Sentences of wisdom

by on April 12, 2007 at 3:27 pm in Economics | Permalink

To the extent that the superrich are pulling away from the rest of us…the most parsimonious explanation seems to be the massive increase in the efficiency, and size, of American capital markets.

Here is more.  Here are my views on the same.

Addendum: In the comments read the discussion between Jane Galt, James Surowiecki, and myself.

1 spencer April 12, 2007 at 4:46 pm

I would accept your argument with few qualms if I thought that the
pay of CEOs was set in pure free markets. But the pay of CEOs is
less a function of a free market then union pay in an oligopoly or
monopoly. CEOs have rigged the rules of the game so that owners have
lost effective control over them.

2 vlorbik April 12, 2007 at 8:24 pm

your page is buggy.
it takes a long time to load
and doesn’t always load right even then.
i expect it has something to do
with the quasi-animated ad (yick).

i was referred here by god of the machine, btw.

3 Wild Pegasus April 12, 2007 at 9:47 pm


Where did Tyler say it was due to free markets, as opposed to the markets we have?

– Josh

4 Steve Sailer April 13, 2007 at 12:04 am

Shouldn’t a more efficient financial market mean that the ROI gap on the investments of the rich and non-rich should narrow, not widen? In 1907, it helped to be as rich as J.P. Morgan to profit reliably in the financial markets because the cost of monitoring one’s investments to make sure you weren’t being ripped off was so great. Now, the friction cost of investments for small investors should be less prohibitive. So, I don’t see this as much of an explanation.

5 James Surowiecki April 13, 2007 at 3:43 am

Jane, the more efficient a market becomes, the slimmer the opportunities for profits become, since the market’s pricing becomes more accurate. So “sitting at the nexus” of an efficient market shouldn’t afford people more of a chance to become immensely wealthy. (In fact, I think the more efficient a market becomes, the less meaningful the idea of a market “nexus” should be.) More to the point, Steve’s right: a more efficient capital market is one in which there should be a smaller, not bigger, role for intermediaries. So it seems peculiar to argue that the greater efficiency of capital markets is responsible for making all these intermediaries incredibly rich.

Also, where is the evidence that “technology workers who benefit from stock options” have been, as a group, pulling in sizeable pay hauls since the bursting of the bubble? Not to mention the fact that, again, the opportunity to make huge sums of money from stock options is evidence of market inefficiency, not efficiency.

6 Steve Sailer April 13, 2007 at 8:28 am

I’m struck by the tremendous ROI’s generated in the last 15 years or so by the huge Yale and Harvard endowments — around 15% per year, much better than the average for smaller endowments, and much, much better than the average investor’s ROI.

Is that efficiency, or the opposite?

7 Steve Sailer April 13, 2007 at 8:52 am

Pablo Escobar used to “sit at the nexus” between Bolivian cocao farmers and American coke-snorters and made billions. In contrast, the average Joe could buy into Peter Lynch’s Fidelity Fund in the 1980s and do pretty well for himself.

Which market seemed more efficient? And why does investing today in the hedge fund era with million dollar minimums look more like a game biased in favor of the big money boys than in the recent past?

8 Jane Galt April 13, 2007 at 9:00 am

This is indeed a semantic battle over efficiency. Practically, efficient markets have many characteristics, only one of which is that arbitrage opportunities are relatively rare, though this characteristic is definitional. They are also bigger and do more transactions, and may (do) offer more opportunity for intermediaries to add value.

I don’t actually view, say, M&A fees as an example of market efficiency; the size of their commissions kind of mystifies me. But even on a 7% commission, the size of the fee you take home is directly correlated to the size and number of transactions you do. These have increased, which I do view as an effect of efficiency. Even if the merger is a waste, as they so often are, the transaction itself is frequently made possible by innovations in the size, depth, and structure of capital markets.

9 Jane Galt April 13, 2007 at 10:47 am

But size of the deal and frequency of deals has to be the explanation for the level of wealth coming out of investment banking; AFAIK, the fees for M&A are the same “gentlemen’s agreement” fees they were in 1930. Trading fees, meanwhile, have gone down. So to the extent that the banks are making more money, it is because there is more securitisation and equity financing and fewer straight bank loans, and because the value of the deals has gone up. Or because banks are creating entirely new financial instruments (like credit derivatives) where they’re adding value.

I agree that the M&A fees should be lower, and I don’t have a great explanation for why they are not. But you don’t need to believe that the market for investment bankers is efficient to believe that the capital markets overall are. Middlemen can be skimming quite a lot, but the overall allocation of capital can still be improving.

