Institutional Investor’s Alpha published its rich list for 2013 this week which, as Matt Levine has described with flair and some made-up maths, is only tangentially related to how well the hedge fund managers in question performed last year:
If you start with a ton of money, and/or your hedge fund has really good returns, you will make a lot of money. Notions of fair compensation for your labor, or appropriate pay for performance, just don’t enter into it. Money begets money, lots of money begets lots of money, and skill in the begetting is a nice bonus.
That post is also his contribution to the burgeoning mountain of Piketty-related comment, and without tossing another pebble onto the pile, it is worth digging a little more into the reasons for those vast fortunes to exist, and why that matters.
The simplest is that some investors are more talented managers of hedge funds than others. Trite, yes, but notice the difference between being a good investor and being a good manager of a hedge fund. To get into Carnegie levels of cash involves not just investing well, but piling up very large sums of other people’s money to play with.
Israel “Izzy” Englander at Millennium is a case in point. A manager of men, rather than money, he hires traders and portfolio managers to do the investing, but Institutional Investor’s Alpha put his so-called earnings (an alchemic mix of pre-tax and pre-cost fees with personal unrealised investment gains) at $850m last year.
Still, the classic route is to put up a big investment performance early on that draws attention and capital, then don’t do anything too stupid. (In the mutual fund world that means hug the index; for hedge funds it means not losing money while projecting a sense of intelligence, process and structure.)
Small and young hedge funds are nimble, their managers are focused, and they can concentrate their capital in a small number of good ideas without moving prices or attracting attention. One study by Barclays found that funds under two year’s old, and managing less than $100m typically make better investment returns than their larger older peers.
Small funds are also more likely to blow up, and it is hard (impossible?) to spot good funds consistently in advance, so money follows the performance — which explains why investors in hedge funds have historically earned far less than headline indices of performance suggest.
Meanwhile, the hedge fund economics of a big annual management fee, and shares in profits but not losses, are such that once you pass a certain point even big losses aren’t the end of the world. Ken Griffin (no. 5 at $950m last year) oversaw flagship funds that halved in 2008, while John Paulson ($2.3bn) steered some of his funds even further into the red in 2011.
But let’s take a couple of steps back. How do you become a super-wealthy hedge fund manager in the first place?
Picking a career in finance 30-ish years ago was a good place to start. Here is Philippe Jabre of Jabre Capital Partners, in the most recent issue of Graham & Doddsville, the newsletter from the students of Columbia Business School:
Before you start a hedge fund you have to follow the right steps. I always tell people it’s the same as if you are a doctor, architect, or lawyer opening a practice. I first joined a bank, then after ten years I joined Lehman Brothers. Then, with a group of four partners, we spun off from Lehman Brothers and created GLG. And then after that, I created my own fund. You follow the steps so people will follow you.
There is skill, but also plenty of luck in the process, beginning with that decision to work for a bank rather than go into medicine. Indeed, as Chrystia Freedland found in her portrait of billionaire Leon Cooperman, who is rare among the super rich for recognising the role of serendipity:
I joined the right firm in the right industry,” he said. “I started an investment partnership at the right time.” In the fall of 1963, he enrolled in dental school at the University of Pennsylvania, but within the first week he began to have doubts, and he dropped out soon afterward. “My father, may he rest in peace, was going to work saying, ‘My son, the dentist,’ ” Cooperman said. “It was a total embarrassment amongst his friends.”
Cooperman went on to make a series of fortunate choices. Chief among those was entering the financial markets, after graduating in 1967 from Columbia Business School. In the sixties, Wall Street wasn’t yet the obvious destination for the smart and ambitious, but it was on the verge of becoming the most lucrative industry in America.
Cooperman founded Omega Advisors in 1991, an ideal time to start an investment business — and indeed most of the big earners on the Institutional Investor’s Alpha list started their funds in those early days of the industry.
