Earning excess returns

Mark Thoma calls attention to this Washington Post article by Wharton Professor Dean Foster and Oxford Professor Peyton Young:

To illustrate how easy it is to set up a hedge fund scam, consider the following example. An enterprising man named Oz sets up a new fund with the stated aim of earning 10 percent in excess of some benchmark rate of return, say 4 percent. The fund will run for five years, and investors can cash out at the end of each year if they wish. The fee is the standard “2 and 20″: 2 percent annually for funds under management, and a 20 percent incentive fee for returns that exceed the benchmark.

Although he has no investment track record, Oz has a smooth manner, a doctorate in physics and many rich acquaintances. He raises $100 million and opens shop. He then studies the derivatives market and finds an event on which the market places fairly long odds, say 9:1. In other words, it costs $.10 to buy an option that pays $1 if the event occurs and $0 otherwise. The nature of the event is unimportant: it might be a large fall in the stock market, Florida getting hit by a Category 5 hurricane or Russian President Vladimir Putin dying before the end of the year.

Next Oz writes some covered options on this event and sells 110 million of them in the derivatives market. This obligates him to pay the option holders $110 million if the event does occur and nothing if it does not. He collects $11 million on the options. To cover his obligations in case the “bad” event occurs, he uses the investors’ money plus the proceeds from the options to buy $110 million in one-year Treasury bills yielding 4 percent, which he deposits in escrow. This leaves $1 million in “pocket money,” which he uses to lease some computer terminals and hire a few geeks to sit in front of them, just in case his investors drop by.

The probability is ninety percent that the bad event does not occur and Oz owes nothing to the option holders. With a gross return (before expenses) of $15,400,000, the investors are thrilled, and so is Oz. He collects $2 million in management fees (of which he has only spent $1 million), plus a performance bonus equal to 20 percent of the ‘excess return’, namely, 20 percent of $11,400,000. All in all, Oz nets over $3 million for doing absolutely nothing.

Oz can then repeat the same gambit next year. When the fund terminates after five years, the chances are nearly 60 percent that the unlucky event will never have occurred. Oz looks like a genius and gets paid like a genius.

As news of huge financial losses continues to come in, it’s looking like there were plenty of fund managers suckered into versions of this strategy, deluding themselves into believing they were earning excess returns. If you leverage the position rather than cushion with all equity as in the Foster-Young example, you can earn some spectacular returns. At least for a while.

But since we’ve been warning about this scam here for two years, no Econbrowser readers would fall for this, right?

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14 thoughts on “Earning excess returns

  1. phyron

    What if instead of writing a put he wrote a put spread.. i.e slightly lower return.. but no chance of blowing up…
    Or in plain English an Arrow Debreu..
    Would you be appalled then????

  2. PaulS

    Of course, if you expect that the Fed, or the Congress, or both, will monetize your “failure” if the “bad” event occurs, then go for limitless leverage. If you can stick somebody else with the bill via inflation, as is now happening with Dr. Greenspan’s house-price bubble, then you can leverage to your heart’s content with impunity.
    Oz should have raised trillions, rather than just a measly 100 million, in order to benefit from the one-way bet one is entitled to when one is too big to be allowed to fail…

  3. JDH

    Phyron, there are all sorts of ways you can run this scam, including a put spread. The key ingredient is that you only lose in a low probability event. And the determinant of how big your losses are when that event occurs comes down to leverage.

    Really, I think the broader theme that characterizes our current problems arose not from playing with put options, but with various fancy instruments that all had the characteristic of having a low probability of being wiped out.

  4. Anarchus

    In truth, I think the broader theme that characterizes our current problems arises from the fact that people systematically make bad decisions when prospective returns are immediate and clear and risks are intermediate-term and hazy.
    For most participants in fin’l services, the major portion of compensation is an annual bonus determined by sales volume and/or profits. So if you’re a broker at Countrywide or a CDO banker at Merrill Lynch, it’s very important to keep pumping out the volume so that your year-end bonus is bigger than last year’s. If in a pinch that requires cutting a few corners in credit analysis or in taking the unsaleable toxic tranche of last month’s CDO and plugging it into this month’s best quality CDO (creating a CDO-squared), well, the problems created by such decisions might come back to bite you in two or three years, but the bonus THIS YEAR will be very nice. And who knows where you’ll be in two years? People change jobs all the time in financial services.
    Maybe the bigger problem is why investors on the other side were so gullibly gobbling up highly complicated investments – or why investors were so willing to buy bonds with big yields while blindly taking comfort from AAA ratings?
    Maybe we should call this crisis: “Gullible Investment Gobblers and the Lying Liars who fed them”. Or as they used to say, “The ducks are quacking. FEED THEM”.

