November 15, 2005
Hedge Funds, Mutual Funds, 401K’s and Traditional Pensions
Posted by Bill Henderson

Vic has posted some interesting comments (here and here) on hedge funds. Since (a) investments in hedge funds have grown exponentially, (b) the SEC recently enacted new rules for this investment vehicle, and (c) there is a paucity of scholarly literature (at least by legal academics), hedge funds represent a terrific opportunity for young scholars looking for a research niche.

Vic raises the question, “What if the defining characteristic of hedge funds is the compensation scheme, not the underlying portfolio? What are the normative implications?”

According to a detailed SEC Staff Report (Sept 2003), most hedge funds have two financing components: (1) a 1 to 2 percent asset-based investment management fee (similar to mutual funds), and (2) an incentive allocation, which tend to be “20 percent” of “the hedge fund’s net investment income, realized capital gains and unrealized capital appreciation.” Re #2, “high water marks” and “hurdle rates” are contractual terms that reduce the likelihood that a hedge fund manager will profit from poor performance.  The SEC Report suggests (and James Cramer’s entertaining book, Confessions of a Street Addict, corroborates) that the “20 percent / high-water mark” are fairly standard. So I think that Vic is correct that compensation scheme is “a” (or “the”) defining characteristic of hedge funds.

Regarding the normative implications of that observation, I will take off my academic hat and speak only as a concerned citizen.

Just like there are good and bad lawyers or doctors, there are good and bad money managers. It is now obvious that the best money managers are running hedge funds.  Last month, the N.Y. Times  reported that the top money managers for Harvard University quit because their annual compensation would be capped at $20 to $25 million—far below what professionals with similar performance records would earn if they were managing hedge funds (their current jobs). There are countless other stories documenting the migration of the “best and brightest” to hedge funds.

That said, absence a Long Term Capital Management problem, the compensation schemes of hedge funds is an issue that only affects rich people. (SEC rules like Reg D generally prohibit low-net worth people from investing in hedge funds; and regardless, most successful hedge funds require very high minimum investments.) Most of us are stuck in the lackluster world of 401K’s and mutual funds.

I’ll never forget the SEC roundtable discussion in which David Swensen, Chief Investment Officer of Yale University  (whose financial performance has exceeded Harvard’s), heaped derision on the mutual fund world:

[W]e've got thousands and thousands of mutual funds. On average, the experience of individual investors is quite poor there. They would be far better off with an index fund than with the high cost active management that they've got in the mutual fund world. Of the thousands of mutual funds, there are probably several dozen that are worthy of investment.

Okay, Dave, just tell me the top dozen—or better yet, manage my money.

To my mind, the academic debate on the Efficient Capital Market Hypothesis was settled when I saw the gleaming marble floors of Citadel Investment Group, one of the nation’s leading hedge fund managers (note that I was not permitted past the lobby because of airtight security). The longstanding success of hedge funds like Citadel—and there are many others—is clear evidence that supra-normal returns are possible over the long term. Of course, fund managers have zero interest in sharing their trading strategies in order to settle academic debates.

So what is my normative bottom-line?

I worry that the retirement of most Americans depends upon “B” quality money managers at mutual funds. At least with defined benefit pension plans, managers have—in theory, anyway—sufficient resources and negotiating leverage to tap into truly talented investment advisors. Unfortunately, many of these plans are being shed in bankruptcy proceedings (e.g., airlines, steel industry). With the ascendancy of 401K plans and talk of privatizing social security—so more of the Wall Street “B” crowd can collect management fees—I fear we are headed for an economic and political train wreck.

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June 27, 2005
Scented Bowling Balls?
Posted by Caroline Bradley

As I was driving to pick up my sons from their half-day basketball camp I heard an item on NPR on scented bowling balls, developed by a Utah business called Storm Bowling. As I was about to go into a Gym full of young and older boys who had been playing basketball all morning I thought for a moment that perhaps scented basketballs might be a good idea. But then again this story is an example of why I am sceptical about how markets allocate resources. Who needs scented bowling balls? Or scented crayons, markers and play-doh? Even scented basketballs?

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April 11, 2005
What's the Proper Usage of "Ironic"
Posted by Christine Hurt

A reader points out that although my usage of "comprise" is spot-on, my statement that the proper use of the term is "more honored in the breach" is quite off.  Although I'd never paid close attention, the phrase is used to describe situations where the waiving of a custom is a more honorable practice than devotion to it.  I can't think of a good modern example, but maybe readers can.

Anyway, when I quit laughing at myself I'll be sheepish at my attempt to show off my superior writing talent.

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The Zeal of the Converted
Posted by Christine Hurt

If you read Kevin Drum, you know that he is a recent convert to the proper use of the phrase "begs the question."  (Nutshell:  the phrase translates "begs off the question," not "begs for the question.")  His new-found zeal reminds me of my own pet peeve:  the misuse of the term "comprise." 

99.9% of the population uses "comprise" to mean "constitute."  This is wrong, according to wise people like Strunk & White (and me).  I learned this in law school:  "comprise" means "is constituted by."  So, the whole comprises the parts, not the other way around.  So, "the faculty comprises classroom and clinical teachers," not "classroom and clinical teachers comprise the faculty."  My yellowed copy of Strunk & White states:

Comprise. Literally, "embrace": A zoo comprises mammals, reptiles, and birds (because it "embraces," or "includes," them). But animals do not comprise ("embrace") a zoo -- they constitute a zoo.

This usage seems more honored in the breach, but perhaps I am being part of the solution here!

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March 17, 2004
Posted by Gordon Smith

I just spent a good chunk of my day applying for new passports for my five children. If you have never had this experience, count yourself lucky. Because of concerns over kidnapping, both parents must appear before a postal service employee upon application. The documentation is extensive, including an application (same basic information, but filled out longhand five times), birth certificates, and old passports. Oh, and don't forget your checkbook: $70 for each child. Unless you need it expedited, in which case you can more than double that. On the heels of completing my tax return, this was not a happy day.

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March 15, 2004
PayPal ... I trusted you!
Posted by Gordon Smith

In the late 1990s, some internet experts were weaving tales of a security horror. Since then we have become comfortable shopping on the internet. While ads about identity theft are funny, my usual reaction is, "that couldn't happen to me." Nevertheless, stories like this give me pause.

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October 17, 2003
Can I get some service?
Posted by Gordon Smith

After returning from my fall color tour, I decided to take advantage of the Grand Opening of a Michael's store not far from my home.

We had stockpiled a number of prints and other art works that needed framing, and Michael's was offering 50% off. Hard to resist. Three hours and $500 later, I emerged from the store, beaten into submission by a scatterbrained "framing consultant."

When I arrived at the framing department, I was the only customer, and only one framing expert was on duty. A perfect match. Except that whenever another customer arrived, my faithless helper would divert her attention to the new person, attempting somehow to satisfy both of us, but in fact satisfying neither.

Several times, I almost packed up and left, but I kept thinking that we were almost done. Just another reminder that retail is not just about products or systems, but pervasively about people.

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