Back to me

I know more about the hedge fund business now that friend and former student Chris Clair, who works for Hedge World, the industry newsletter, has explain how the funds work.

For a review of my original post, which inspired Chris, go here. For his response go here, here ,here and here.

Silly fellow that I am, I still maintain that when one person "earns" $2.8 billion (with a "b") in one year, something is amiss. With that amount, you could meet the salaries every wage earner in Beaverton and Gresham.

You could feed entire impoverished populations for a year. Children would not starve.

You could save thousands of lives.

But $2.8 billion is what one mortal man, hedge fund manager James Simons, took in last year. Others in the industry, if that is what it is, merely made hundreds of millions.

At its heart, my issue is not a financial one but a moral one.

In his conclusion, Chris maintains that the question of "how much" these guys should be paid (and they are guys) is "settled by supply and demand" and "this annoyingly elusive concept of 'quality.'"

Supply and demand? The world has only one Chris Clair and Rick Seifert. We are in short supply. A mere one of each of us. We do good work. We are in demand. We are paid adequately. We are paid enough and should be thankful for it and the skills we have to make us "worth" as much.

Where's the short supply and pressing demand for hedge fund managers that justifies nine- and 10-digit payments?

No, these guys pay themselves these amounts because they can and because they love money. They live and breathe money. No doubt they are pleasant enough people. They tuck their kids into bed at night, kissing them lovingly on their foreheads. Most are ,no doubt, gracious, kind, engaging.

But they must be blind to the world we live in.

This is not a matter of "supply and demand;" this is a matter of blinding greed.

I'm not inclined to quote Scripture, but these men would do well to ponder the passage from Matthew:

For where your treasure is, there your heart will be also.

As for quality, how can you measure quality when the job description is satisfying greed? As Chris suggests, "quality" is a big topic. It is also amoral. I'm sure there are quality child molesters, hit men, embezzlers, terrorists and torturers. Should society reward them for their quality work?

As far as I can tell from reading Chris' account, hedge fund managers are skilled gamblers who stake other people's money (and sometimes their own) and rake off their mind-boggling cuts. Oh, and they manage to do this at the lowest possible tax rate. You and I make up the difference.

While the world runs on the labor of farmers, truck drivers, teachers, nurses, cops, carpenters, secretaries, the editors of industry newsletters etc. Simons receives $2,800,000,000 for clever gambling.

What's wrong with this picture?

Or is it, as Chris has said, simply "hogwash" to question the "worth" of this "industry," and its lavish individual compensations?

Hedge Hog "Hogwash" — Part IV: The Bottom Line

This is the conclusion of Chris Clair's four-part answer to my questions about the "worth"of hedge funds (Do they actually contribute to society?) and their exorbitantly paid managers (How much is enough? How much is simply obscene?) continues.

For a review of my original post, which inspired Chris, go here. The first three parts of his response are here, here and here.

As noted previously, Chris, a friend and former student, writes for Hedge World, an industry newsletter.

Part IV — The Bottom Line

Hedge funds are like bogeymen. They are little understood by anyone outside the investment world. They have operated under exemptions from regulation. Some managers make lots of money.

Going forward they, and the rest of the financial system, will likely be more tightly regulated. There will be fewer managers and assets.

Already, hedge fund assets are half what they were in late 2007, when the industry topped out at $2.8 trillion. For reference, when I started covering hedge funds in 2001, they had about $800 billion in assets, compared to mutual funds with $8 trillion. As more investors sought positive returns after the bear market of the early 2000s, hedge funds became popular. Assets flowed in from foundations, endowments, pension funds and the nouveaux riche.

Lots of people started hedge funds to capture some of the inflows. Not all were qualified, and many are now out of business, having lost not only their own money, but their investors' money as well.

A smaller hedge fund industry, with fewer high-quality managers fed by knowledgeable investors is a better scenario. This business isn't for everyone. Done correctly, hedge funds smooth out price inefficiencies and can contribute to better functioning capital markets. Done incorrectly, hedge funds can exacerbate market declines and add to volatility.

