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.

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.