MAY 3, 2013
AS THE RECENT FINANCIAL CRISIS recedes slowly into our collective memory, there are still many aspects of the global financial system that warrant closer scrutiny. Among the prime targets for further analysis and criticism are hedge funds, whose operations have in the past been shrouded in some mystery.
After a decade of sustained growth, hedge funds were in their stride when the markets began to wobble and contract in late 2008. Record sums of money had been pouring into them year after year after year. New funds were launching each week, and for a short period of time, it seemed as if anyone with even a rudimentary knowledge of stocks, bonds and derivatives could earn vast fortunes as a hedge fund manager.
By 2009, a more realistic assessment was the order of the day. In a few months, several hundred hedge funds had closed their doors, with investors facing significant losses. A handful of hedge fund managers were able to deliver eye-watering profits during these volatile months, but overall appetite for the risks needed to generate the returns declined markedly.
As time passes, though, the hedge fund model is proving resilient. Investors are returning to these funds in significant numbers, in the hope that their money will grow at rates that far outpace what is otherwise available.
Reports of the “death of hedge funds” as a feature of modern financial markets have thus proven to be premature, making it imperative that these investment vehicles be thoroughly understood, by investors and regulators and law enforcement and market counter-parties, in order to ensure that the overall functioning of our markets, and our economies, is not compromised.
Les Leopold’s How to Make a Million Dollars an Hour, therefore, might seem to arrive at a propitious moment. Given the complexities that have developed during our lifetimes in the types and structure of financial instruments, as well as the rapid evolution of investment banks and the infrastructure of Wall Street, a book addressing how hedge funds actually operate, the manner in which they generate their returns, the reasons that investors entrust their money to them and the consequences for savers and retirees when they do their job particularly well (or particularly poorly, as the case might be) would be very welcomed.
Unfortunately, Leopold’s How to Make a Million Dollars an Hour is not that book.
Clearly, Leopold’s heart lies with labor market issues and when he discusses these issues, either in setting up his analysis of hedge funds initially or at irregular intervals along the way, his writing is informed and instructive. Unfortunately, his impassioned arguments are ineffectively stitched together around a theme — hedge funds — that doesn’t really suit either his interests or his experience. The sincere concern he repeatedly expresses floats awkwardly between a series of extensive extracts from other books and anodyne retellings of stories already better told by others.
Leopold contends early on that “the straight answer is hard to come by” regarding hedge funds. He demonstrates in subsequent chapters that, in fact, this is not the case, by recounting in great detail some of the fine academic and journalistic work that has been done in the last five years on hedge funds, their managers, and the large institutions that invest with them. In fact, more is being written about hedge funds today than at any time previously and that trend looks set to continue for years to come.
Congress and the Securities and Exchange Commission (SEC) have been instrumental in increasing requirements for further disclosures of information by these funds and their managers. In the past, arcane rules regarding the conduct of so-called “private placements” meant that if hedge funds ever spoke too publically about their successful trades or high returns, the SEC would be required to punish them severely for any perceived attempts to “pump up” interest in their funds with would-be investors. Accordingly, silence was the rule. With the Dodd-Frank reforms and the JOBS Act, many of these outdated provisions have been swept aside by the Obama administration. As a result, hedge funds are now able to walk out of the shadows and take their place center stage.
Given Leopold’s eye-catching title, his book wastes little time in establishing the stratospheric earning that top hedge funds have garnered. These amounts far outstrip the earnings of actors, musicians, athletes, lawyers and business leaders. He reports that the top 10 hedge fund managers in 2010 earned an average of $1.75 billion each, or $842,788 for a mythical hour’s work.
As Leopold acknowledges subsequently, the gateway to these vast sums is the simple fact that hedge funds earn a 20 percent performance fee on the profits they generate for their clients. For example, a manager who receives $500 from a client, and doubles it to $1000, would be entitled to 20 percent of the $500 profit, or $100. The client, of course, now has $900 and is not unhappy with the results by any stretch of the imagination. Along the way, the hedge fund manager will also charge his client a 2 percent per year management fee for the ongoing services he or she provides. However, since this is a fraction of the much larger fees routinely charged to “Mom and Pop” retail investors by mutual funds for the good services they provide, this revenue stream is clearly secondary to generating the large earnings that offend Leopold’s sympathies so much.
