The current shakeout in the hedge fund industry is capturing headlines, as managers who suffered large double-digit losses in 2008 are likely to have little choice but to shutter their funds. But even if the past year’s turbulent financial markets had been more forgiving, the business would be facing a serious challenge from another source. Hedge funds’ fee structure, combined with an almost total lack of transparency, makes the industry vulnerable to invasion by low-quality entrants who could undermine returns and trigger a collapse of confidence. The trouble is that when hedge fund investors are not allowed to look “under the hood,” it can take a very long time for them to determine whether a manager is consistently generating true alpha or is simply having a run of good luck. Even worse, this information gap provides an opportunity for outright charlatans to enter the market — looking just like the real McCoys — without getting caught.
In this article we show how easy it is to generate “fake alpha” when investors can’t see what you are doing, and how much money you can make in the process. Although this potential problem has been discussed in the academic literature and is understood by some sophisticated players in the industry, how serious it is and how difficult it will be to fix is less widely appreciated. The problem can’t be rectified simply by tinkering with the hedge fund fee structure. It is not enough to defer performance fees for managers or require them to hold an equity stake, nor will it work to levy monetary penalties on managers who underperform. Returns can, in effect, be manipulated using a certain options trading strategy. We argue that the only solution is far greater transparency and that the industry itself has a strong interest in providing it.