In a book last year (and in a very complicated, fairly obscure paper in 2001, downloadable here), MIT Professor Andrew Lo, one of the most quoted and respected of the quantitative analysts who have lately transformed the financial universe, imagined a hedge fund he called Capital Decimation Partners.
Lo described a simple investment strategy that was very likely to return big profits in the short term, and almost guaranteed to crater in the medium-to-long term. Lo posited that the outsized pay and strange compensation schedule for hedge-fund managers--typically, every year they keep 2 percent of the assets they manage plus 20 percent of their reported investment gains--could lead to their taking outsized risks with other people's money.
"I propose a research agenda for developing a new set of risk analytics specifically designed for hedge-fund investments, with the ultimate goal of creating risk transparency without compromising the proprietary nature of hedge-fund investment strategies," Lo wrote then.
Alas, Lo's proposal was not implemented. It appears that AIG's now infamous Financial Products Division was CDP incarnate. Only worse.
According to the compensation contracts released yesterday by U.S. House Banking Committee Chairman Barney Frank, the AIG folks got a full 30 percent of all the cash they claimed to have made. And as the New York Times' Steven M. Davidoff explains on his blog, the AIG people had less skin in the game than the typical hedgie.