November 14, 2005
Hedge Funds: A Compensation Scheme Masquerading as an Asset Class
Posted by Victor Fleischer

After a long weekend trying to figure out exactly what I want to say in my hedge fund paper (apologies to those who muddled through Friday's long post) ... I've decided to move the project to the back burner to let it simmer while I finish a few other things. 

One reason I'm setting it aside is that I think there's a bigger story here than just another lap around the track on whether regulation is helpful or hurtful.

Several times in my research I came across the saying, "Hedge funds are a compensation scheme masquerading as an asset class."  People who say this usually just mean that hedge fund managers are greedy.  But what if it's true?  What if the defining characteristic of hedge funds is the compensation scheme, not the underlying portfolio?  What are the normative implications?

Perhaps a magic formula isn't the reason hedge funds are thriving.  Maybe they are thriving because they have legal and institutional advantanges over other forms of managing financial capital. 

Many hedge funds are like the proprietary trading desks of investment banks, only wrapped in a limited partnership shell.  Others are like buyout funds (but move more quickly), which are also like the holding company of a conglomerate (but in a very different organizational form).  Still others are like mutual funds, but with a different clientele.  What all hedge funds have in common is the compensation scheme.  Hedge funds are an efficient way for the most talented managers to extract out as much rent as they deserve (and maybe more).  And because the human capital talent here is mobile (not tied to physical capital or even firm-specific capital), stars are free agents, able to move around or start a new fund, extracting nearly all the surplus they create from the investors who put up the financial capital. 

More on the normative implications when I get a chance.  Think of it as the exact opposite of team production -- more like A Terrell Owens Theory of the Firm. 

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» A semi-final word on hedge funds from Ideoblog ...
"I think the various positions on the hedge fund debate have been well aired, including in David Skee ..." [more] (Tracked on November 14, 2005 @ 18:02)
» Hedge Funds: What Compensation Do Managers "Deserve" from PrawfsBlawg ...
"Over at the newly redesigned Conglomerate, there is an interesting discussion about the level of com ..." [more] (Tracked on November 17, 2005 @ 19:45)
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