Over $2 trillion is believed to be invested in hedge funds now. This is a strikingly large amount of money. A few basic calculations, however, are instructive at this point. Let’s assume, just to put the earnings of hedge fund managers in perspective, that half of that $2 trillion does not generate any profits this year, and that the remaining half generates a 10 percent return — crude approximations, but the point here is to place the early numbers Leopold trumpets into a more meaningful context — then the $1 trillion of profitably invested hedge fund money would generate a $100 billion in profits. The clients who provide the money would keep $80 billion, the lion’s share by far, and $20 billion would be paid out to the managers who delivered this return. Since the clients only need to pay out these high fees when the funds generate high returns, they are happy and are, no doubt, often clamoring at this time to put even more money to work with these successful men and women overseeing their savings.
Simply put, to say a hedge fund manager earned $1 million or $500 million or $2 billion is just another way of saying that his or her clients earned $4 million or $2 billion or $8 billion this year. Unfortunately, Leopold’s attentions are strangely absent from the actual clients of these funds. This strange absence is made all the stranger by his background as a researcher and writer into labor issues: Leopold completely omits to mention that the majority of new money flowing into hedge funds in recent years, and the bulk of money invested in private equity and other similar funds historically, actually comes from U.S. public pension plans. That’s right: the pools of money that will ultimately pay out retirement benefits to teachers, policemen, firemen and other government employees in California, Texas, New York, Virginia and across the country are pouring massive sums of money into these alternative investment funds. This void at the heart of How to Make a Million, this “dog that did not bark,” should make readers, upon completing the book, sit back and reassess how they have spent their last few hours.
The reason hedge funds are now written up in magazines like The New Yorker or Vanity Fair, or get name-checked in episodes of trendy TV shows such as Sex and the City, is not that some faceless cabal of wealthy families has started putting their children’s nest eggs in these funds (at least no more so than in the past). Hedge funds grew so much so quickly because U.S. public pensions needed to earn the highest returns possible in order to ensure that their beneficiaries received the gold-plated retirement benefits that they had been promised.
One could argue, with some degree of sincerity, that we don’t actually have a “hedge fund problem,” or that we don’t even have a “private equity problem,” despite the vitriol thrown around on the campaign trail last year. Instead, we seem to have a public pension problem, which is driving large sums of money into these vehicles in order to keep up with the obligations they have to upcoming generations of retirees.
Leopold, however, chooses to avoid this more difficult, but more pressing, topic, and his book suffers greatly from the omission.
Hedge funds are in need of sustained and rigorous study, together with informed and specific criticism. Critics have an important role to play in helping us better understand how our financial system works, and the particular role that should be played by the growing variety of alternative investment vehicles that are now plying their trade in the market.
One of the fundamental questions any critic must answer is, “Do you believe in talent?”
Just as Lionel Messi can kick a soccer ball better than any other person on the planet, and his equivalents in baseball, basketball, golf, and tennis can make similar claims in their sports, there do appear to be investment professionals who can generate sustained performance over periods of time, performance that seems to withstand statistical scrutiny.
But if talent is a mirage, and there is no way to beat the market consistently over time, then it is not just hedge funds that are incriminated. It is the entirety of the investment management industry, including the mutual funds and 401K plans that Aunt Edna and Uncle Edgar have been diligently participating in over the last several decades.
If there is talent in literature, and talent in music, and talent in art, and talent in thousands of other human endeavors, but no talent in investing and finance, then the so-called “efficient market hypothesis” championed by a handful of ardent academics for years is indeed correct. However, the consequences are much broader than just lambasting hedge fund managers, as Leopold does.
Expanding and improving financial literacy remains one of the greatest challenges we currently face, as we continue to adapt to a world where global markets — in goods, in services, in currencies, in securities — increasingly dominate our daily lives. Everyone with a savings account or a retirement plan or a mortgage has a stake in how financial markets are structured and regulated.
The question of what good a hedge fund actually does is an important one, on which we should all have an informed opinion. Although Leopold’s heart was no doubt in the right place when he set off to write How to Make a Million Dollars an Hour, his book fails to drill deep enough into the relationship between these alternative funds and their managers, on the one hand, and the millions of government employees whose retirement savings are flooding into them every week, on the other — not deep enough to make the important observations and connections that are needed today.