Executive summary - Udo Bullmann

the fund exceeds the highest value it has previously achieved. From the point of view ofinvestors, this measure is intended to link the manager’s interests more closely to those ofinvestors and to reduce the incentive for managers to seek volatile trades. Thus, if a high watermark is not used, a fund that ends alternate years at 100 and 110 would generate performance feesevery other year, enriching the manager but not the investorsPerformance fees of the types described here tend to encourage investment strategies thatincrease the probability of exceeding comparatively high return benchmarks. Such strategies aremost likely to entail greater risk, risk that – in the advent of failure – could spark a crisis.Risk taking is also likely to be closely linked with competition in the hedge fund industry. Inthe recent decade, the hedge fund market has grown at a staggering pace – in terms of the numberof active hedge funds that we will turn to here and in terms of the assets under management,which we will return to further below (see table 1).Table 1 : Hedge Fund Assets under Management and Number of Hedge Funds, 1950-2005 30The rising number of hedge funds appears to go hand in hand with increasing competitionbetween hedge funds. The market for those hedge funds pursuing arbitrage strategies is but oneexample of this. Here, a massive inflow of money managed by a growing number of hedge fundsappears to have competed away many arbitrage opportunities.Due to increasing competition hedge fund managers have engaged in a search for alternativeways to maintain or increase yields in a market where average yields seem to be slopingdownwards. In this context, many hedge fund managers are likely to consider investmentopportunities involving more risk than was the case in the past. At least this is what has happenedin the past, for instance in the early 1970s. In his recent book Hedge Hogging, the hedge fund andWall Street veteran Barton Biggs describes the years from 1970 to 1973 as a period in whichincreasing competition led many hedge fund managers to take ever greater risks, with facilehedges. As a consequence “(…) many hedge funds crashed and burned because they were reallyjust leveraged long funds and as a result suffered huge declines”, Biggs writes, adding “Otherfunds had bought private equity-venture deals that turned out to be totally illiquid when things30 Source: Hennessee Group and CISDM, http://www.magnum.com/hedgefunds/articles/2005/050101.pdf andhttp://cisdm.som.umass.edu/research/pdffiles/benefitsofhedgefunds.pdf (04.01.2007).