If you have billions of dollars at the beginning of the year, and you invest your money, and the market goes up, then at the end of the year you'll have made hundreds of millions of dollars. This is very obvious, but here is your annual reminder of it, dressed up as overpaid hedge fund managers:
For investors in hedge funds, like big pension funds, 2014 was not a lucrative year. But for those who managed their money, the pay was spectacular.
The top 25 hedge fund managers reaped $11.62 billion in compensation in 2014, according to an annual ranking to be published on Tuesday by Institutional Investor’s Alpha magazine.
This is not especially true, though, for ordinary uses of the word "compensation." Here is how Institutional Investor describes its methodology:
To estimate a hedge fund manager's total earnings for one year, we draw from two components. As always, Institutional Investor's Alpha counts the individual's share of a firm's management and performance fees. The management fees often add up to a sizable sum at the largest firms, many of which charge between 2 and 5 percent. We also count the gains on the individual's own capital in their funds, which can be considerable. If a manager still has not reached his high-water mark, we count just management fees and the gains on his personal capital for the year.
Emphasis added. Most of this "compensation" is not "compensation," in the sense of amounts that pension funds paid these guys to manage their money. Most of it is just return on capital: The managers had money in their funds, and the funds went up, so the managers had more money at the end of the year than at the beginning. They invested a lot of money reasonably successfully, so now they have more money.
So I mean look: The best-paid hedge fund managers do seem to have been paid pretty well. Even subtracting returns on their own funds, several of them seem to have made hundreds of millions of dollars from fee income. But most of the best-paid hedge fund managers aren't getting richer mainly by being paid to manage hedge funds, just like Warren Buffett's wealth is not mainly driven by his $100,000 salary at Berkshire Hathaway. They got rich initially by being paid to manage hedge funds -- mostly because they did a good job of it -- but their income now comes mostly from having a lot of money and investing it. As I said when we talked about this list last year, they live in a Pikettian world where returns on capital outstrip returns to labor.
What else should we think about this list? One thing to consider is alignment of incentives. There's a stereotype that small hedge funds live on their performance fees, so they are hungry and motivated: A 2 percent management fee on a small amount of money is a very small amount of money, so to keep the lights on and send the kids to sailing camp you need to make your 20 percent performance fee as big as possible. Big hedge funds, on the other hand, can live comfortably on their management fees, because 2 percent of a lot of money is still a lot of money. So you'd expect them to be more conservative asset gatherers, and less inclined to chase performance, relative to smaller funds.
And then there are the "best paid" hedge funds, where the manager has billions of dollars invested in his own fund. He's not living on management fees or performance fees; the main determinant of his earnings -- um,"earnings" -- for the year is not how much he charges but just how much he returns on his own money. The classic hedge-fund-manager 2-and-20 fee structure is swamped, for him, by his personal investment. In some ways this is an ideal alignment of incentives: The manager participates alongside his investors, rather than getting paid mostly in an option on their returns (performance fees) or a flat cut of assets (management fees).
But "hedge funds are a compensation scheme masquerading as an asset class," and maybe there's some value in the compensation scheme itself. If you are looking to hedge funds for outsize returns, you might want to pay your manager an option on your returns, by giving him a performance fee of 20 percent of the upside and limited penalties on the downside. Options increase in value with volatility, and giving a manager asymmetric rewards might encourage desirable risk-taking. That might be exactly what you want if you're a pension fund investing a small chunk of your portfolio with hedge funds in order to earn above-market returns. On the other hand, if your manager is already a billionaire investing a big percentage of his net worth alongside you, he might be more conservative with your money than you are, or than you want. It's probably more important for him to stay a billionaire than to rack up more money.