Ed Thorp explains the new hedge fund reality

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I had a nice e-mail conversation with Ed Thorp last week. Some of it was reproduced in my Time column, but I thought the world’s legions of Thorp fans might want more.

For those who don’t know the man, he’s a math professor (he spent most of his career at UC Irvine), who figured out in the early 1960s how to beat the house at blackjack by counting cards, wrote a bestselling book about it, then decided Wall Street was probably a more lucrative casino than any of the ones in Nevada. He figured out the Black-Scholes option pricing formula a few months before Black and Scholes did, but instead of telling anybody about it he used it to launch what as far as I know was the first quantitative, computer-driven, “black-box” hedge fund, Princeton Newport Partners.

Anyway, here’s his take on where hedge funds are headed:

What has happened overall in the hedge fund world is a vast rapid
increase in total assets under management and in the number of hedge funds.
The pool of less skilled managers has increased and the more skilled
managers have in some cases closed to new partners and/or to new capital
from existing partners. My perception is that the average edge (“alpha”)
that investors receive is declining due to (1) more capital chasing the same
situations, (2) the entry of less skilled managers, and (3) rising fee
structure. The typical “old” fee structure was 1% annually plus 20% of the
profits. Now it typically is 2% plus 20% of the profits. Furthermore,
there are more packagers of hedge funds–”funds of funds” and institutional
sellers, who add their own additional layers of fees, like 1% annually and
10% of the profits.
Another adverse development, due to the relative increase in demand
versus supply, is the reduction of liquidity for investors because hedge
funds have introduced lockups on withdrawals, often 2 years or more (the 2
years arose from an ill considered SEC move to “regulate” hedge funds,
giving an exemption to funds with a 2 year or longer lockup–which the funds
loved as it gave them a more secure and permanent capital base and the SEC
gave them the excuse they needed to move in this direction).
Hedge fund blow-ups occur continually though not at high frequency so
far, given their number. Amaranth recently lost more money than LTCM though
without threatening to destabilize the financial markets. The real concern
isn’t so much blowups, even big ones, but rather whether there will be a
blowup that does destabilize the financial markets. The way this works,
simplistically, is something like this: A big fund fails; institutions or
funds with assets in the failed fund now have their asset base temporarily
or permanently reduced. Some of them now fail. Institutions or funds with
assets in the newly failed funds now have their asset base reduced. It
cascades out of control. Of course, the government could step in, better
earlier than later, and “save” the system much as the consortium did with
LTCM.
My opinion is that the most likely scenario is not a blowup but rather
that hedge funds as a group will gradually and continuously lose their edge
(if they haven’t already) over other asset classes (the decline to
“mediocrity”). Then they will “top out” –like mutual funds, real estate,
etc.–and then just be a fluctuating fraction of total financial
assets–part of the financial landscape.

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