At the end of the day, hedge funds are like any other industry – their contribution to society (or the economy or whatever) is only as great as the individual contributors.

Are there some greedy bastards out there? Yes.

Are there also managers who sincerely believe in a mission of fulfilling a fiduciary responsibility to their clients - which include pension funds? Absolutely.

None of this is meant as a defense of the industry at large, only as a partial explanation of a very complex corner of the investment world and a rebuttal to the contention that hedge fund managers, as a group, contribute nothing and therefore should be paid nothing. Some … most, even … do contribute and should be paid something.

How much? Everyone can make his or her on judgment on that, but the way the system is set up now the question of “how much” is settled by supply and demand and this annoyingly elusive concept of “quality.” Now that would be a fun and high-level discussion. What is quality? Robert Persig wrote a whole book (Zen and the Art of Motorcycle Maintenance) about that. And I’ll stop now before this reaches book-length.

Back to you, Rick....

Hedge Hog "Hogwash" — Part III: How funds do it

Chris Clair's on-going answer to my questions about the "worth"of hedge funds (Do they actually contribute to society?) and their exorbitantly paid managers (How much is enough? How much is simply obscene?) continues.

I've decided to extend Chris' response to four parts. Part III appears here. Part IV, a summation, will come later in the week.

For a review of my original post, which inspired Chris, go here. The first two parts of his response are here and here.

As noted previously, Chris, a friend and former student, writes for Hedge World, an industry newsletter.

Part III — How the funds make their money

For the most part hedge fund managers trade securities, just like mutual fund managers. The key difference is that hedge funds can bet on falling securities prices as well as rising prices through a process known as “shorting.” In a short sale, the hedge fund manager borrows securities – let's say stock in a company the manager believes is overvalued by the market – and sells them. When it comes time to repay the borrowed securities, the manager hopes the price has fallen so they can be repurchased at a lower price. The manager pockets the difference, and the brokerage pockets the borrowing fee.

Hedge funds also bet on what are known as "spreads" or the difference in price between securities. Sophisticated pricing models can be employed to estimate securities prices. If the manager sees a too-large or too-small discrepancy between the prices of two securities, the manager can bet on the spread to either narrow or widen.

Those are just two examples of many different strategies managers follow.

Often hedge funds are engaged in what Roger Lowenstein called “vacuuming up pennies” in his book When Genius Failed, about the failure of the hedge fund Long-Term Capital Management. As he explains, "vacuuming up pennies" involves leveraging loans 100 or more times over.

LTCM was using that kind of leverage, which worked fine as long as the models were correct. However when Russia defaulted on its debt, bond spread characteristics changed beyond the model's ability to handle the calculations. Because LTCM worked with so much borrowed money – hundreds of millions of dollars – when its bets appeared to go wrong, the banks called for more collateral. To them LTCM was a counterparty, and to a certain extent its losses became the banks' losses, at least as far as balance sheets were concerned. This was why the government had to step in and back LTCM, so that the hedge fund's counterparties wouldn't be dragged down by its problems.

Today, similar problems have been exacerbated because the financial world is even more intertwined now and securitization is more prevalent.

Hedge funds also were players in the securitized credit markets that resulted from packaging and repackaging loans (many of which had highly risky contents). Now some funds are hurting. Even many of those that earned positive returns last year are losing assets, as investors pull out what money they can find to cover losses elsewhere, or to live on.

Hedge Hog "Hogwash" — Part II: What they do

Chris Clair’s rebuttal of my questioning the compensation and worth of hedge fund managers continues.

For those who would like to follow the thread back to its Red Electric origins, my initial post, which invited Chris to comment, is here.

Part I of his response is here. I'll post Part III later in the week.

Note: Chris, a friend, journalist and former student, has reported on the hedge fund industry for the past eight years. He lives and works in Chicago and is the managing editor of Reuters HedgeWorld.


