Hedge Hog "Hogwash" — Part I: Contributions

Chris Clair, friend, journalist and former student, has reported on hedge funds and the financial industry for eight years. He lives and works in Chicago and is the managing editor of Reuters HedgeWorld.

I invited him to respond to my recent post, "Top Hedge Hogs of 2008." He has been kind enough to do so.

As you will see, he takes serious exception to my suggestion that hedge fund managers don’t earn their keep. I’ll run his response in three parts over the next few days.

Thanks, Chris, for taking the time to share your observations.

PART I

The quick and dirty response to your observation, "By comparison to most American workers, hedge fund managers contribute zilch and should be paid accordingly," is “hogwash.” The devil is in the details, however, so let’s get into some.

There are probably 4,000 or 5,000 hedge fund managers in the world, give or take a thousand. To say none of them contribute anything casts the net too wide. One can examine a sample of 4,000 or 5,000 anything – waitresses, teachers, nurses, policemen, construction workers, politicians, journalists – and find a certain percentage who don’t appear to contribute to the economy or to society, or who don’t contribute on a par with what they earn.

If you ask which bothers me more – knowing John Paulson earned $2.8 billion or knowing a half-dozen politically-connected trucking firms were paid millions of dollars by the city of Chicago for doing nothing – my answer is the trucking scandal, hands-down. John Paulson’s salary in and of itself doesn’t affect me. Having my tax dollars wasted affects me – by misallocating resources and depriving worthy and necessary projects the funds they need. And in fact, although there is a strong argument to be made that John Paulson does not pay enough in taxes on his income, at least he pays some taxes. Government waste squanders money and actually is a negative contribution to society and to the economy.

Two questions I see contained in your “Hedge Hogs” post, Rick, are “What does it mean to contribute?” and “How much money is ‘too much?’”

I’ll discuss later some ways hedge fund managers earn their money (and make money for their investors) and this notion of “too much.” For now I’ll focus on the contribution question. It’s true that hedge funds do not manufacture anything. But they do provide jobs, and not just jobs for traders with Ivy League business degrees. They hire analysts with economics degrees and clerical staff, for instance. These are good-paying jobs filled by people with all manner of experience, including some who don’t have the skills to work in construction or the temperament for teaching or the compassion to be a nurse. Hedge funds pay these employees good salaries – better than waitressing – and that money is in turn spent elsewhere.

The presence of hedge funds also means jobs for accountants, lawyers, traders in the pits at financial exchanges and others.

As other highly compensated people often do, hedge fund managers contribute money and time to philanthropic endeavors – charities, education and the arts. They do this for tax purposes, sure, but some of them also believe deeply in the causes they support. I know one manager who has plowed millions of dollars he’s made into a foundation he created that is dedicated to funding organizations that prevent child abuse and treat abused children. Another manager I know started a foundation to provide prosthetic limbs, and training on how to use them, to children in third-world countries. Neither of these managers can be found in that top-25 earners list published by Alpha.

It’s not how much one makes that matters, but what one does with the money one earns.

But where does this money come from? One might posit that the cost to society and the economy of the hedge fund managers’ strategies outweighs the contributions those managers make through their hiring, trading and philanthropic work. (By the way, I don’t consider criminals like Bernie Madoff to be hedge fund managers. They are con men, and if they hadn’t been running hedge fund cons they would have been swindling people some other way.)

To start with, it helps to understand how these guys get paid. Hedge fund managers make money from fees they charge investors. Hedge funds are restricted to investors who meet certain income/investable asset guidelines. You or I could not invest in them. Also hedge funds can't advertise like mutual funds can

Fund managers typically charge two kinds of fees: a straight management fee, usually 2% to 5%, that is based on the amount of assets they manage, and a performance or incentive fee, usually about 20% of whatever positive return they generate. A manager running a $100 million fund who earns a 15% return over 12 months, will, at the end of the year, collect between $2.3 million to $5.75 million from the management fee and another $3 million from the incentive fee.

It sounds like a lot of money, and compared to $50,000 or even $100,000, it is. However out of that pool of money the manager also must pay his or her employees their salaries and benefits, as well as office rent, brokerage fees, legal fees, accounting fees, etc. Some say hedge fund fees are too high and investors are being gouged. But hedge fund managers are paid what the market will bear. Investors know the fees going in and agree to pay them.

Most hedge fund managers manage between $100 million and $1 billion in assets. The people on Alpha’s list are those operating in rarefied air, people who have built enormous operations employing hundreds or thousands of people, or who have made exceptional bets and been right.

For Part II, What Hedge Fund managers actually do, go HERE.