Hedge-Fund Growth and Tax Arbitrage

Skin in the game.

Everyone knows the stereotypical way that hedge funds work: You start a little hedge fund, raise a little money, and go invest it in your best ideas. Those ideas do well and you have good returns. You then market your fund based on those returns, and raise a lot more money. Now you have a big hedge fund, and you invest it in your best ideas, but also your second- and third-best ideas, because there is no room in the best ideas for all the money. Then you have mediocre returns. This is fine for you, because you are getting paid management fees on all the money in your hedge fund, and getting paid 2 percent on billions of dollars is a perfectly fine way to make a living. It is less good for your investors, though: They wanted the good returns you used to get on the small amount of money, not the mediocre returns you now get on their big pile of money.