PART II

So what are hedge fund managers doing to earn positive returns? The best and brightest hedge fund managers exploit price inefficiencies in the market. They bet against securities (stocks, bonds and their derivatives) they believe are overvalued and buy securities they believe are underpriced or that have growth potential. Different managers do this in different ways and employ varying degrees of risk. Some funds are very low-risk and are designed to provide steady, incremental returns – say, 10% to 15% per year – in all market conditions (whether stocks are way up, way down or flat). Some funds use lots of leverage (borrowed money) to increase returns, or trade in complex securities that few understand, thereby raising the level of risk. The type of strategy any particular hedge fund follows and its riskiness is outlined in its offering documents.

Speaking of offering documents, I have to digress for a second here to talk about the “gambling” issue. Rick, you wrote, “Then there’s the question of whether the top 25 actually did anything to “earn” their largesse besides gamble with other people’s money.” Hedge funds invest money on behalf of other investors, but most hedge fund managers also place their own money in the funds they manage. In fact, outside investors often won’t even consider a relationship with a hedge fund manager that does not place a substantial amount of his or her own net worth in the funds that manager runs. It’s about alignment of interests. So while the managers are investing other people’s money, they are also investing their own money.

Additionally, it's not like the hedge fund managers stole the money they invest from somewhere; when the system works correctly, investors conduct extensive due diligence on managers and make a careful and conscious decision to gamble their own money. It's up to the investor to understand what he or she is investing in. Caveat emptor!

If one wants a risk-free investment, one should buy Treasury bills or open a savings account. Historically - like over the past 100 years – stocks have returned about 11% annually and bonds something less than that. When you experience years like we had in the 90s, (between 1990 and 1999 the average annual return of the U.S. stock market was nearly double what it was from 1926 through 1999), and the same in the middle part of this decade, you can bet there's going to be a reversion to the mean. In other words, people who got in at the end are going to lose money, at least in the short term.

Instead we seem to keep buying into the notion that every time we enter a bull market, it's a "new paradigm" and the "old rules" don't apply. That's just stupidity. So of course any investment in the stock market or anything else (even Treasuries when you get right down to it) carries the risk of loss. Hell, stuffing money in your mattress carries the risk of loss (fire, flood) but without any possibility of earning a positive return.

The hedge fund manager’s job is to earn money in all markets – to be smart enough to avail himself or herself of all the investment tools at his or her disposal to earn investors a positive return no matter what. Historically, the good ones have done that, which is why they can get away with charging higher fees. In the process they have helped boost university endowment returns and protected workers’ pensions. Even last year, the worst year on record for hedge funds (the average fund was down 19%) they still performed only half as bad as the stock market. And since the bulk of a hedge fund manager’s compensation comes from the performance fee, when a hedge fund manager loses money he gives up most of his or her income. And not just for that year, either. Most hedge funds have what are known as “high water marks,” whereby the manager must make up all that he has lost and then some before he can begin collecting the performance fee again. After 2008’s debacle, some hedge fund managers may not collect performance fees this year or next year.

I make that point simply to illustrate that not all hedge fund managers are John Paulson or George Soros, that some of them are essentially small businessmen and that they also face the same risk of loss as their investors.

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.

Top Hedge Hogs of 2008

Holy Madoff with it! Today's New York Times “Business Day” section showed the mug shots of the eight "top" hedge fund managers ranked by what they “made” in 2008.

For an accounting of their nine- and ten-digit "takes," go here. For an account of what they don't pay in taxes, go here.

The numbers, of course, boggle the mind. James Simons leads the list with $2.8 billion. That’s with a “b,” and if you write it out, it looks like this:

$2,800,000,000.

To put Mr. Simons' annual compensation in perspective, $2.8 billion is 56,000 times a salary of $50,000.

Think of it — one person whose compensation is that of 56,000 fellow human beings earning $50,000 each.

The $11.6 billion earned in 2008 by the top 25 hedgers is substantially more than the State of Oregon’s annual $7 billion general fund. What this coterie of cash churners paid themselves last year is nearly quadruple Oregon's annual contribution to all its K-12 schools.

Then there is the question of whether any of the top 25 actually did anything to “earn” their largess besides gamble with other people’s money.

