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In a Crackpot Economy, Endless Jackpots

Research & Commentary
April 09, 2012


At what point will our world wake up to the fantastically rewarding scam that our hedge fund masters of the universe have been running?

No single individual in the United States had a more lucrative year at the office in 2011 than Raymond Dalio. Working out of his Bridgewater Associates headquarters in Westport, Connecticut, the 63-year-old hedge fund manager pulled down a sweet $3.9 billion.[pullquote]By any rational benchmark, hedge fund manager rewards remain positively stratospheric. [/pullquote]

The typical American worker, by contrast, ended 2011 earning just under $40,000. That typical worker would have had to labor over 97,000 years to equal what Dalio made in just one.

The irony here: By the hedge fund yardstick, the United States actually became a little more equal in 2011. The year before, in 2010, the typical U.S. worker would have had to labor over 120,000 years to make as much in compensation as the year’s top-earning hedge fund manager.

For these stunning hedge fund compensation totals, we can thank the AR financial trade journal. AR has been tallying up hedge fund pay ever since the start of the 21st century, and the magazine’s new figures for 2011 appeared just over a week ago.

Hedge fund managers, AR informs us, experienced a bit of a downshift in 2011. The top 25 hedge fund only collected a combined $14.4 billion for the year. That total does run higher than the $11.6 billion the top 25 collected in 2008. But last year that top 25 amassed nearly $22.1 billion.

By any rational benchmark, of course, hedge fund manager rewards remain positively stratospheric. Back in 2002, a hedge fund manager needed to earn $30 million to enter the hedge fund industry’s top 25. In 2011, a downer of a year for hedge fund managers, that entry level stood at $100 million.[pullquote]Top hedge fund managers make hundreds of millions, the industry line posits, because they bring such incredible smarts to the table.[/pullquote]

How do hedge fund industry movers and shakers justify such incredible windfalls? Top hedge fund managers make hundreds of millions of dollars, the industry line posits, because they bring such incredible smarts to the table.

Hedge fund industry superstar James Simons, industry apologists love to note, used to chair a university math department. Simons and his fellow hedgies, we’re told, have honed the tools of “quantitative” analysis. Their super sophisticated statistical models can work a magic the rest of us can’t possibly comprehend.

But the investing gains from this magic, the hedge fund industry line continues, should nonetheless gladden us all. High hedge fund earnings, the industry’s friends and flacks insist, mean a better tomorrow for Main Street.

“My customers are pension funds, teachers,” as superstar hedgie Raymond Dalio noted in one recent interview, “and I’m going to say that they are very grateful.”

Most Americans have a hard time evaluating these hedge industry claims, mainly because hedge funds operate almost entirely behind closed doors that average American never get to enter beyond.

You can’t, after all, just walk off the street into a stockbroker’s office and invest in a hedge fund. To enter hedge fund land, you either have to be a person of means — with at least $1 million available to invest — or an institutional investor, a college endowment, for instance, or a pension fund.[pullquote]Hedge funds, at base, amount to mutual funds for deep pockets.[/pullquote]

Hedge funds, at base, amount to mutual funds for deep pockets. Normal mutual funds face all sorts of federal regulations designed to protect the general investing public. Hedge funds don’t serve the general investing public and face precious little regulation. Federal law assumes that deep-pocketed investors have the sophistication to protect their own interests.

This regulatory hands-off leaves hedge fund managers almost totally free to invest anyway and in anything they want. They can buy new-fangled speculative assets they think will soar in value. They can also “hedge” their bets, by laying down financial wagers that a particular asset’s value is going to sag.

For all this investing and hedging, hedge fund managers demand majestic levels of compensation. They typically charge clients by a “2 and 20” formula. Investors pay the hedge fund wizards who manage their money an annual fee that equals 2 percent of the total money they invest, plus 20 percent of any profits that selling their invested assets might bring.

The biggest hedge fund industry stars charge even more. The clients of Tudor Investment’s Paul Tudor Jones II pay a 4 percent management fee and cough over 23 percent of any investment profits their money makes. SAC Capital Advisors kingfish Steven Cohen grabs away 50 percent of all investment profits.

