Skeptics to hedge fund managers: Your alpha has been faked!
Apr 3rd, 2008 | Filed under: CAPM / Alpha Theory, Investment Management Fees, Performance, Analytics & MetricsSubscribers to our monthly email update “Alpha Mail” 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"]
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[...] “The birth of ETFs has helped keep mutual fund managers honest.” (All About Alpha) [...]
[...] In the last week, I’ve read the Wharton “Hedge Fund Game” paper (PDF), and commentary on it by All About Alpha, Financial Crookery, Dealbook, and the FT. The debate focuses on one type of manager and fund, and misses the idea that funds and managers are a mixed bag; what matters is WHY THEY WANT YOUR MONEY. [...]