Hedge funds and Econ 101

Felix Salmon has a very interesting post. detailing the fight between Simon Lack, author of The Hedge Fund Mirage: The Illusion of Big Money and Why Its Too Good to Be True. and the Alternative Investment Management Association, which I presume represents the sales departments of a bunch of hedge funds. Basically Lack’s thesis is that hedge fund managers do beat the market, but keep all of the excess returns for themselves.

It seems to me that this result is what is predicted by basic Econ 101. In Econ 101 you have consumer surplus and producer surplus, which are defined by the supply and demand curves:

The size of the two surpluses is determined by the slopes of the curves, which are called the elasticities of supply and demand. If demand is highly elastic — if the demand curve is close to flat — then the consumer surplus will be very small, and most of the benefits of the market will flow to the producers.

Think of hedge funds as producers and investors (who can give their money to hedge funds) as consumers. What do hedge funds produce? They produce money tomorrow, and the price is money today (this ignores risk, but let’s go ahead and ignore risk for the moment). So money tomorrow produced by hedge funds is the commodity being supplied in this Econ 101 diagram, and money today is the units of the price.

Econ 101 teaches us that demand curves are more elastic when there are substitutes available. For example, if New Balance shoes cost $60, and are just as good as Nike shoes, then as soon as Nike raises its price to $65, consumers will buy a lot fewer Nike shoes (because they will flock to New Balance). When the commodity is money tomorrow supplied by hedge funds, there are many close substitutes available — money tomorrow provided by index funds, money tomorrow provided by Treasury bonds, etc.

So we expect demand for hedge funds’ products to be highly elastic. That means that the consumer surplus will be small.

The producer surplus, on the other hand, might be pretty big, because different hedge funds probably have very different costs of production of money tomorrow. A great fund manager might be able to produce a dollar of money tomorrow for only 70 cents today, while a mediocre manager might have a cost of production of 95 cents. Since production techniques can’t easily be copied (investing techniques are secret), this producer cost heterogeneity should persist. Hence, there will be a big producer surplus — great managers will rake in the cash while mediocre managers will scrape by. This will show up as large excess returns to fund managers, which are extracted from investors via large fees.

So Econ 101 tells us that our baseline expectation should be that while hedge fund managers might beat the market, investing in hedge funds is unlikely to let you, the customer, beat the market. Which is Simon Lack’s main result.

Of course, so far we’ve ignored risk. Many hedge fund sales departments, including the AIMA, are eager to remind investors that hedge funds can help you diversify your portfolio even if their after-fee rate of return is no better than any other asset class. This is true. It is true because hedge funds have access to investment opportunities that retail investors and mutual fund managers lack. So you might want to give some of your money to hedge funds (even at below the safe rate of return!), just to have indirect access to these other assets and thus diversify your portfolio.

Also, according to efficient-markets theory, hedge funds in general will have to offer above the safe rate of return (i.e. Treasuries) if most hedge funds take on a bunch of non-diversifiable risk. In this case, giving your money to hedge funds would be pretty much like buying a bunch of risky stocks. You get more returns, but only because you are able to demand those returns in exchange for committing your capital to risky projects.

And finally, if you have some special way of picking which hedge funds will perform the best, then of course you should give your money to those funds. Which basically means that you, yourself, are a market-beating manager of a fund-of-funds.

So there are certainly possible reasons to give your money to hedge funds. But these are side points. The main point is that, if we believe in supply and demand, then we should not expect hedge fund managers to give you their winnings when they could keep the winnings for themselves via fees. Which they usually can do, since the elasticity of demand for money tomorrow is high. Simon Lack’s results should not especially surprise anyone who believes in Econ 101.