MIT's Andrew Lo Explains Why Hedge Funds Are Incentivized To Decimate Capital

Many years ago MIT's Andy Lo made a simple point (weirdly, I haven't been able to track down the paper) about the distortion of incentives inherent in financial-industry compensation. Suppose you're a hedge fund manager, getting 2 and 20 - fees of 2 percent of investors' money, plus 20 percent of profits. What you want to do is load up on as much leverage as possible, and make high-risk, high return investments. This more or less guarantees that your fund will eventually go bust - but in the meantime you'll have raked in huge personal earnings, and can walk away filthy rich from the wreckage.

But surely, you say, investors will see through this strategy. They can't consistently be that stupid or naive, can they?

Hahahaha.

Andy Lo's article was published in the Financial Analysts Journal in 2001: Risk Management for Hedge Funds: Introduction and Overview. An online copy is available here.

Jim Hamilton at Econbrowser has a nice summary from 2005: Hedge fund risk

[L]et me tell you about one fund I do know about called CDP, which was described by MIT Professor Andrew Lo in an article published in Financial Analysts Journal in 2001.

1992-1999 was a good time to be in stocks-- a strategy of buying and holding the S&P 500 would have earned you a 16% annual return, with $100 million invested in 1992 growing to $367 million by 1999. As nice as this was, it pales in comparison to CDP's strategy, which would have turned $100 million into $2.7 billion, a 41% annual compounded return, with a positive return in every single year.

Of course the strategy would eventually go bust, but the managers would be rich!!!