10 Brian McDaniel April 13, 2007 at 11:14 am

I believe Jane has the right of it. Capital markets overall are much more efficient, allowing more and larger transactions. This is reflected in the fact that deal sizes that just a few years would be unthinkable are now routine (go back and read the commentary on the RJR Nabisco buyout). In addition to the liquidity and technology factors cited above, the development of the private equity model has been a huge driver in this development.

However, the market for investment banking, private equity fund management and NY lawyers are, IMHO, no more efficient now than they were 50 years ago. In the big picture it doesn’t matter much because these players take such a small slice of the pie that it doesn’t affect the overall efficiency of the financial markets. But it does mean these players get to earn outsize rents.

I can say this with some confidence as an insider. I don’t know how well it works, though, for an overall explanation of the growing income gap in America.

11 James Surowiecki April 13, 2007 at 11:22 am

I’m not saying that the overall market for capital allocation is not more efficient — I think that it is. I just disagree that the greater efficiency of the market accounts for the massive increase in the amount of money made by people on Wall Street and in capital markets more generally. I suspect that increase is driven in large part by the persistence of atavistic and inefficient practices, which, coupled with the explosion in the size of capital markets, has made it possible for people to skim from a much bigger pool.

12 Francis April 13, 2007 at 11:43 am

To take one example of atavisic and inefficient practices, why is it that shares in IPOs are not allocated in a Dutch auction?

It’s been the better part of 20 years since I lived in NY and worked at the edges of the capital markets. But pretty much every time I got drunk with an investment banker, he’d admit that a vigorous anti-trust investigation could tear Wall Street apart. Tying, kickbacks, price-fixing were all common.

The rumor went that no administration would dare go for it for fear of killing the goose laying golden (campaign contribution) eggs.

13 JPC April 13, 2007 at 11:51 am

As one involved in the hedge fund business I can tell you that the largest contributing factor to the growth in traded capital markets and the ability of a few individuals to capture huge profits has been the information technology improvements over the last decade. In terms of the efficiency arguments above:

–the traded markets are much larger, deeper and more geographically diverse
–the ‘spreads’ are lower in these markets – this is one measure of efficiency
–electronic trading is becoming standard, thereby accelerating growth, volume and efficiency
–because of the above, 10 guys in Greenwich can make [or lose] a billion dollars trading with a few computers

By the way. I’m, talking about the non-investment banking markets: FX, commodities, equities, interest rate products, etc. The investment banking capital market functions of M&A, IPOs and debt issuance are not any more efficient than 10 years ago. This is because they are largely operated in a cartel fashion, controlled by a few players, and are fundamentally relationship, not trading, businesses.

I think the real explosion in “super high net worth” individuals comes from the trading side of the capital markets, not the investment banking side. This is an important distinction.

One further note: the huge influx of funds into hedge funds is explainable in large part because of the poor asset/liability management of defined benefit plans inside Fortune 500 corporations, and their necessity to fund plan deficits by achieving higher returns, when they should have been buying bonds as Fischer Black pointed out long ago. This accounts for the “demand” side and the willingness to pay huge fees to hedge fund managers, for what amounts to leverage that they can’t achieve in other ways.

Finally, as to why the University endowments achieve high returns, this is largely explainable by liquidity premiums in investments like natural resources, real estate, private equity, and leverage in their portfolios, as well as size advantages, ie preferential access to private deals.

14 sourcreamus April 13, 2007 at 12:11 pm

It appears that there is a consensus that the increasing efficiency of the capital markets allows for much bigger transactions. These huge transactions lead to huge commmisions because of the inefficiencies of the current investment banking setup. This would seems to lead to an opportunity to make huge amounts of money by becoming the Walmart of investment banking. I am willing to make huge amounts of money, Do those “For Dummies” people have a book on investment banking?

15 jp April 13, 2007 at 2:08 pm

sourcreamus wrote, “This would seems to lead to an opportunity to make huge amounts of money by becoming the Walmart of investment banking.”

The reason why that has not happened, as others have mentioned above in passing, is that investment banking (along with high-end accounting and corporate lawyering) is heavily brand-dependent. Anyone with a big deal, and many with not-so-big deals, want one of the “top firms” to be handling things. The “top firms” have become natural oligopolists — through experience and carefully maintained reputations, they are able to provide a level of assurance or comfort that lesser-known or less well regarded firms cannot match. The “top firms” can therefore charge oligopoly rents, which naturally increase as deals get bigger and increase in number.

