An evolutionary view of hedge funds’ “fundamental problems”

Critics of the hedge fund industry point to an oft-cited (and in our view, somewhat tired) list of grievances:  lack of liquidity, opacity, potential conflicts of interest and questionable alpha-generation.

You may or may not think any of these claims has legs.  But despite whatever your views are on these charges, it can only be helpful to look back into the evolutionary history of the hedge fund business model itself to gain some insight.  That’s what Yang Cao, Joseph Ogden and Cristian Tiu of the University at Buffalo did in a paper to be presented at a symposium in nearby Toronto later this week (note to CAIA members in Toronto: The European Financial Management Conference on Alternative Investments is being held at York University.  CAIA is co-hosting a kick-off dinner and panel discussion as part of the event on April 7th – click here for more on that dinner.)

Regular readers may remember the name Cristian Tiu.  He was a guest contributor to back in 2007 when he wrote about endowments’ investment in alternatives (see his post).  He was also cited for the same study in a recent World Economic Forum report on long-term investing (p.23).

Cao, Ogden and Tiu chart the evolution of hedge funds from the primordial soup of the investment banking swamps to highly-evolved and intelligent creatures with articulated thumbs.  Along the evolutionary road, they write that hedge funds have taken the form of six distinct business models.

First, there was the so-called traditional investment bank model where clients did business with the bank and the bank’s staff did the trading.  In exchange, those staff were compensated as employees with salary and bonuses.  Although this wasn’t technically a hedge fund model, it did include some of the genetic building blocks for what would become the modern hedge fund.  This structure provided clients with the safety of knowing the i-bank would provide supervision of the trader, lest it suffer reputational damage.  However, the trader was constrained by risk parameters and their incentive was diluted through pooling across the bank.  Plus, the administrative cost of recording each trade for each client was burdensome.

This model is described by the schematic below from the trio’s paper:

In an effort to simply rationalize all this trading and to provide staff with more of a direct incentive to produce returns, the investment banks then took the first tentative steps toward something that resembles a modern hedge fund.  The researchers call this model the inside-only hedge fund model since the clients of the hedge fund are all clients of the i-bank.

The trio writes that such a model has many advantages and doesn’t sacrifice the “trust” advantages of the traditional structure.  In fact, this is clearly their favorite model for hedge fund management…

“Overall, we conclude that the inside-only hedge fund structure dominates the traditional investment bank structure… [T]he inside-only hedge fund structure also appears to dominate other hedge fund structures.”

But an “inside only” hedge fund can only grow so large.  In order to really take advantage of economies of scale, a hedge fund needs to look beyond its parent bank’s client roster and bring in outside investors.  Enter the straddling hedge fund model.

This model allows the fund to seek outside investors.  But it also raises several new issues.  Namely, it creates “adjacency risk” since the outside investors are able to run for the exits at the first sign of trouble.  When all the investors were internal, the bank had more influence.  It also raises questions about who should get what level of transparency.  In addition, when the fund grows too large, alpha is likely to be diluted.

In an effort to mitigate the risk of outside capital sloshing in and out of the fund (and therefore causing its illiquid holdings to gyrate in value), Cao, Ogden and Tiu suggest that a straddling hedge fund could always allocate to a second fund – perhaps an outside fund.  They say this could act as a “relief valve,” effectively creating a straddling feeder fund of fund model. This next rung on the evolutionary ladder is captured by the schematic below from their paper:

This might help with liquidity management.  But the trio argue that it also gives the fund an incentive to put money anywhere they can find that looks better than cash.  Ergo, it introduces a “lemon” problem where a fund of funds involves one core fund and a bunch of lemons around it.

This brings us to the modern-day stand-alone outside hedge fund. This model lacks the (perceived or real) safety of being “tethered to an investment bank and its reputational capital.”  As a result, the trio argues, it is at a greater risk of being front-run or “mimicked” by other hedge funds.

They write that some of these risks can be ameliorated by packaging these funds together into an “outside feeder fund of funds” – or, as we know it today, a plain vanilla fund of funds.       

But in an effort to fix successive deficiencies in earlier business models, the trio argues that the much-heralded fund of hedge funds still suffers from the same “fundamental problems” as its genetic ancestors:

“[T]he outside ‘feeder’ FOF structure is also replete with problems. First, adjacency risk may be substantial despite the moderating effect of a FOF because the investor base does not include a cadre of stable ‘inside’ investors. For this reason, we predict that an outside FOF may actually be forced to offer relatively poor liquidity for outside investors (i.e., in terms of lock-up period, redemption notice period, and redemption frequency). Second, the general managers of both the outside FOF and the outside hedge funds in which it invests may have relatively small amount of reputational capital at stake, which can lead to a situation in which many of the outside hedge funds in the structure may be lemons. Third and finally, the bond between each hedge fund and the prime broker(s) it uses is much weaker than for ‘inside’ hedge funds. Consequently, the stand-alone hedge funds in this structure may still need to employ multiple prime brokers to mitigate front running risk.”

Clearly, all of these models co-exist today (from traditional investment banking models to outside feeder funds of  funds models).  We’ve recapped their “fundamental problems” below:

But this paper is unabashedly critical of what some surely see as the pinnacle of achievement in Hedgistan – the fund of funds.  Sure, some of it may be a bit of a stretch.  But before you write in to complain, tune in tomorrow when we cover the second half of this new and controversial study…

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