Hedge Funds & Lemons

Martin Wolf today explicates why the hedge fund industry will not be around much longer.

"Why today's hedge fund industry may not survive" | Financial Times | 19 Mar 2008

In the piece, Wolf explores several important, if not new, market concepts having relevance to the fucked up fee structures of hedge funds:

The Taleb Distribution ...

"At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period."

The Clawback ...

When a hedge fund manager must return prior fees to investors for subsequent failure to meet the return benchmark.

The No-Clawback ...

Greed.

Moral Hazzard ...

"...the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit."

The Lemons Problem ...

"... in this business it is really hard to distinguish talented managers from untalented ones. For this reason, the business is bound to attract the unscrupulous and unskilled, just as such people are attracted to dealing in used cars (which was the original example of a market in lemons). The lemons theorem states that such markets are likely to disappear."

These are problems which arise when certain activities are unregulated. I think it would be unfortunate if governments view the collapse of the structured finance and private equity sectors as a mandate to regulate the markets, but what alternative is there if in the unregulated spaces it should be impossible to distinguish merit from luck?