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With the recent news of another large hedge fund failure, the usual talking heads start their annual calls for “greater regulation” and talk about the “outsized risks” these funds take as reasons for the failure. While there may be some validity to these claims, they are not the real reason that hedge funds often fail in spectacular fashion. The real reason is that the hedge fund system encourages managers to roll the dice.
Think about it, your a manager of a $1 billion hedge fund. The 2% management fee is a mere $20 million a year and most of that is eaten up by overhead costs. The real money is in the 20% performance fee. Therefore, you decide to leverage the fund 10:1 in S&P futures. Now each 1% increase in the S&P is a 10% move for your fund. Lets also assume that if your fund is up 30% for the year you’ll stop trading for the year and just collect your additional $60 million (you personally will pocket $25million of that) while if your fund is down 30%, the investors will demand their money back and the fund will be shut down.
Now we’re in a coin flip situation, pick a random day to start from and see if the S&P moves up 3% before it moves down 3%. The odds are close to 50/50 on a given day. Now lets look at the consequences for you the manager.
1. S&P goes up 3%, you’re a hedge fund golden boy, and earned over $25 million in a single year, plus your recent performance has increased your profile and now your fund has double to $2 billion meaning that the management fee is now $40 million, guaranteeing an extremely generous salary for you even if the fund does not outperform the next year.
2. S&P goes down 3% and your investors all demand their money back. You still made a good salary for the year, and since you’re an “experienced hedge fund manager”, you’ll have no trouble being backed to start another fund where you can flip the coin again.
Remember, it only takes being right once to be financially set for live and Wall St. is the land of second chances. Don’t believe me? Anyone remember Brian Hunter?
- John
August 2nd, 2007 at 2:53 pm
[...] only problem is you need the $1billion for this scenario to be potentially [...]
August 3rd, 2007 at 7:16 pm
Great read about Dave’s true color and amateurish writing skills coupled with a long position……Ouch…
“The Glorious Vindication of Timothy Knight
I’m going to do a lot of charts later. But I’d just like to twist the knife a bit on the bulls while I have the opportunity.
Writing a blog that actually has an opinion is tough. Writing a blog whose opinion runs contrary to a worldwide manipulation of financial markets is enough tougher. Because the sheep love to go along for the ride.
A guy named Dave Johnson has a (very minor) blog where there was a chat room. On July 16th, there was this snippet, when someone asked him about me:
dayvejohnson: yes but i’ll need specific calls each day
dayvejohnson: dim tim is just an idiot
dayvejohnson: he writes technical analysis software
dayvejohnson: a cant figure out how to use it?
In case you are wondering, I have produced a chart of the Dow 30 with an arrow highlighting the precise point where the above slander was written.”
September 19th, 2007 at 3:18 am
Thanks for sharing this article. I hope hedgefund will soon be properly regulated.
December 18th, 2007 at 12:28 pm
[...] a previous post of mine, I talked about how the compensation structure of the average hedge fund could lead to unnecessary [...]
May 17th, 2008 at 8:49 pm
Interesting article but I think what is not often discussed is the path to become a $1B hedge fund…most hedge funds are $30M-$300M in size and make much less off of just the management fees, yes they still make a lot but the math is much different. You could probably dedicated a whole blog to the risks different hedge fund managers take on within different strategy segments of the hedge fund industry..anyways good post. Thanks for this.
- Richard
http://richard-wilson.blogspot.com
November 12th, 2008 at 9:47 pm
The reason for hedge fund failures goes beyond the usual suspects of hedge funds taking on undue risk because of their compensation structure and high leverage. The most simple reason is that there are more than 5000 hedge funds in the US. The fact that less than 1% have failed this year is not that difficult to believe. If you gave a hundred day traders a certain amount of money and told them to go for high returns, a lot more than one of them would be bankrupt by the end of the year.
For more info on hedge fund failures see:
http://hedgefundblogman.blogspot.com/search/label/hedge%20fund%20closings