Skill was required, but don’t forget the lottery effect when large numbers of people are investing. As we wrote about Bill Miller of Legg Mason, the chances of him outperforming the S&P for 12 years in a row (he eventually managed 15) were calculated at 1 in 2.2bn by Credit Suisse First Boston in 2003. But given the number of funds available, the odds of any one portfolio manager hitting a 15 year streak were very high, a three in four chance.
Money accrues to those lucky enough to find their skills are a good match to market circumstances, and eventually you are left with a small number of billionaires, and plenty of dead hedge funds that didn’t make it.
Which is fair enough, but let’s not stop there, seeing as Piketty has everybody in a mood to consider underlying societal forces. And in one of the more widely read reviews of Piketty’s book, Paul Krugman showed something of a blind spot when it came to the hedgies:
I didn’t mention hedge fund managers idly: such people are paid based on their ability to attract clients and achieve investment returns. You can question the social value of modern finance, but the Gordon Gekkos out there are clearly good at something, and their rise can’t be attributed solely to power relations, although I guess you could argue that willingness to engage in morally dubious wheeling and dealing, like willingness to flout pay norms, is encouraged by low marginal tax rates.
While Krugman has laid into banks and financiers generally, he seems broadly neutral on the role of asset management. There are two aspects of the rise of the asset management billionaires that might be worth considering here: the setting, rather than the flouting, of pay norms; and the role of hedge funds as the enablers of modern finance more generally.
On the first of those, part of the conundrum about modern US inequality is the rise of the super-manager in the form of very highly paid executives, and it is possible to see the effect of private equity and hedge funds here.
For instance, the greed of Ross Johnson, the chief executive of RJR Nabisco immortalised in Barbarians at the Gate, seems quite modest, even quaint, by the standards of modern pay packages. But the era of leveraged buyouts that eventually followed the 1988 sale of the company to KKR opened up the possibility of big executive paydays over relatively short timescales. Made possible by the incentive structures of buy-outs — a big share of profits from leverage and using other people’s capital — it added to the competition for chief executive “talent”.
At the same time, hedge funds have become the marginal investors in companies, while activists in particular are a means by which disparate shareholder sentiment is focused. If it is considered normal among the loudest and most active shareholders that taking a fifth of any profits as a fee is fair and reasonable, then it becomes less of a stretch to justify big payouts for success. Hey, we’re all getting rich here.
But there is a bigger point, and it’s about the way money gets into the hands of those billionaires.
Very large pots of money in pension funds and endowments are controlled by trustees, who have been advised en masse to invest some of those pots in alternative investments. More mundane investments won’t cut it if they want to meet their obligations, the story goes.
So even as low fee index fund investing has taken hold, pushing high fee alternatives has become a way to make money advising those pension funds (or to make the job of working for a pension fund interesting). Hedge fund billionaires are celebrated as evidence of the wisdom of investing in hedge funds, while the pattern mentioned above — take risk, attract assets, look respectable and don’t do anything stupid — has worked at the industry level as well. Good performance by hedge funds when the industry was small and managing a few hundred billion dollars is used to justify investments in a sector now managing $2.7tn, according to HFR, one that is also far more pedestrian.
Indeed, consider the inequality aspect. Pension funds prefer very large, stable and safe blue chip hedge funds, characteristics which also make significant excess investment performance unlikely over pension fund type timescales. Yet for that investment stewardship pension savers are paying very high fees to a small set of very rich men.
But also recognise the incentives for the investment banks to push money from those pension funds and endownments towards hedge funds. At its most obvious the parts of banks which lend to hedge funds for trading purposes, prime brokers, offer free capital introduction services to help their customers raise cash. The relationship is deeper, though. Throughout their trading arms banks want customers and counterparties who have plenty of capital to risk, generating the activity that produces fees. Finance thrives on the friction from activity, however socially redundant.
A pension fund has no particular reason to care about doing that — but if the pension fund is convinced to give $1bn to hedgies, then that’s exactly what it’s doing.
So this is not to say hedge fund fortunes have been built without merit or skill. Rather it is to reiterate the point that money begets more money, and in a big debate about inequality the question of where that money comes from should not be neglected.