Hedge Funds: A ‘Lemon’ Market?

Date: Friday, April 4, 2008
Author: The New York Times

A new twist has emerged in the long-running debate over whether the $2 trillion hedge fund industry uses its power for good or for evil.

Wharton’s monthly publication, Knowledge@Wharton, reports that new research by Wharton statistics professor Dean P. Foster and Brookings Institution senior fellow H. Peyton Young argues that it’s easy for hedge funds to fool their investors into believing the managers are better than they really are, making it extremely difficult for for investors to distinguish good managers from bad.

According to Mr. Foster and Mr. Young, investing in a hedge fund is like buying a “lemon” — a car with hidden flaws. “This is a potential ‘lemons’ market in which lemons can be manufactured at will, and the lemons look good for a long time before their true nature is revealed.”

One way hedge funds appear to encourage good performance and keep managers’ interests in line with investors’ is to load management contracts with incentives. But the paper notes that, in practice, there is no way to encourage excellence without making scamming profitable as well.

The researchers argue that it’s easy for an unscrupulous hedge fund manager to make himself look better than he is. “We show, in particular, that managers can mimic exceptional performance records with high probability (and thereby earn large fees) without delivering exceptional performance.”