Compare their real contribution and productivity to that of the worker who patches pavement, picks lettuce, teaches school, waits on tables, checks out groceries, manages a store, shingles roofs, nurses the ailing, polices the streets and repairs the plumbing.

I have a friend and former student who actually writes for a hedge fund newsletter. I invite him to enlighten me by responding to the following observation: By comparison to most American workers, hedge fund managers contribute zilch and should be paid accordingly.

UPDATE: Chris Clair, who is referred to in the above paragraph, works for the industry newsletter Hedge World. Chris has passed on a three-part response to this post. The first, with links to the second, starts HERE. The third part will be posted later Friday, April 3.

America, the isolated

Lizi Zach, our Berlin correspondent, responds to Chris Clair, our Chicago correspondent and his thoughts about dots in need of connecting.

Me? I'm enjoying the back-and-forth.

I'm with Chris - all politics is dirty, and since the advent Bush/Rove, I must admit, I see no evil in the Left (or, rather, what Americans think of as the Left) throwing counter punches. (Let it be known that while registering Americans here in Berlin to vote, another volunteer and I never bothered to put up the "Republicans can also register here!" sign on our booth.)

Just read Chris' post on the Red Electric re Sarah Palin and civics lessons and self-education. Roger Ebert (bless his heart for in this time of great moral crisis, he has put aside his movie reviews and delved into political commentary) opined some months ago about Palin's lack of curiosity. It would seem that indeed that is the crux of the problem, and not just hers, but America's.

The country is so utterly isolated (not just geographically) and, moreover, is purely content that way. Consider one fact along: the overwhelming majority has no more than two weeks of paid annual leave. No wonder so few travel abroad and see how the other half (or 3/4) live on this planet.

The sheer refusal to institute any viable foreign language curriculum in the schools is another embarrassment.

The government has no serious interest at all in having an educated populace. It makes it easier to launch unwinnable wars, fart around with public monies, and pass ineffective legislation that way.

I think back to my father, age 80, immigrating to the States from Hungary in 1956, fleeing the Communist Revolution. If anyone should have been a cheerleader for capitalism and the GOP, it is he, and indeed, many, if not most, of his compatriots became card-carrying members of that ilk.

My father waffled, questioned, thrashed about. And then came Watergate and he asked an American colleague how anyone could possibly remain in the Republican party after such an event. It's irrelevant what his colleague answered; my father's conclusion is that Americans like crooks for politicians.

There seems to be no other explanation.

Chris weighs in — Part 2

Chris Clair, who lives and works in Chicago (and is now officially The Red Electric's Chicago correspondent) has been sharing his impressions of the Blagojevich scandal in e-mails. That's a subject to return to.

Here, though, is the continuation of his thoughts about some unconnected "dots" I mentioned the other day.

He takes up with Sarah Palin's demonstrated ignorance during the campaign. I had suggested she suffered from a lack of education. Chris has a different take.


What was her education? I would ask what does it matter? What is education? Jane Jacobs said in "Dark Age Ahead" that today's colleges and universities do little more than grant certifications. Very little "education" takes place. But whose fault is that? Do we blame the professors or the academic programs themselves?

I happen to think education is a personal matter. You choose to be educated. I'm sure her K-12 experience included the standard civics classes, but what did she take from them?

I spent half my time in 12th-grade economics goofing off in the back of the room. I absorbed some information, sure, enough to pass the tests. But what I've learned about Keynes, Adam Smith and bell curves, as well as the Constitution, government and issues like freedom of speech I've learned on my own, by seeking out information, either in college or in books or magazines or online.

The fact that Sarah Palin doesn't understand the First Amendment isn't her high school social studies teacher's fault; it's hers. The same goes for not understanding the duties of the office to which she was seeking election. As individuals we have a responsibility to educate ourselves through a variety of means, including but not limited to, formal schooling.

What about personal curiosity – the desire, or even the need in some cases – to learn more about the world around us? How can anyone else be responsible for that? What about parents? What is their role in fostering curiosity in their children? As a parent, how do you teach curiosity? How do you teach critical thinking?

