Wednesday, March 05, 2008

Jackpots and optionally ending games

Mish at Global Economic Analysis is taking a look at a hedge fund that is closing down. It opened a while back with $1 billion from investors, and it now is worth $200 million dollars. However it had a good year before it went bust. The managers of the hedge fun are bailing and closing it down now. However, take a look at the pay package:

Focus Capital had $1 billion under management and made 33% in 2007.
Let's do the math.

$1 billion in assets
33% return in 2007
20% of the gains go to fund management.
6.6% net goes to managers
2.0% management fee is on top of that
8.6% total
$1,000,000,000 * .086 = $86,000,000

$86 Million is not a bad sum of money to make for turning $1 billion into $200 million. Clearly this is the advantage of leverage (at least for those running the fund). All you need is one big year. Who cares after that? I think I could almost retire on $86 million.

In this incentive structure, with minimal personal skin in the game, one good year is all one needs to cash out and be able to do whatever one wishes to do for the rest of one's life. And people wonder why there is so much short-sightedness, and herd behavior. If you only have to be lucky once and being subsequently bad has next to no material impacts, the incentive is strong to gamble with other people's money to enrich oneself legally if potentially unwisely.

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