Capital Decimation Partners

Tyler Cowen directs us to Foster and Young explaining how a hedge fund manager can make himself rich simply by exposing his investors to risks they don’t understand.

But this isn’t new. Andy Lo of MIT explained it all with his Capital Decimation Partners example, way back in 2001. [Aha: Calculated Risk made the same point.]

Why is this obvious point only getting attention now?

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Having invested in a hedge fund (I am now out of it) with a broker that will remain nameless, I can tell you that very little information is actually provided to the buying public. Either that, or I was stupid

This scheme is at least 100 years old. The Yellow Kid used it, when racing odds were not posted but only the winning results.

Your readers might interested in what I wrote about it, here:


The huge downside risk was usually supposed to be hedged away. That’s where the name “hedge fund” comes from.

But too much hedging is like saving money without corresponding investment. When everybody has a hedge, nobody has a hedge, or at least not a sufficient hedge. When hedging strategies became increasingly popular, they became increasingly ineffective as well. This is because the overall level of risk was growing as well.

Effective distribution of risk has not resulted in everybody taking a smaller piece of it. Instead, it has resulted in a huge growth in the aggregate risk.

What is frustrating is that this growing monster was so visible for so many years. Many hedge fund managers must have been fully aware of what they were doing. This has probably lead some to give up hedging completely, and just squeezing the last drops out of the leverage system before the inevitable collapse.

If only Charles Ponzi had predicated his scheme on buying debt instead of postage stamps he would have been the first hedge fund founder — and we could have called them Ponzi Funds instead of Hedge Funds.

Looks like the negative externalities of hedge ‘debt bombs’ may turn out to be more deadly than the plain old unfiltered negative externalities of tobacco smoke.

On the bright side, ‘debt bomb’ externalities don’t take decades before we can even detect and excise the cancer.

Why do people waste their money on the lottery, or at the casino? For the big score. Of course,no need for regulation, as the hedge funds were sold to wealthy, “sophisticated” investors.

One of the basic rules of investing is that return is proportional to risk. Big returns, big risks. But people- even those who should know better- persist in believing you can get something for nothing, or can find the “system” that can’t fail.

I fully agree that Andy Lo’s CDP fund does what our example does. But this isn’t the primary point of our paper.

The primary point of our article is that it is hard to write incentives that will reward good hedge fund managers without also giving lots of money to bad hedge fund managers.