Dr Myers’ 2 guesses on hedge funds…

FEN: The hedge fund industry passed the $1 trillion mark earlier this year. Do you think the corporate structure and compensation systems for hedge funds make sense, or are those areas that are evolving as the market matures?

Myers: I?m not a hedge fund insider but I?ll give you two guesses. Guess #1 is that hedge funds are too popular for their own good and there will be shakeout. Guess #2 is that the governance structure for hedge funds is going to evolve and improve. I suspect that the governance structure that hedge funds have now is well short of optimal.

he also compared VC to hedge funds:

Myers: A venture capital firm investing in startup companies makes a series of illiquid investments. If the VC firm puts $X in Startup Y, the VCs have to work with that startup for some period of time. They can?t wait a month or two and say, ?Let?s sell that one and buy something else.? The VCs hold on to that startup until it either fails or reaches an IPO or some other exit point. VC investors ? the limited partners ? therefore know which startups are in the portfolio, they know that they?re actually there, and they know that they?re not going to change over the weekend.

On the other hand, let?s say a hedge fund is investing in corporate debt. If the hedge fund incurs losses, the hedge fund managers ? the general partners ? may not have much left over after the limited partners are satisfied. This creates an incentive to increase risk. How do you prevent the managers from increasing risk? They?re trading all the time and have a wide range of securities to choose from. Investors can?t track trading positions in real time or see trading motives. So we have a paradox: liquidity is generally a good thing, but it also means that the risk of an actively traded portfolio can change rapidly. The opportunity to trade and risk-shift can amplify incentive problems.

Stewart C. Myers: FEN One on One Interview

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