Tuesday, December 15, 2009

Earn More by Doing Worse: Or, Who’s the Golden Goose of Hedge Funds?

In the popular imagination, hedge funds are exclusive outfits that deliver scads of profit at minimal risk. Sadly, though, the investors as a group have found that the outcome is precisely the opposite of what they had fancied.

In terms of net returns to the customers, even the top tier of hedge funds lag comfortably behind mutual funds; and the latter pools are widely known to underperform the benchmarks of the stock market. To make matters worse, though, hedge funds go out of business in droves whether the market at large happens to be rising or falling.

The custodians of hedge funds take a big chunk of the earnings, usually ranging from 20 to 50 percent of the spoils, during any period in which the portfolio happens to turn in a profit. For this reason, the general public believes that the goals of the stewards are aligned with those of the patrons.

But this outcome is only half of the arrangement. Unfortunately, the bulk of investors pay little or no mind to the flip side of the picture. And the downside is the scary part. When a bet goes sour, the investors take the fall while the plungers that caused the blowup get off without a scratch.

Due to the twisted pattern of payouts, the incentives of the operators are at odds with the objectives of the investors. Moreover, the crummy performance of hedge funds on average indicates that the operators as a group do in fact place their own interests ahead of their patrons’.

The purpose of this article is to lay bare the absurd pattern of payoffs which pits the earnings of the operators against those of the investors. Due to the mismatch, the stewards of wildcat pools take batty risks that bolster their own welfare at the expense of the clients.

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