Beware Of Rigged Bets

Hedge fund managers basically offer a “heads I win, tails you lose” bet to their clients, something investors appear surprisingly happy to sign up to. The hedge fund industry’s assets surpassed pre-crisis levels last spring, according to State Street, although the average fund ended up losing 5 percent during 2011.

It’s presumptuous to question the sanity of investors controlling US$2 trillion. All the same, I’d be interested to hear their collective take on the astonishing figure reported by Jonathan Davis in the Financial Times earlier this week.

“Between 1998 and 2010,” says Davis, quoting from a new book by Simon Lack called The Hedge Fund Mirage, “even on favourable assumptions hedge fund managers earned an estimated US$379bn in fees, out of total investment gains (before fees) of US$449bn. In other words, they took 84 per cent of the investment profits their funds made, leaving just 16 per cent for the investors.”

Principal-agent problems (to use economists’ jargon for a biased coin toss) aren’t confined to hedge funds. Private equity fund managers enjoy a very similar fee structure, this time with tax breaks thrown in. In the banking sector, a taxpayer guarantee has underwritten the large cheques employees have been paying themselves at the expense of bank owners. Over the last decade, those bank shareholders have been led by the nose to the same slaughterhouse as the average hedge fund investor.

Share options, supposedly there to align the interests of managers and shareholders, can easily end up incentivising the pursuit of short-term share price gains at the expense of companies’ long-term health. In fact, conflicts of interest are embedded in all limited liability corporations. The high debt levels at banks, hedge funds and in private equity firms’ leveraged buyouts only serve to exacerbate the problem.

It’s worth remembering that new joint stock companies were banned in the UK for over a hundred years following the bursting in 1720 of the South Sea bubble, one of the very biggest financial booms and busts. Adam Smith, who was born three years later, in 1723, wrote of the irreconcilable and fundamental conflicts of interest that occur when there’s a separation of those owning a company from those controlling it.

When new joint stock companies were once again allowed in the UK in 1825, investors in companies’ shares had to carry unlimited liability for losses for another three decades. The 1855 introduction of limited liability was opposed by many precisely because it was felt that this would lead to more reckless behaviour by those running companies.”[The Limited Liability Act] proposes to depart from the old-established maxim that all the partners are individually liable for the whole of the debts of the concern,” said Earl Grey in the House of Lords.

Unfortunately, even though owners carrying unlimited liability should have kept tight reins on those to whome they delegated management duties, they didn’t always exercise sufficient care. Many bank shareholders continued to have unlimited liability until 1879, and when the City of Glasgow Bank failed in 1878 as a result of misjudged speculations in emerging markets, it bankrupted almost all of its stock owners, including John Buchan, grandfather of the famous novelist. The story is recounted by Buchan’s great-great-grandson, James, a former FT journalist, in his excellent 1997 history of money, Frozen Desire.

It’s hard to imagine a world more different from the recent “devil take the hindmost” philosophy characterising the behaviour of those running the financial markets.

Principal-agent problems are therefore a recurring theme in financial history, although they’ve reached a new extreme since the mid-1990s. The recent boom in ETFs is in no small part a reaction to excesses in fund managers’ pay policies and the resulting poor value of many investment products.

But investors need to be aware of misaligned incentives, whomever they’re dealing with. As we reported last week, the blurring of the lines between ETF firms and index providers raises some tricky questions over governance. The recurring debates about collateral, counterparty and stock lending risks in ETFs are also, at their heart, expressions of concern about conflicts of interest.

The ETF market has already spawned a few multi-millionaire financiers, but no billionaires of the scale of Soros, Simons and Paulson. But if ETFs are still, fortunately, far from meeting Warren Buffett’s famous description of hedge funds, “a compensation scheme dressed up as an asset class”, there’s also no room for complacency. With reforms bogged down by lobbyists and overshadowed by the debt and euro crises, politicians and regulators are far from addressing the root causes of the agency problems that still beset the whole financial sector.

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