Hedge funds are key players in the world’s financial markets, but no one knows exactly what they’re up to. Some believe these thinly regulated, secretive investment pools had a role in the subprime mortgage crisis, because they helped create a market for risky securities backed by those loans. Others think hedge funds have so much power they can whipsaw the markets at will, making money by driving prices down as well as up.

Yet others think they are a beneficial stabilizing force, helping markets settle on true values by using short sales, leverage and derivatives bets that are not available to other big players like mutual funds.

Critics and supporters, however, tend to share one assumption: that hedge funds are managed by some pretty talented people. Otherwise, investors would not pay the hefty management fees, typically 1% to 2% of assets and 20% of profits.

But new research by Wharton statistics professor Dean P. Foster and Brookings Institution senior fellow H. Peyton Young questions that assumption, arguing that it’s easy for hedge funds to fool their investors into believing the managers are better than they really are. If so, investors cannot distinguish good managers from bad.

While it’s not possible to determine how many hedge fund managers are scammers, if there were many it would suggest that hedge funds are doing more harm to the financial markets than good. According to the researchers, the industry “risks being inundated by managers who are gaming the system rather than delivering high returns, which could ultimately lead to a collapse in investor confidence.”

At first glance, hedge funds appear to load management contracts with incentives to encourage good performance and to keep managers’ interests in line with investors’. But in practice, there is no way to encourage excellence without making scamming profitable as well. “The main claim of our paper is there is no way to write an incentive contract which will differentiate the two,” Foster said.

Three factors make hedge funds especially susceptible to this problem: secrecy, investing with borrowed money and the use of derivatives, the researchers write in their paper, “The Hedge Fund Game: Incentives, Excess Returns, and Piggy-Backing.

Buying a Lemon

According to Foster and 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.”

While numbers are imprecise because reporting is light, there are more than 10,000 hedge funds today controlling about $1.9 trillion in assets, compared to more than 8,000 mutual funds with $11.7 trillion in assets.

Because mutual funds are open to all investors, including those with limited means, they are tightly regulated. They must stick to the investing strategies they describe in their prospectuses and marketing materials, and they must regularly report their holdings and performance. It is therefore easy for investors, analysts and regulators to assess mutual fund managers’ performance relative to one another and against standard industry benchmarks.

Hedge funds operate in the shadows. Many give only the sketchiest descriptions of their investment strategies, and they do not report their holdings. Unlike mutual funds, they are allowed to invest with borrowed money, to engage in short sales which pay off when securities prices fall, and to place bets on derivatives such as stock options, commodities futures and credit default swaps. While mutual-fund investors can take their money out whenever they want, many hedge funds restrict withdrawals to give managers more freedom to invest as they see fit.

Because hedge funds can take on great risks, federal regulations allow investments only by people with net worth of at least $1 million or annual incomes exceeding $200,000 for individuals, $300,000 for couples.

The typical actively managed stock-owning mutual fund charges annual fees of about 1.3% of the investor’s holdings, while many passively managed index-style mutual funds charge 0.2% or less. Compared to this, hedge fund fees are very high, at 1% to 2% of assets and 20% of profits.

If the market returned 8%, a mutual fund matching it would return 6.7% to 7.8% after fees were paid. A hedge fund with the same results would return 4.4% to 5.4% after fees.

To offset these charges, hedge funds need dramatic results, but research indicates they have not been able to deliver over the long term. A 2007 study of 300 hedge funds by two University of Texas finance professors, John M. Griffin and Jin Xu, found that, from 1980 through 2004, hedge funds outperformed mutual funds by 1.4 percentage points a year. But that was before fees were taken into account. Moreover, the average was driven up by the tech-stock bubble of 1999 and 2000; otherwise, hedge funds did no better than mutual funds.

While Griffin and Xu were unable to get some data, such as the funds’ short positions (bets that stock prices would fall), they concluded that hedge fund managers were not significantly better than mutual fund managers.

