Everyone wants to manage a hedge fund |
Date: Friday, July 6, 2007
Author: Robert H. Frank, International Herald Tribune
Little wonder. According to Institutional Investor's Alpha magazine, the
hedge fund manager James Simons earned $1.7 billion last year, and two other
managers earned more than $1 billion. The combined income of the top 25 hedge
fund managers exceeded $14 billion in 2006.
These managers also enjoy remarkably favorable tax treatment in the
For example, even though "carried interest" - mainly their 20
percent commission on portfolio gains - has the look and feel of ordinary
income, it is taxed at the 15 percent capital gains rate rather than the 35
percent top rate for ordinary income. That provision alone saved Simons several
hundred million dollars in taxes last year.
Congress is now considering a proposal to tax carried interest as ordinary
income. To no one's surprise, private equity lobbyists were quick to insist
that doing so would cause grave economic damage. The deals brokered by their
clients often create enormous value, to be sure.
Yet the proposed legislation would not block a single
transaction worth doing. What is more, economic analysis suggests that it would
actually increase production in other sectors of the economy by reducing
wasteful overcrowding in the market for aspiring portfolio managers.
This market is what economists call a winner-take-all market - essentially a
tournament in which a handful of winners are selected from a much larger field
of initial contestants. Such markets tend to attract too many contestants for
two reasons.
The first is an information bias. An intelligent decision about whether to
enter any tournament requires an accurate estimate of the odds of winning. Yet
people's assessments of their relative skill levels are notoriously optimistic.
Surveys show, for example, that more than 90 percent of workers consider
themselves more productive than their average colleague.
This overconfidence bias is especially likely to distort career choice
because, in addition to the motivational forces that support it, the biggest
winners in many tournaments are so conspicuous. For example, NBA stars who earn
eight-figure salaries appear on television several nights a week, whereas the
thousands who failed to make the league attract little notice.
Similarly, hedge fund managers with 10-figure incomes are far more visible
than the legions of contestants who never made the final cut.
When people overestimate their chances of winning, too many forsake
productive occupations in traditional markets to compete in winner-take-all
markets.
A second reason for persistent overcrowding in winner-take-all markets is a
structural problem called "the tragedy of the commons."
This problem helps explain, for instance, why we see too many gold
prospectors, an occupation that has much in common with prospecting for
corporate deals. In the initial stages of exploiting a newly discovered gold
field, adding another prospector may significantly increase the total amount of
gold found.
Beyond some point, however, additional prospectors contribute little. The
gold found by a newcomer to a crowded field is largely gold that would have
been found by existing searchers.
A simple numerical example helps illustrate why private incentives often
lead to wasteful overcrowding under these circumstances.
Consider a man who must choose whether to work as an engineer for $100,000
or become a prospector for gold. Suppose he considers the nonfinancial aspects
of the two careers equally attractive and expects to find $110,000 in gold if
he becomes a prospector, $90,000 of which would have been found in his absence
by existing prospectors.
Self-interest would then dictate a career in prospecting, since $110,000
exceeds the $100,000 engineering salary. But because his efforts would increase
the total value of gold found by only $20,000, society's total income would
have been $80,000 higher had he instead become an engineer.
Similar incentives confront aspiring portfolio managers. Beyond some point,
adding another highly paid manager produces little increase in industry
commissions on managed investments.
As in a crowded real estate market, the additional manager's commissions
come largely at the expense of commissions that would have been generated by
existing managers. So here, too, private incentives result in wasteful
overcrowding.
Matthew Rhodes-Kropf, a finance professor at
"Private equity is a very important part our economy," he said,
adding that higher taxes will discourage it. Others have characterized the
proposed legislation as envy-driven class warfare.
Both observations miss the essential point. No one denies that the talented
people who guide capital to its most highly valued uses perform a vital service
for society.
But at any given moment, there are only so many deals to be struck. Sending
ever larger numbers of our most talented graduates out to prospect for them has
a high opportunity cost, yet adds little economic value.
By making the after-tax rewards in the investment industry a little less
spectacular, the proposed legislation would raise the attractiveness of other
career paths, ones in which extra talent would yield substantial gains.
And the additional tax revenue could pay for things that clearly need doing.
For example, we could reduce the number of children who currently lack health
insurance, or reduce the number of cargo containers that enter our ports
without inspection.
Opponents of higher taxes often invoke the celebrated trade-off between
equity and efficiency. But that objection makes no sense here.
Ending preferential tax treatment of portfolio managers' earnings would
serve both goals at once.