  5. General Specific

    An askew observation:
    I just finished reading Fogelin’s “Walking the Tightrope of Reason: The precarious life of a rational animal” and it touches upon the well-known contrast between the coherence theory of truth and the correspondence (fundamentalist) theory.
    Should a system refer to something tangible, e.g. a language to a measurement? The coherence theorists would say “nope” and the correspondence theorists “yup.”
    Postmodernists say “nope” as well and are quite happy creating a self-referential–ungrounded–system.
    The derivatives market sometimes reminds me of a postmodernist approach to meaning. It has a tendency towards self-reference, which in most cases works, but on occasion becomes ungrounded.
    Those who thought they were grounded were simply pointing to a similarly ungrounded reference. And then the whole floated away in coherent harmony until reality reasserted itself.

  6. calmo

    Nice to see a…philosophical (such a guess!) entry General…So how “grounded” are you?
    Which one of these “reviews” were “grounded”:
    “Few have described better than Robert Fogelin the peculiar poise that reasoning requires.”–San Francisco Chronicle
    “An insightful examination of the precarious character of our intellectual lives.”–New York Law Journal
    “An intellectual pleasure for those who like their philosophy cool and combative.”–Publishers Weekly
    “A rare book that makes philosophy matter for ordinary people in everyday life.”–Booklist

    Not only the reviews are murdering philosophy.

  7. General Specific

    Calmo: I’m not sure I follow your comment (can’t find the common ground to respond), but I’ve long pondered–at a qualitative level–the problem that the interconnected world of financial instruments makes for assessing risk. Because the risks are all intermingled, pointing at one another. Increasing the potential for systemic problems when a node in the interlinked network fails–in particular the creation of a perception–on paper, or in the computer model–of much lower risk levels than actually exist–because they are correlated.
    Anyway, I don’t think I know what I’m talking about and should follow Wittgenstein’s advice, paraphrasing: I should just shut up.

  8. James I. Hymas

    I see the problem as being not so much the amount of risk, but the mischaracterization of risk. The investment as presented in the article isn’t really so bad – the expected return isn’t negative, gross of fees anyway – but, although this is not made explicit, the investment manager appearst to be benchmarked against T-Bills. It should also be noted that there has been no attempt to make the portfolio market-neutral (the only thing that would make such a benchmark appropriate), but this only proves his investors are stupid.

    There are an awful lot of things floating around in bond portfolios that are not bonds. In Canada, for instance, I’ve heard of Income Trusts being held in bond portfolios, but the portfolio managers are, by all reports, still able to walk around without having rocks thrown at them. I’ve been offered all kinds of crazy things to stick into a bond portfolio that are not bonds … maybe they’re good investments, maybe they’re bad; I don’t know, I don’t look at them because they’re NOT BONDS. Even the main Canadian bond index includes banks’ Innovative Tier 1 Capital which – regardless of price – are NOT BONDS.

    There’s no real cure for this; as always, the only thing that will work is for all ultimate beneficiaries of the investment to have solid understandings of the investment and that’s not going to happen.

    However, good things could be achieved by improving governance in the intermediation process. When I looked at the Florida State Investment Board in my own blog I was struck by two salient facts:

    (1) The CEO of a $184-billion investment fund was being paid less than a junior portfolio manager.

    (2) He was a political appointee.

    At that point – regardless of Mr. Stipanovich’s contribution, or the actual ex-ante merits of the investments – I lost all sympathy for the Florida local funds that are experiencing difficulty due to problems in the MM fund: they are getting exactly what they deserve.

