At the American Economics Association’s annual meeting in January of this year, one of the sessions I attended was Hedge Funds: Performance and Persistence. It was presided over by Cliff Asness, head of AQR Capital Management, LLC. One of the commentators was Peter Muller, a special advisor to Morgan Stanley (and hedge fund manager). If I remember right, the essence of his story was that the hedge fund structure was fundamentally flawed. To be sure, the best and brightest financiers have every incentive to do their best work at first. They need to establish a track record. But once they’ve gained a reputation for savvy money making the name of the game changes. What matters to the hedge fund managers is gathering an ever larger pot of money. The reason is that their pockets are lined not from investing well, but in pocketing the 1.5% to 2% of assets fee. It’s a lot more lucrative to run a $1 billion hedge fund than a $100 million one—let alone $10 billion. The money managers do well no matter how well their investors fare.

I was reminded of his talk while reading the latest shareholder letter by Warren Buffett at www.berkshirehathaway.com/letters/2006ltr.pdf.

I’m going to quote from it at length. It’s worth reading. And the same skepticism and lesson holds when hiring any money manager. Ask yourself: Where do the incentives lie?

In last year’s report I allegorically described the Gotrocks family – a clan that owned all of America’s businesses and that counterproductively attempted to increase its investment returns by paying ever-greater commissions and fees to “helpers.” Sad to say, the “family” continued its self-destructive ways in 2006.

In part the family persists in this folly because it harbors unrealistic expectations about obtainable returns. Sometimes these delusions are self-serving. For example, private pension plans can temporarily overstate their earnings, and public pension plans can defer the need for increased taxes, by using investment assumptions that are likely to be out of reach. Actuaries and auditors go along with these tactics, and it can be decades before the chickens come home to roost (at which point the CEO or public official who misled the world is apt to be gone).

Meanwhile, Wall Street’s Pied Pipers of Performance will have encouraged the futile hopes of the family. The hapless Gotrocks will be assured that they all can achieve above-average investment performance – but only by paying ever-higher fees. Call this promise the adult version of Lake Woebegon.

In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee.

The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these “hyper-helpers.” Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.