16 happyjuggler0 April 13, 2007 at 2:41 pm

James Surowiecki,

I’m not saying you are right, and I’m not saying you are wrong, regarding how easy it may be for those on the far right of the curve to beat the amrket. However I do want to point out that I may have been careless in my use of the term arbitrage. Most people in the market usually think of arbitrage in terms of buying gold in NY and selling it in Chicago, or arbitraging the difference between 3 and 6 month puts (or something more sophisticated), or buying 29 year bonds and shorting 30 year bonds etc.

That may indeed be quite hard to beat, and beat by a significantly large amount to get recurring outsized gains.

What I was talking about is arbitraging XYZ stock when it is selling at 50 based on short and medium term financial prospects but is worth 100 and would be priced at about 100 if “everyone” saw further into the future, sort of like my example regarding the housing bubble and subprime. Thus I am talking about not arbitraging a few basis points but a 100% price difference between what something “ought” to be priced at and what it actually is priced at. Reading stories of hedge fund managers who use “fundamental analysis” one gets the feeling this si the type of things they look for, i.e. superior economic analysis of trends or changes of broad conditions, and then they do bottom up searches for trades that usefully fit their broader insights.

Thus my use of the term arbitrage is about arbitraging assets priced on short and medium term insights with the “correct”, or more correct, long term insights. I am not convinced that beating the collective wisdom incorporated into prices isn’t something that someone quite bright couldn’t do with longer time horizons via a proper understanding of economics for example. I also think it plausible that someone crunching price data couldn’t use superior math and statistics to extrapolate (correctly) useful patterns to yield profits over time, and this latter methodology is hardly something the rank and file are qualified to do.

I also can’t help but wonder if there is such a thing as a “proper” price for currencies. People tend to think it “ought” to be the level implied by PPP (if PPP could be accurately computed that is). However freely floating currencies are determined by capital flows, and these capital flows are only marginally anchored by PPP forces short and medium term. As such, they are driven by saavings rates and investment opportunities in various countries, and these things tend to trend to extremes. As such, currency isn’t arbitrageable the way bonds or equities or commodities would be with an automatic negative feedback mechanism. If the Euro goes up vs the Yen, it tends to attract rearview mirros to that trade, which makes it go up even more and so on, and the natural negative feedback mechanism of trade in goods and services is weak until it hits extremes, when the trend may be positively reinforcing the other direction. In the meantime “real world” users of foreign currencies pay the market price regardless of price until their margins get squeezed out by rising currency. When the market turns and fund managers want to unwind their positions (an indeed take the other side of the trade), the “real world” users of currencies for goods and services wind up taking a disproportionate amount of the other side of the trade, as opposed to what happens with commodities trades for example.

I am not sure how much this is a factor, but I can see how a majority of players might have nicely positive FX numbers on a consistent basis.

Anyway, I am not ruling out rent seeking explanations, just positing a hypothesis or two. The real question is how rare such talents are, and is the current trend of very bright students doing salary arbitrage and moving to try to get jobs in the finance industry (instead of business management or theoretical physics or whatever) going to arbitrage away the outsize gains over time?

17 Tyler Cowen April 13, 2007 at 3:50 pm

Does the existence of Bill Gates “count against” the efficient market hypothesis? After all, he invested in Microsoft quite early, before other people knew how much the company would be worth. He also helped produce the company, obviously. Standard efficient markets theory assumes a convenient separation between the real and financial sectors of the economy, with the real sector held constant. Once we modify the constancy of the real sector, what EMH implies is pretty tricky and not at all obvious.

18 James Surowiecki April 13, 2007 at 4:41 pm

There is, I think, an obvious tension between the reality of entrepreneurial success and the broader idea of efficient markets — if you think of the famous joke about the economist refusing to pick up the $20 bill because if it was real, someone would already have picked it up, the success of people like Gates is evidence that there are plenty of $20 bills out there, if you know where to look. But I actually don’t think that EMH is disproven by the mere fact that some people are occasionally able to make a lot of money by somehow outthinking the market (in this case, the market for new technologies, I guess — if you allow enough businesses to be started, some will succeed, if only by randomness. The real question is whether there are a significant number of people who are able to systematically and consistently outthink the market — and the evidence for that is, I think, pretty shaky. How many genuinely profitable lines of business other than Windows and Office has Microsoft started in the past fifteen years?

Happy, I actually understood that you were using (appropriately, I think) a more capacious definition of arbitrage, and that’s why I was suggesting that much of what looks like fundamental alpha in the hedge-fund world may just be an alternative form of beta (JPC’s important point about leverage and the carry trade is additional evidence in favor of this hypothesis). Again, I don’t disagree that there are some individuals who are able to consistently outperform the market (certainly I think Buffett is one, as is Bill Miller). I just think there are many fewer of them than there are money managers who have gotten absurdly rich for reasons other than their actual skill at finding undervalued assets.

