How an 8 (or 10) figure income can make sense

Fees 24 May 2007

Kudos to the New York Times’ David Leonhardt for stating an uncomfortable, yet accurate economic truth about hedge fund compensation.  In response to Alpha Magazine’s newest hedge fund rankings, he wrote yesterday:

“I realize that a lot of people find 9- and 10-figure incomes to be inherently excessive. Or even immoral. From a strictly economic point of view, however, they are also perfectly rational. You cannot find anyone else who is providing the same returns as the best hedge fund managers at a lower price. If you don’t like it, you don’t have to give them your money.”

For a supposedly liberal news outlet, the NYT has approached this topic with refreshing clarity.  In New York Magazine’s feature on the industry last month, economist Tim Harford said:

“Ultimately, investors have to decide which funds make the fees worth paying. Some fees might eventually be lowered, but those tempted to do that might choose to simply close their doors. Despite the boom, some funds have already done that. That’s exactly what we’d expect from a competitive industry that refuses to cut prices. The laws of economics haven’t been suspended, after all.”

Leonhardt concludes his piece in the Times by suggesting exorbitant compensation is a result of industry structure and can’t really be blamed on managers themselves.  Although he pins the blame on “human nature”, he is mostly correct.  We all have a right to charge as much as markets will bear.  If markets will bear high prices, there must be a reason for that.

For example, in the case of professional sports, players extract high incomes because they create a lot of value (as evidenced by the amount of money owners are willing to pay them).  These players are the source of such value due to local monopolies.  If Major League Baseball were to put 10 teams in the New York area, ticket prices would fall,  the fan-base would be divided 10 ways and 44 year old Roger Clemens wouldn’t get $28 million for his one-year encore.

While the industry dynamics are different, there is a similarly cogent economic explanation for the high incomes of hedge fund managers.  Accusing hedge fund investors such as the multi-gajillion dollar California Public Employees Retirement System of simply being stupid for paying such fees is like accusing baseball fans of paying up to $400 a seat to see Clemens’ Yankees.  Sure $400 is high.  But obviously the buyers of those tickets see commensurate value in them.

Likewise, buyers of hedge funds see value that justified the fees they pay.  Perhaps it’s the fact that hedge funds tend to produce more alpha.  Perhaps these investors believe that index-hugging long-only funds also charge about the same fees per unit of alpha as hedge funds.

Who knows?  But these dispassionate views of a journalist and an economist are helpful in guiding us to an answer.

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