Doing the Real Hedge fund math: The 2-and-20 Plan

We'll bet you dollars to donuts, the $1.2-trillion hedge fund biz must almost be weeping with sheer relief. What ailed Amaranth doesn't appear to be ailing everyone else. Sure, Amaranth was utterly reckless in placing roulette-style bets -- black or red --on one asset class. The wrong colour came up and the firm is finished. Rival hedge funds would never put all the chips on a 50/50 outcome.

Really? Can we talk? I mean can we talk here? The hedgies are virtually programmed to make the same mistake. What is astounding is that Amaranth and Long Term Capital Management were the only multibillion-dollar blowups of the past decade. There will be more -- there has to be -- for the simple reason that the funds' compensation schemes encourage unusually risky bets.

The Amaranth tsunami has sent ripples of fear through the industry. The hedgies will examine their portfolios closely to make sure the bulk of their capital isn't in the hands of some kid who thinks he's a whiz at egg or camel-leather futures. The risk management book will get rewritten.

But how long before the hedgies start taking crazy risks again? The "2 and 20" incentive remains in place. What's more, hedge funds' returns are mediocre at best. The widely followed Credit Suisse/Tremont hedge fund index reports a year-to-date return for multistrategy funds (as opposed to narrowly focused funds such as convertible arbitrage or emerging market funds) of 7.9 per cent.

Before you clap your hands in glee, consider the S&P 500 went up 5.8 per cent over the same period. Sobering ain't it.

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