19 White Sox fan April 14, 2007 at 2:31 am

Just a note in support of happyjuggler: I used to work on the exchanges here in Chicago. The futures market is a classic example of a zero-sum game ( if you disregard its hedging function ). The CME did a study regarding the outcomes of its members, most of which were locals, or those that traded for themselves and liquated their positions before the end of each trading day. It concluded that over a 5 year span, 80% quit or lost money, 10% broke even, and 10% made money. A few years later, during the internet-fueled daytrading craze, I seem to remember a study that reported very similar numbers for daytraders. Now, maybe those fortunate 10% were very good at what they did or maybe they were just the very lucky; But either way, those guys were basically taking money from the bottom 80% and making money hand over fist. The saying on the exhcange was that “there is no middle class on the trading floor”.

20 Steve Sailer April 14, 2007 at 9:22 am

Back when I was taking economics courses at MBA school in the turning point year of 1982, economics professors drilled into us that financial markets were efficient, and therefore you should just put your money into a no load mutual fund because even professionals can’t beat the market. Being a trusting soul, I believed them and went into the incredibly lucrative marketing research industry. My classmates at MBA school paid no attention, went to Wall Street, and got rich.

So, why exactly did the Efficient Markets Hypothesis fail so badly in reality, despite conquering academia?

21 White Sox Fan April 14, 2007 at 12:55 pm

I’ve only been glancing at the blog and it has been a while since I studied this, but I believe the problem is that efficient market hypothesis ( EMH ) is being misunderstood. As I remember it, the emh it its various forms ( weak, semi-strong, and strong ) implies that at any given moment, prices in the financial markets reflect all information. It doesn’t state anything concerning the distribution of the profits resulting from bringing the information into the market. For example, in the semi-strong form, all relevent info concerning past price movements and all info regarding publicly available financial statements is priced into the market. However, those with lower transaction costs ( such as floor traders ) could generate profits in excess of what the average market participant could. Also, those acting upon non-public info could generate excess profits. So while the market is efficiently priced, the distribution of profits will be skewed toward those will lower transaction costs and those acting upon non-public info. Nothing beyond that should be read into the EMH.

22 happyjuggler0 April 14, 2007 at 3:34 pm

White Sox Fan,

Thanks for the info on the Chicago trader info. This is roughly what I would’ve guessed, and is precisely the point of my poker analogy.

Before taking into account transaction costs and overhead, the only way to beat a zero sum game is to take your winnings from those who lose at the game. In order to beat the averages in a positive sum game (pre-costs) like the US stock market, one also needs to take one’s gains from those who underperform. So if the gain from the US stock market is x% over time, then to get (x+y)% on average over time, with y being a positive number, and your initial Stock Market Investment is SMI, then your gain is SMI*y=z. In order for you to gain z then other participants must on average lose z.

Thus one would expect that the ones who are more astute and industrious would be the winners and those to their left on the astute+industriousness curve would be the losers, and that this distribution would look something like a few big winners and a lot of small losers.

All of that is before transaction costs and overhead. After factoring in those expenses, the numbers would skew even more.

It is worth noting though that all of this assumes only one particular market and an easily defined “average” that one is beating or underperforming. Add in leverage, whether explicit via borrowing or implicit in risk/reward ratio of an underlying asset, combine multiple markets, and add in an expanded risk capital pool searching for returns higher than from “safe” assets categories, and one can explain the outsized returns from fund managers with asymetrical reward mechanisms such as 2+20 (or whatever).

I am also not convinced that FX isn’t a positive sum game for traders as a group (before the bid/ask spread anyway, and likely after that spread too), with more than half of their collective counterparties to their trades being “real world” participants (via bank FX department intermediaries) with highly inelastic FX needs, not to mention government with non-profit motives adding expensive misadventures for their citizens. FX can also involve some outsize beta which tends to confuse the issue as well. None of this is meant to imply that FX is in any way easy to profit from, but it would seem to me that it would be additive to the trader pool overall instead of subtractive.

23 happyjuggler0 April 14, 2007 at 3:53 pm

Hmmmm, I am not satisfied with my “half of their collective counterparties” line. My point is that more than 0% of FX traders collective trades effectively have “real world” counterparties such as companies repatriating net overseas profits and buying or selling currencies for export/import purposes.

By government misadventures I am talking about vainly defending some artificial exchange rate, with the bulk of their eventual losses going to traders as a group.