Why, then, have hedge funds attracted so many well-to-do investors? “Everybody believes in the free lunch,” Foster said.

‘Fake Alpha’

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

An investment pool’s returns come in two parts: beta, which is merely riding the coattails of a rising market, and alpha, the extra return produced by smart investment choices. Because hedge funds use leverage, or borrowed money, and invest in derivatives, it is fairly easy to produce “fake alpha,” the researchers say.

In their hypothetical example, a fund manager named Oz sets up a $100 million hedge fund with the goal of earning 10 percentage points a year above the 4% annual yield of one-year government bonds. The fund will run for five years and charge a management fee of 2% of assets and an incentive fee of 20% of any profits that exceed the bond yield.

Oz creates and sells a series of “covered calls” and sells them for $11 million. Each call is a stock option that will pay the investor who bought it $1 million if the stock market rises by a given percentage. Using historical information, Oz figures there is only a 10% probability the market will rise that much. If it does, the hedge fund will be virtually wiped out by being forced to pay $111 million to the call owners. If it does not, the fund will pay nothing — and the $11 million received from the call buyers will be profit.

Oz now has $100 million received from his investors, plus $11 million from the options sales. He invests the $111 million in risk-free U.S. Treasury bills earning 4%. After a year, the fund thus grows to $115.5 million. To his investors, this is a 15.5% return on their original $100 million.

Oz earns his 2% management fee on the $115.5 million, plus 20% of the return exceeding what came from the 4% Treasury yield — or 20% of $11.5 million.

There’s a 59% chance this process can continue for five years without a market downturn annihilating the fund, allowing Oz to collect $19 million in fees as compounding makes the fund grow larger and larger. If the market does crash, Oz can close the fund, leaving the investors with devastating losses but keeping the fees he’s been paid to that point.

This simplified “piggy-back strategy” involves no borrowing, or leverage. A real-world manager could inflate his incentive fee by borrowing money to increase the size of his bets, though that would deepen the investors’ losses if things went wrong.

The bottom line is that Oz’s investors, who don’t know what he is doing, may well believe his market-beating results come from brilliant stock picking or other wizardry. In fact, anyone could set up this simple strategy. Moreover, the investors are in the dark about the risks they are taking. They might well assume that if they make in excess of 15% one year, they might lose 15% in another. In fact, there’s a 10% chance they will lose more than 95% of the money they put in.

“Our object is not to concoct the cleverest way to deceive investors using this approach, but to exploit the transparency of the piggy-back strategy to make two general points,” Foster and Young write.

“First, it is extremely difficult to detect, from a fund’s track record, whether a manager is actually able to deliver excess returns, is merely lucky, or is an outright con artist. Second, we show that it is essentially impossible to redesign the incentive structure so that it keeps the con artists out of the market: Any contract that rewards skilled managers will also confer substantial expected rewards on the unskilled (and unscrupulous) managers as well.”

Giving the manager a small ownership position in the fund, for example, does not put enough of his wealth at risk to discourage scamming that can be highly profitable, Foster said. Taking the opposite approach — providing a large ownership stake — is counter-productive as well because the manager is wealthy even if the investors are unhappy with their returns.

Penalizing managers for poor performance discourages risk-taking by bad managers but has the same effect on good ones — undesirably. And basing manager pay on fund returns doesn’t work because unless one knows what the manager is doing, the scammer looks just as good as the talented managers do. “My returns will look like their returns, except that occasionally I will crash and burn,” Foster said. “The bottom line is that I can fake any series of returns by gambling.”

Con artists might be deterred by greater transparency, such as more public disclosure of investment strategies, he said. But talented managers are sure to object to sharing their investment insights with the world — just as untalented and unscrupulous ones will object to revealing their feet of clay.

Given hedge funds’ shortcomings, is there any long-term benefit to investing in them? “I certainly wouldn’t advocate it,” Foster said. “I see no reason to believe they are outperforming the markets.”

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