Hedge funds are small aggressively run funds that use advanced strategies and advanced derivatives to produce high returns in either absolute marks or market bench marks. The $2 trillion hedge fund market brings around questions about their power, performance, and economic impact. Compared to the highly regulated mutual funds, the secretive and mostly unregulated hedge funds can bring around problems to people investing in hedge funds because their strategies aren’t necessarily as descriptive and stern.

Recently there has been new substantial research by Wharton statistics professor Dean P. Foster and Brookings Institution senior fellow H. Peyton Young about the statistics of hedge funds and how managers of these small and secretive, and mostly unregulated funds, can use statistics in their favor and convince investors that their profitable yields might be larger and more appealing than what they really are. Their comparison of the hedge fund market to a lemon market is riveting because of the huge power that hedge funds have in the financial world. Also, with the huge yields that hedge funds produce for the managers, with about 1% to 2% of assets and up to 20% of returns. The publication in Knowledge@Wharton and a research article “The Hedge Fund Game: Incentives, Excess Returns, and Piggy‐Backing” at Wharton Business School explored the incentives and tactics that hedge fund managers could possibly use to in a sense “scam” high-risk investors.

The underlying issue within lemon markets is the idea of scamming consumers into believing that there are more “good” products than there are “bad” products, driving consumers to make decisions based on probabilities. “‘According to Mr. Foster and Mr. 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.’” (DealBook Blogs, NYtimes)

The market for lemons that we covered in lecture stated that the limited information when deciding to make a purchase in a market with varied quality of products produces this market of uncertainty for the consumer. When the seller knows the quality of specific products, they have different values for the products than the buyers do. There is some sort of scamming principles in this idea as naturally sellers and buyers want to get the most profit possible, but the sellers have more information, therefore usually profit more. Then the idea of assumptions and probabilities of assumptions and how these probabilities affect consumers’ decisions comes into play.

“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.” (Knowledge@Wharton)

This statistical research showed the ways that managers could possibly manipulate investors more than highly regulated mutual funds. It does not mean that every hedge fund manager is trying to scam their investors, but in a world of money and greed and trying to get the greatest profit, it is interesting to compare the hedge fund sector to a lemon market.

sources:

http://knowledge.wharton.upenn.edu/papers/1352.pdf

http://knowledge.wharton.upenn.edu/article.cfm?articleid=1931&CFID=58584308&CFTOKEN=13228094&jsessionid=a8302864a51c13425137

http://dealbook.blogs.nytimes.com/2008/04/03/hedge-funds-a-lemon-market/