategy" involves no borrowing, or leverage. A real-world manager could inflate his incentive fee by borrowing money to increase the size of his bets, though that would deepen the investors' losses if things went wrong.
The bottom line is that Oz's investors, who don't know what he is doing, may well believe his market-beating results come from brilliant stock picking or other wizardry. In fact, anyone could set up this simple strategy. Moreover, the investors are in the dark about the risks they are taking. They might well assume that if they make in excess of 15% one year, they might lose 15% in another. In fact, there's a 10% chance they will lose more than 95% of the money they put in.>>>MORE