Investors Need More Hedge Fund Transparency

H. Peyton Young
H. Peyton Young Professor in Economics - Johns Hopkins University

January 14, 2008

(A letter to the editor)

Sir, Raghuram Rajan argues that bankers’ compensation schemes are flawed because they encourage excessive risk-taking (Bankers’ Pay is Deeply Flawed, January 9). A similar argument holds for hedge fund managers, who are typically paid 20 per cent of the excess returns they generate. The problem is that managers can generate “apparent” excess returns by taking on huge tail risks that are hidden from investors and the managers get paid handsomely before the fund blows up.

Prof Rajan suggests that the problem can be fixed by deferring performance bonuses until investors can be reasonably sure the excess returns are real. Unfortunately, this can take so long that it is not a practical solution. Consider the following example: using options, a manager can generate annual returns that exceed the S&P 500 by 5 per cent while exposing the investors to a 5 per cent chance each year of losing all their money.

Suppose that the manager’s bonus is deferred for 10 years and that his deferred bonus equals 20 per cent of the cumulative excess return, assuming the fund does not blow up before then. The probability of this outcome is about 60 per cent and the cumulative excess return is over 60 per cent times the 10-year return of an ordinary S&P 500 index fund. Even for a modest-sized fund this represents a huge deferred bonus, and the manager has a 60 per cent chance of realising it even though the excess returns are faked.

Even with longer deferral times and claw-back provisions, it is very difficult to fix the problem by redesigning the incentive structure. A better remedy is for investors to insist on greater transparency so they know what risks are lurking in the tails.