What's the difference between information one is given (traditional, formal education) versus information one seeks (reading for pleasure, magazine/newspaper subscriptions)? Is the latter somehow more valuable?

Who's to blame here?

We are. Individually and collectively.

What does it mean to be informed…? What does it mean to be aware…? Does a mass of disconnected information block awareness? Maybe seemingly disconnected information only blocks our awareness if we let it. But why don't people employ more filters? Perhaps that's something civics classes in high school should be including in their curricula, and maybe colleges should include "media studies" as a core requirement. Again, you can't teach people what they don't want to learn but you can plant the seed.

Why does the nature of information have to change because the medium changes? Isn't information information? Our interaction with it may change, but does that really change the information?

So many of our problems fall to the schools to solve, but are the schools … up to a task of this enormity? Why is it schools' responsibility? What about parents, other family members? This goes back to the question of who teaches critical thinking skills?

Are our leaders intelligent? Who ARE our leaders? Elected officials? Corporate chief executives? College professors? Pundits? TV and radio talk show hosts? Actors? How do we choose them? I see where Fran Drescher's spokesman has indicated she's interested in Hillary Clinton's N.Y. senate seat. What qualifies her to serve in the U.S. Senate? What does it mean to lead?

What is wealth? Monetary wealth is transitory and based on collectively agreed-upon values. What happens when agreement disintegrates, as with credit? Can wealth disappear or is wealth accumulation a zero-sum game – for every loser there is a winner, for every loss a corresponding gain elsewhere? Who controls our financial future?

Those are a few dots.

Chris weighs in — Part 1

Another former student, Chris Clair, has responded to the "dot" questions. He's written a long response. I'll publish it in parts. Here's part 1:

So first off, anyone else's governor arrested today? No? In Illinois, our last two governors have now faced federal charges; both hailed from the Chicago area. The tradition continues. It took me quite a while longer to put this together today than I expected; I found I couldn't stop reading the Blagojevich indictment. If you haven't I highly recommend visiting the Tribune's web site and perusing it. It definitely sets up a clear distinction between "hubris" and "sociopathic." Anyway, here are some thoughts on the previously listed dots, and some new dots. Then my take on the whole "thinning the herd" discussion.

Building off Rick's and Aaron's emails….

What is the difference between information and knowledge? One thing to consider – knowledge could be the synthesis of information with experience, context and possibly emotion. Further to that, what roles do emotion and experience play in turning "information" into knowledge?

Which vehicles … does the public use to obtain information and/or knowledge? Increasingly the Internet? Newspapers, print or online mostly? Their neighbors? Television? Radio? Video games? Don't forget movies. Also, we have to subdivide "the Internet" and "newspapers." When we speak of the Internet, do we mean blogs? CNN? Matt Drudge? Online newspapers? MoveOn.org? Daily Kos? WSJ's Best of the Web? Conservative sites? Liberal sites? Similarly with newspapers are we talking Chicago Tribune (oops)? NYT? Washington Times? (Note I did not say Post.) Wall Street Journal? Chicago Reader? Willamette Week? SW Connection? Sherwood Gazette?

You see where I'm going here. There's so much fragmentation in the information space it really requires drilling down, getting at the filters through which information is flowing, and how people self-select those filters. Are they doing it consciously? In fact, ARE there "general" news sources any more? CNN? Fox? MSNBC? In addressing "which vehicles," we have to consider partisanship and bias in news.

The late Bob Fulford, my university media professor, used to beat this gong: there is no such thing as unbiased news. To get the full picture on, say, the election, you have to follow CNN, MSNBC and FOX; read the New York Times, the Wall Street Journal and your local paper; listen to NPR and Rush Limbaugh. The more sources of information, the better "informed" you are. Of course, you'll also have to work harder, but maybe that's the true payoff.

When they obtain information and/or knowledge, do people act? Or just talk? Or forget it? Or ignore it? How do people use information? What information is useful? What constitutes action? How does the method of action depend on where that intersection of knowledge and information is for an individual?