Subscribers to our monthly email update “Alpha Digest” will notice that one of the top 10 most popular postings last month was one on a research paper by William Goetzmann of Yale University that explores ways that investment managers can potentially “game” their compensation system to generate illusionary alpha.
Now Wharton’s Dean Foster and Peyton Young of Oxford University and the Brookings Institution have added to the manager-as-scammer literature with a new paper entitled “The Hedge Fund Game: Incentives, Excess Returns and Piggybacking“. In it, they decry the proliferation of “fake alpha” (e.g. selling options and using the wrong benchmark to calculate alpha). The paper was published in January, but didn’t start making serious waves until mid-March when Martin Wolf, Chief Economics Commentator at the Financial Times wrote a column about it.
Wolf points out the asymmetry inherent in any type of incentive fee and holds up the Foster/Peyton paper as a “beautiful” example of how incentive fees can be gamed. He says that such a structure bears a resemblance to the used car industry. Like the used car industry, he says the hedge fund industry “is bound to attract the unscrupulous and unskilled.” [Ed: We’re reminded of the famous Forbes cover story on hedge funds in May 2004 “The Sleaziest Show on Earth“]
Wolf is right to question the true value-add created by active managers. Many mutual and hedge fund managers have been producing what investors erroneously believe is alpha for a long time. Ross Miller’s excellent paper in the Journal of Investment Management last year on the lack of value added by mutual fund managers contains some proof of this.
As we’ve argued before, investors should essentially be paying for tracking error, not simply performance. Riding betas up and down does not take skill – as author Alexander Ineichen pointed out in his book Asymmetric Returns (see related posting). In other words, investors should pay active management fees for active management, not simply for a short-volatility strategy (in the case of hedge funds) or an index-hugging strategy (in the case of mutual funds).
The birth of ETFs has helped keep mutual fund managers honest (and has given life to a new form of active manager who uses only these vehicles). And the birth of “hedge fund replication” will help keep hedge fund managers honest (and, like ETFs, has given birth to a new form of hedge fund that embraces these products).
Wolf emphasizes two improvements to the “game-able” system of incentive fees proposed by Foster and Peyton. One is to hold the manager’s feet to the fire by decreasing the frequency of their performance fee payout. The other is to do away with fees altogether and require managers to invest alongside investors.
Both are a step in the right direction. But neither is without serious drawbacks. As Wolf points out, longer payout periods will discourage both “scammers” and good managers; and manager co-investment is a very imperfect form of incentive alignment. (We’ve heard institutions that are frustrated with the conservatism shown by their hedge fund managers since the manager’s stake in the fund means so much more to them that the institutions stake does to it.)
Wolf’s piece elicited rebuttals from several in the hedge fund industry. Riskdata, a firm that specializes in figuring out how much of returns are “luck” and how much are “skill”, issued its own article in response. The March 28 edition of Global Investor (story available here) reports:
“The answer to these problems may well be more regulation, says Riskdata. ‘We need to correct a systematic bias of the system.’ But banning hedge funds, and going back to a mutual funds-only world, is not the answer. ‘Mutual funds lost much more in the recent period than hedge funds. Hedge funds are so far the best investments to secure our pension plansâ€”considering their long term performance. One could say that just going back to the old world would be like going back to old monopolistic telecoms as an answer to the Worldcom bankruptcy.'”
Christopher Miller, CEO of Allenbridge HedgeInfo, another analytics firm, responded directly to the FT (available here). He brings up a number of excellent (but slightly unrelated) arguments in defense of hedge funds. But on the topic alpha, he says:
“…I find that (the) conclusion – that it is too difficult or impossible to differentiate between good managers and bad ones – to be defeatist and not cognisant of how the industry has worked around these issues already. Don’t take my word for it. I can point you towards hedge funds of funds who have consistently produced good low volatility performance for many years, despite the extra layer of fees.”
The debate over the role of incentive fees wil surely rage for a long time to come. In fact, a paper last year by Vikas Agarwal, Naveen Daniel, and Narayan Naik says that incentive fees actually lead to higher returns. They analyze the option-like qualities of the typical performance fee contract and conclude that a mixture of performance fee and co-investment may be best:
“…funds with better managerial incentives (higher total deltas, higher option deltas, greater managerial ownership, and the presence of a high-water mark provision in the hedge fund contract) are associated with better performance. Furthermore…the sensitivity of the manager’s compensation to the fund’s near-term performance is a much better measure of incentives than the incentive fee rate. Our results also demonstrate the importance of managerial ownership, which lends support to the industry wisdom of requiring co-investment by the manager. Second, we observe that funds with greater managerial discretion (longer lockup and restriction periods) generate higher returns…”
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