Hedge fund clients gladly pay these exorbitant fees. Hedge fund managers, they believe, possess a secret wisdom that reliably delivers spectacular investment returns. But hedge fund managers, in real life, have no secret wisdom. And they don’t reliably deliver spectacular returns. [pullquote]Hedge fund managers, in real life, have no secret wisdom.[/pullquote]

One example: Kenneth Griffin, the hedge fund manager at Citadel, personally pulled down $700 million in 2011, and the two big funds he manages each gained over 20 percent for the year. But those same funds lost 55 percent in 2008.

Another example: John Paulson took home $4.9 billion in 2010, that year’s highest hedge fund manager windfall, after his investments in gold returned over 35 percent. Last year, Paulson’s bets on Bank of America went the wrong way and gave clients in one of his funds a 52.5 percent haircut.

Some hedge fund managers do, to be sure, seem to deliver consistent results. SAC Capital Advisors founder Steven Cohen, for instance, trumpets “double-digit returns for the better part of two decades.” One apparent driver of this consistency: insider trading. Seven former SAC Capital employees have either pled guilty to criminal charges or settled fraud charges in civil proceedings.

Most other hedge funds don’t have rap sheets. Nor do they show anything close to consistently positive results. Those institutional investors that have placed pension and endowment dollars in these funds have been coming up short.

Over the last five years, the New York Times revealed last week, the ten public employee pension funds with the highest share of their dollars invested in hedge funds and other “alternative investments” only gained an average 4.1 percent a year on their money. The ten pension funds with the least share of their dollars plowed into hedge funds returned an average 5.3 percent.[pullquote]The ten public employee pension funds with the highest share of their dollars invested in hedge funds only gained an average 4.1 percent a year on their money.[/pullquote]

The only consistent gainers from the billions that institutional investors have dumped into hedge funds: hedge fund managers. The ten pension funds most invested in hedge funds paid almost four times more in investment management fees than the ten pension funds with the least hedge fund exposure.

California’s giant state pension system, notes Times analyst Julie Creswell, saw its fees nearly double, to over $1 billion a year, after the system “increased its holdings in private assets and hedge funds to 26 percent of its total in 2010, from 16 percent in 2006.”

What does this California pension system have to show for these lofty fees? A modest 3.4 percent annual return over the last five years.

And California’s public employees actually did better than clients for the hedge fund industry as a whole. Industry-wide, hedge funds lost their clients 5 percent of their money in 2011, according to the Hedge Fund Research Composite Index, a tally that tracks almost 2,000 hedge fund portfolios

“Boring low-fee index funds,” notes one Forbes analysis, “continue to run circles around many investing titans.”

But these titans continue to pull in hundreds of millions year after year. Why? The assets they manage have become so huge, the financial journal AR points out, that the income that their 2 percent management fees generate has become a “huge profit center” in and of itself.

And if hedge fund manager investing labors should actually produce “performance” gains, the 20 percent chunk of these gains they grab gets preferential treatment in the tax code, the notorious “carried interest” loophole.

On the bulk of their earnings, the nation’s top-paid hedge fund managers pay federal income tax at just the 15 percent “carried interest” rate, not the 35 percent that applies to ordinary income in the top tax bracket.

Sign up for To MuchCongress has so far done nothing to stop this preferential treatment. In fact, Congress is moving in the wrong direction. A bipartisan majority has just passed legislation — the Jump-start Our Business Start-ups Act, or JOBS Act — that will free hedge funds in the future to more aggressively market their wares.

This new marketing flexibility will likely add to the over $2 trillion in assets now under hedge fund management — and add even more to the paydays of hedge fund superstars.

About that possibility, a great many of our pols seem absolutely giddy — and why not? In the third quarter of 2011 alone, notes the AR financial trade journal, hedge fund manager Kenneth Griffin and his spouse deposited $300,000 into the super PAC that conservative political strategist Karl Rove runs.

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