http://us.ft.com/ftgateway/superpage.ft?news_id=fto031820081426064497

http://www.economics.ox.ac.uk/research/WP/pdf/paper378.pdf

http://www.bepress.com/cgi/viewcontent.cgi?article=1311&context=ev

http://www.jstor.org/stable/view/1879431

In the market for lemons model a buyer is unable to determine the quality of a product before purchasing it due to asymmetric information. As a result, the seller has an incentive to sell low-quality goods (lemons) as if they were high-quality goods. The earliest work on the market for lemons was published by George Akerlof in his paper, “The Market for Lemons: Quality Uncertainty and the Market Mechanism” (http://www.jstor.org/stable/view/1879431), which illustrates the market for used cars as an example of how quality uncertainty can distort a market. Because of the uncertainty, sellers of high-quality products are unable to obtain good prices. They must sell the high quality goods for less, increasing the incentive for sellers to simply sell low-quality goods as high quality goods.

A lemon market will be produced by the following (from http://en.wikipedia.org/wiki/Market_for_lemons)

1. Asymmetry of information- No buyers can accurately assess the value of a product through examination before sale is made. All sellers can more accurately assess the value of a product prior to sale

2. An incentive exists for the seller to pass off a low quality product as a higher quality one

3. Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers)

4. Deficiency of effective public quality assurances (by reputation or regulation)

5. Deficiency of effective guarantees / warranties

This model can be applied to the market for hedge fund managers, where it is difficult for a buyer to determine their skill. A few months ago we were in a bull market and everyone was doing well. Now almost every other week another hedge fund collapses. Many investors, even sophisticated ones, are losing badly. This is because these investors were unable to determine the quality of the hedge fund manager before investing and the hedge fund managers had an incentive to exploit the reward distributions to their own benefit.

The point is explained by Dean P. Foster and H. Peyton Young of Oxford University in a recent paper, “The Hedge Fund Game: Incentives, Excess Returns, and Piggy-Backing”, (http://www.economics.ox.ac.uk/research/WP/pdf/paper378.pdf), and described in “Hedge Fund Wizards” (http://www.bepress.com/cgi/viewcontent.cgi?article=1311&context=ev). They explain the dramatic problem in the hedge fund industry that allows hedge fund managers to profit greatly while exposing their investors to significant unknown risks.

They exemplify how shopping for a hedge fund manager is like shopping for a designer car with amazing performance that is manufactured using top-secret methods and is completely unique. The problem in shopping for such a car, like shopping for a hedge fund manager, is that neither you nor your mechanic is allowed to look under the hood (uncertainty). Furthermore, you cannot evaluate the performance of similar vehicles because they do not exist. Investors are not allowed to know how hedge funds work because every fund is different, and they offer no warranties (one of the criteria that determine a lemon market). It easy for a hedge fund manager to fake high performance over an extended period of time without getting caught. It is like buying a car that is initially “turbo-charged,” but in reality is “constructed using spare parts and will eventually blow up.” So essentially we have a situation in which sellers of low-quality products can sell them as high-quality because buyers cannot determine quality before purchase.

The authors illustrate how a fund can borrow massively by leveraging their investors’ money in short-term money markets in order to purchase high-yielding paper. If the leverage is sufficient, the fund will likely make profit for years, but is also likely to be wiped out at some point. If the manager is good with probabilities but not good with investments, they illustrate how the fund can run for more then five years earning huge returns with a high probability, attracting more investors and new money. The fund becomes enormous. The trouble is that investors do not know that this manager has no investment talent. They see returns given what happened (the shiny car in the lot). These returns are very good if risks are sufficiently low, which the manager tells them they are (i.e. he sells a low-quality good as a high-quality and reliable good). When the rare event occurs (the lemon breaks down), and it eventually will, the investors will be cleaned out if they leave their money in the fund. But at this point the manager has already made a killing, earning 20% of the returns each year before the crash. This wipe out is what has been happening to many hedge funds recently.

They demonstrate how it is very difficult to structure incentive schemes that distinguish between unskilled hedge fund managers, who cannot generate excess returns, and highly skilled managers who can consistently deliver such returns. “Under any incentive scheme that does not levy penalties for underperformance, managers with no investment skill can ‘game’ the system to earn expected fees that are at least as high, relative to expected gross returns, as they are for the most skilled managers.”

Like a market for lemons, the good funds are hurt by this uncertainty. With a rising tide of collapsing hedge funds, investor confidence is on the decline, decreasing the demand for the good funds’ product.

Martin Wolf pointed out in an article in the Financial Times on March 19 (http://us.ft.com/ftgateway/superpage.ft?news_id=fto031820081426064497) that this is undoubtedly a huge “lemons” problem. It is a business in which it is hard to distinguish talented managers from untalented ones. For this reason, the business is likely to attract “the unskilled and unscrupulous”, just as people are attracted to selling used cars. In the lemon market model, it was determined that such markets are likely to disappear. This is what might happen to today’s hedge fund industry if more transparency or regulation are not introduced.