Why hedge fund managers make very risky bets with other people's money

Well, the simple answer is already in the question: It's Other People's Money (title of a 1980's Wall Street movie starring Danny DeVito).



But many hedge fund managers have a portion of their own money invested in the fund, and stand to lose when their investors lose. This practice is designed to give investors confidence that the hedge fund manager will use judgment and invest wisely. Yet, these "investment" managers make exorbitantly leveraged suicidal bets with derivatives and lose their investors' money along with their own. Why?



The truth is, even when the manager is invested in the fund, his risk/reward ratio is not the same as his investors. Let's say I manage a fund of 100m dollars of capital, 10m of it is my own money. Bob, one of my investors, has 10m in the fund, too. I want to enter into a risky derivative contract which if successful, will yield a 100% return (the 100m fund will grow quickly to 200m). If the bet fails we lose everything (100m).



For me, the investment manager, if the bet fails, I will lose all my 10 million in the fund - the same amount Bob will lose. Bob feels confident now that I'm in the same boat as him.



However, if the bet succeeds I will make 10m on my own investment, plus another 18m from the other investors' money (the normal 20% performance fee), for a total gain of 28 million dollars.



Bob, on the other hand, will only make 8 million dollars if the bet succeeds (10m profit less the 20% fee to me!).



My incentive to take risks is high!





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