Tuesday, April 24, 2007

Masters of the Virtual World: Billion dollar hedge fund managers and the equity price premium

MR reviews the news on hedge fund manager earnings:
Marginal Revolution: Jordan fact of the day:

..."The combined earnings of the world's top 25 hedge fund managers of more than $14bn ... exceeded the national income of Jordan last year and three individuals took home more than $1bn, according to the biggest annual industry survey...

... What we see are the fearless super-rich having the resources and the liquidity to bid away the equity price premium, plus grab extra profits on the side...
MR has some important links, including to a NYT article Emphases mine:
... The earnings of these masters of the new universe — Mr. Simons took $1.7 billion — dwarfs the $54.3 million that Goldman Sachs chief executive Lloyd C. Blankfein earned last year, a sum that itself sparked controversy among industry watchers, including DealBook readers.

Some view these handsomely rewarded managers as this generation’s robber barons, using wealth to create wealth, often in secretive ways, and leaving little that is tangible in their wake.

“There is some question as to what the hell they are doing that is worth” that kind of money, J. Bradford DeLong, an economist at the University of California, Berkeley, told the Times. “The answer is damned mysterious.”

Others look upon them as new-economy financiers, evoking the likes of John D. Rockefeller or John Pierpont Morgan as they provide liquidity to the markets and broadly diversify risks in the banking and financial systems.

“You had railroads in the 19th century, which led to the opening up of the steel industry and huge fortunes being made,” Stephen Brown, a professor at the Stern School of Business of New York University, told the Times. “Now we’re seeing changes in financial technology leading to new fortunes being made and new dynasties created.”

... Combined, the top 25 hedge fund managers last year earned $14 billion — enough to pay New York City’s 80,000 public school teachers for nearly three years, the Times said....

... Mr. Simons, for example, has some of the highest fees in the business — 5 percent of assets under management and 44 percent of profits. But the Times notes that he trounces most of his competitors year after year: In 2006, the $6 billion Medallion fund posted gross returns of 84 percent; 44 percent after fees, explaining his $1.7 billion take.

“If you pay peanuts, you get monkeys,” said Jim Dunn, a managing director with Wilshire Associates, an investment advisory firm. “We don’t concern ourselves with fees. If you can provide Alpha, I’m less concerned about what you bring home.” (Alpha is producing returns that are not tied to a market benchmark like the Standard & Poor’s 500-stock index.)
Lord, words like "we don't concerns ourselves with costs" sound very bubbly to me. My knowledge-free bet, based solely on observing how humans work, is that MR is right that the "equity premium" (the reason that stock markets have historically been a better investment than loaning money directly) is overly large in Economy 3.0, and Simons and his kin are winning the prize for sucking it down. Once it's down, however, it has nowhere to go, and the money will run dry. Also based on how humans work, I bet the "legitimate" efficiency work was finished over a year ago, and the prizes now are financial bubbles flowing into the pockets of the luck-favored prepared mind. Naturally the winners, Masters of the (virtual) Universe, assume they are deities and the prize reflects their superhuman worth. Tears are likely to lie ahead ...

Billions. Sloshing around. Wouldn't you like to be there to catch the spills?

In the meantime, if one assumes the risk premium has been over-deflated, it is likely that investors in today's market are being under-rewarded for the risks they are bearing. Which means, given the recent rise in the market, that the risk is rather substantial.

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