Institutional Investor's Alpha Magazine - December 2008 / January 2009 - (Page 38)

Gaming the System as they are rewarded for good performance. In our view this is not likely to happen, but in any event it won’t solve the problem. The essential difficulty is this: Really bad performance means that the manager loses a lot of money. How can the investors be sure the manager is going to pay the penalty? The answer is to hold the potential penalty in escrow in case the bad outcome occurs. (Obviously, this money can’t be invested in the fund or it could be blown away too; hence, it must be kept in something safe, like bonds yielding a risk-free rate.) If the amount held in escrow is sufﬁciently large, mimics would be deterred from entering the market. But there is no way to differentiate ex ante between the mimics and the real McCoys. Thus the latter would also be required to post a bond. A little calculation shows that they won’t agree to this because they would do better by investing an equivalent amount in their private hedge fund and not taking any money from outsiders. (This rather surprising result is proved in the companion paper on our Web site.)6 What are the implications of this analysis for the hedge fund industry? Essentially, we have shown that the industry is vulnerable to entry by managers who have no particular skill but whose lack of ability is difﬁcult to detect, based solely on their track records. In short, the hedge fund industry has a potential “lemon” problem. This term was coined by economist George Akerlof to describe the used-car market, where sellers tend to have much more information about the reliability of their cars than do potential buyers. This leads buyers to insist on lower prices to compensate for their risk. But then the owners of cars that actually are of high quality will withdraw them from the market, which means that the remaining cars will be, on average, even riskier. The result is a downward spiral in prices and a situation where no one can sell a car at a reasonable price. The hedge fund industry could be facing a similar situation. The root of the problem is lack of transparency: If investors have only track records to go on, they can’t be sure whether they are dealing with a skilled manager or a lowquality manager who is merely mimicking a skilled one. The problem is potentially much worse than in the used car market because it is so easy for unskilled (or unscrupulous) entrants to set up shop. It is as if anyone could manufacture a car in their garage that looks turbocharged for a while but eventually blows up. What is the prognosis for the industry as a whole and what are the possible remedies? We predict that, as lowquality imitators come in, average performance will deteriorate and the number of fund closures will rise. This process ENDNOTES 1. Here is the calculation: Suppose that you have s shares in the fund and you sell n puts. Each put is worth α/(1 + α) shares — its expected value — because by assumption the time to expiration is short. (For longer-dated options the computations involve Black-Scholes pricing, but the idea is similar.) By selling n puts you can therefore buy an additional n [α/(1+ α)] shares, so you now have s + n [α/ (1 + α)] shares altogether. Solving the equation n = s + n [α/ (1 + α)], it follows that you can sell or go short n = (1 + α) may already be under way, though it is being masked for the moment by closures resulting from market turbulence. The problem can’t be ﬁxed simply by reforming the fee structure. The reason is that it costs relatively little to enter the business and it is easy to ape the track records of highly successful managers. Hence any reform in the fees that is potent enough to drive out the mimics is likely to drive out skilled managers too. Rather, the root of the problem is lack of transparency. Skilled managers need to ﬁnd a way to distinguish themselves from the low-quality entrants. Here the analogy with the used-car market provides some clues to the solution. Just as a buyer can hire a mechanic to look under the hood of a possible purchase, so hedge fund managers may have to allow professional intermediaries (acting on behalf of potential investors) to have extensive access to their books and trading strategies, not just once but on an ongoing basis. Alternatively, individual fund managers may ﬁnd it advantageous to operate under the umbrella of a large organization that can guarantee the product, just as the owner of a used car may prefer to sell it through a dealer rather than try to market it himself. The bottom line is that the present arrangement, in which investors have no guarantees against downside risk and must rely solely on funds’ track records to determine fund quality, is likely to unravel sooner or later. The industry’s leaders have a strong interest in making sure that this doesn’t happen. Dean P. Foster is a professor of statistics at the Wharton School of the University of Pennsylvania. He has been a council member of the Game Theory Society since 2005. His primary areas of research are machine learning, game theory and ﬁnance. He has also done work on measuring risk in ﬁnancial markets, making good predictions in the context of data mining and learning the strategic choices made by an adversary. H. Peyton Young is James Meade Professor of Economics at the University of Oxford and a senior fellow in Economic Studies at the Brookings Institution in Washington. Previously, he was Scott and Barbara Black Professor of Economics at Johns Hopkins University. He is a past president of the Game Theory Society, a fellow of the British Academy and a fellow of the Econometric Society. His current research interests are strategic learning, game theory and applications of game theory to ﬁnance. He has also written on the diffusion of innovations and the evolution of social norms. s puts, and this is the number of shares you will have if they are not exercised. 2. At all times you keep your fund fully invested in the desired benchmark asset, in this case short-term government bonds that mature in a year. Once a year you take a short position in cash-or-nothing puts on a stochastic asset (like the S&P 500) that have a nearby expiration date. The strike price is chosen so that the puts are not exercised with probability 1/1.10. More generally, if α is the target amount by which you want to inﬂate your returns, choose the strike price so that the probability is 1/(1 + α) that the puts are not exercised. 3. The fund grows by a factor of 1.144, or 1.04 x 1.10, a year. 4. The calculation is: 1.07 -5, or 0.713. 5. The annualized growth is 1.166, or 1.07 x 1.09. 6. See “The Hedge Fund Game: Incentives, Excess Returns, and Performance Mimics,” Working Paper No. 07-42, Wharton Financial Institutions Center, University of Pennsylvania, November 2007, at http://ﬁc.wharton.upenn.edu/ﬁc/papers/07/p0742.htm. 38 • INSTITUTIONAL INVESTOR’S ALPHA • DECEMBER 2008/JANUARY 2009 http://fic.wharton.upenn.edu/fic/papers/07/p0742.htm

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - December 2008

Institutional Investor's Alpha Magazine - December 2008 Contents Letter from the Editor Longs & Shorts Inside the Trade Pension Corner The Good Guys Interview: Stanley Fink Cover Story: The New Regulatory Reality United States: The Usual Suspects Europe: Flirting with Unity Asia-Pacific: What Asian Contagion? In Theory In Focus Strategies Research Center Alpha Bytes Unhedged Commentary

Institutional Investor's Alpha Magazine - December 2008

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