  9. Fred

    The CEO of a $184-billion investment fund was being paid less than a junior portfolio manager.
    He was paid something north of $150K/year, as I recall. And why isn’t that enough? The man with his finger on the red button (the one that sends off the nukes which provoke a russion retaliation, thereby bringing the history of humanity to an end) doesn’t make much more than that. The secretary of the Treasury, a man who can waltz into the buildings where they print dollar bills and presumably walk off with a bundle of them “for official purposes” any time he wants, doesn’t make much than that. The chairman of the Fed, who could makes billions by insider trading, doesn’t make much more than that.
    The hedge fund issue will resolve itself of its own accord, when lots of people lose lots of money. The only risk is a public sector bailout. My own preference for dealing with that is to establish a precedent whereby the government can reach back and renege on bailouts performed by a previous administration and confiscate everything from everyone associated with the bailout. It wouldn’t disturb me to see the scoundels responsible for and benefitting from any bailout shot by a firing squad while we are at it, though I know some people might think that is going a bit far…

  10. Joseph

    James I. Hymas: The investment as presented in the article isn’t really so bad – the expected return isn’t negative …
    That seems to be a pretty low bar for an investment. If I offered to triple your wealth or else you give me everything you own based on a single coin flip, would you take the bet? Would your answer change if the stakes were $100, or $100 thousand, or $100 million?

  11. James I. Hymas

    Joseph -

    Yes, an expected return of zero is a very low bar for an investment. My comment only came to mind because JDH has commented on investments with an expected long term return that is negative.

    In terms of the investment used in JDH’s post, stating that the market thinks that there’s a 10% probability of an event is … well, it’s not wrong, but it’s not really all that right, either. It’s priced that way because that’s where the guys who think the probability is really 9% are selling to the guys who think the probability is really 11%. With a fair bit of noise added by guys like the hedge fund manager in the example who really have no idea.

    As for your coin flip example … Rule #1 states: “Risk not thy whole wad.”. I wouldn’t do it for the whole shebang on one toss.

    If, however, there were numerous counterparties available with whom I could make sufficient such bets that I could be reasonably assured that statistics would get a chance to work (and I’ve assured myself that the odds really are what you’ve quoted!) … sure! I will make as many such bets as I can, staking one percent of wealth on each of them.

    There are many ways to classify schools of investment management thought. One school thinks of a story and invests accordingly … the story could be commodities to China, or death of the greenback, or Internet Everywhere – whatever. The other school distrusts stories and says stuff like … ‘I have no idea how Wall Street as a whole is going to do this year, but at current prices Brokerage X is 10% undervalued relative to Brokerage Y.’ If you make sufficient bets based on relative value AND your evaluation of relative value is correct enough often enough, you’ll make good money.

    Fred: And why isn’t that enough?

    No idea. Blackrock has been called in to fix up the mess – maybe you should address your question to its CEO.

    I personally do not know a single person in the investment industry who got into it due to the potential for power and prestige.

  12. Fred

    No idea. [...] I personally do not know a single person in the investment industry who got into it due to the potential for power and prestige.
    The problem is not that the salary is too low, the problem is the man was paid a bonus for returns in excess of some benchmark. Given the efficiency of the money market, the only way to consistently beat the benchmark is to take on excess risks. If Florida had paid the money-manager $1 billion a year plus bonus, they would have had the same problem.

  13. James I. Hymas

    Performance bonus? I’ve seen this:

    The top five money managers at the SBA were paid bonuses totaling $50,000 last fiscal year for boosting returns earned on Florida’s massive $140 billion pension fund.

    Former Executive Director Coleman Stipanovich received $14,000 in bonus pay, almost 8 percent of his $177,000 salary, according to an executive-compensation study the SBA commissioned.

    These pathetic amounts only reinforce my contempt for the Florida State Board pay-scale. Nobody would work there if their other choice was a private sector investment management firm – although there may have been hazard introduced by the consideration that if they did really well, they had a chance for an interview at a real company.

    I will agree that as a matter of prudence, any performance-based bonus arrangement should be structured (via limits and deferrals) such that keeping the job and delivering performance over the long term are the paramount consideration.

  14. Joseph Somsel

    General Specific’s summation reminds me why we engineers are known for our arrogance and pig-headiness. In most cases, our work WILL be tested against the ground of physical reality. We can have little truck with the ungrounded and the self-referential.
    The latter are great arenas for snowing people and taking their money and/or their votes.
    As to the hedge fund manager in the main entry, he’s gambling. If his investors understand that he’s gambling with THEIR money, fine and well.
    But the math behind gambling shows that if the odds are against you on any roll of the dice, then bet then bet the limit (go all in). If you win in spite of the odds, the problem becomes, when and how do you walk away.
    If each transaction has odds IN your favor, then bet small and repeatedly so that a bad run won’t wipe you out. Barring a truly unlikely run of losses, your wealth will evermore increase.
    In a growing economy, the latter case is a better model so long as you keep picking the right game. Looks like time to move away from the securitized mortgage table.

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