24 Mark Seecof April 14, 2007 at 9:40 pm

In 1985 Ivan Boesky published a book, Merger Mania, about what a hardworking insightful genius of an “arbitrageur” he was. In 1986, his publisher dropped that book the way you might discard an apple after biting through a worm. It had come to light that Boesky made money the old fashioned way: he bribed people for inside information. From this incident, I learned that the stories successful Wall-Street’ers (or Chicago Loop’ers, u.s.w.) tell about themselves should be taken with a large shaker of salt.

I don’t think that everyone who makes big bucks in the markets is a crook like Boesky. I think that a lot of the outsize returns come from rent-seeking, though (which produces anti-competitive rules like the SEC’s ban on “small investors” in the private-equity markets). Also, outsize returns come from participating a cartel so large that no matter where you stand, you can’t see the other side of it, but small enough that members inhabit that special financial stratum you’ve been discussing here.

Michael Lewis recently wrote about that cartel in his Bloomberg column “Stocks: Coach Class of Capitalism” ( and he explained nicely how the very rich are not earning outsized returns in the very efficient stock market (or other public markets) today. They are earning outsized returns in a different market, which exploits stock market investors, partly for rents enabled by corrupt SEC rules.

25 JPC April 14, 2007 at 11:01 pm

Well, certainly happyjuggler should put his money where his FX is! If I might save him some USD with regards to his FX trading, I would humbly observe that perhaps central bank intervention may be the source of his easy alpha…

For the clearly connected Epicurean, I would again point out the terribly unsexy realm of pension fund regulation and accounting. Perhaps the journalists amongst us would view this story as an unobserved an juicy bone?

26 The Epicurean Dealmaker April 15, 2007 at 11:52 am

David Kane —

Sorry, as a non-economist, I played fast and loose with the term “cartel.” I am aware that there is no such thing in actuality in hedge fund land (or private equity). I also know that there is a big range of pay schemes in the industry, ranging from James Simons at Renaissance at 5 and 44 all the way to the much lower schemes you cite (which I understand to be primarily charged by funds of funds, which are secondary aggregators rather than direct hedge funds).

I still would like to know why so many primary hedge funds (anecdotally, I would assert the vast majority) are able to charge what on its face appears to me to be unsustainably high prices (2 and 20) for what seem to be mediocre returns. I have seen no published evidence that every or even most hedge funds consistently outperform their reference markets over time, even if some widely known, experienced hedgies (like James Simons) seem to consistenly hit the ball out of the park. We have a data problem–interesting in itself, with survivor and self-reporting biases–but to the best of my knowledge the hedge fund industry as a whole has not covered itself in glory in its heyday of the past few years.

I might guess that we have a situation in hedge fund land not unlike that cited above (by you? Sorry, it is a long discussion thread) regarding the maturation of baseball. As that market became more “efficient,” pay disparity among players widened, with the best players taking home an increasing portion of the aggregate industry compensation. Perhaps we have a situation here where a pre-existing hedge fund industry (much smaller, dominated by a few very successful traders) becomes swamped with new capital, which allows secondary traders and wannabes to charge the rack rate even as the number of those workers swells. And, as this (temporary?) bolus of money diminishes and consumers have better data to distinguish among the good, the average, and the lousy, pay will again differentiate.

If this is not a bad guess at what happened, one could sensibly ask why the preexisting players–those with the talent, reputation, and experience–did not simply accept more of the incoming money themselves, thereby crowding out latecomers. One answer might be that many of these players were used to operating in an environment where the aggregate money devoted to “hedge fund” investing was far smaller, and they did not see the benefit of taking on more money under management, since the opportunities they were traditionally able to exploit were smaller than the newly available capital would otherwise imply.

The follow-on question becomes whether these experienced hedge fund managers knew something the newbie traders and investors do not–that there are limited market opportunities for the trading and investment strategies grouped under the rubric of hedge fund trading. If they are right, we shoud see diminshing returns to all players in that market over time, perhaps an aggregate reduction in capital committed, and probably an eventual diminishment in prices charged. This hypothesis is certainly consistent with the observed fact that hedge funds have been rapidly diversifying away from their core business into traditional private equity, “activist” investing, and other non-trading focused strategies.

Finally, while I find the baseball analogy quite illuminating and intriguing, it has its limits. As an organized sport with clear and stable rules, clear and focused objectives, and well-established and understood methods of evaluation, it has a transparency and aptness for analysis that is missing in the much more fluid and messy capital markets. That does not mean we should not try, but we should understand the problems we face doing so.

I remain interested in anyone’s perspective on this, since I think the hedge fund industry sits at structural nexus in the capital markets, and the sustainability of its model and performance has strong implications for the near- and intermediate-term health of those markets.

27 The Epicurean Dealmaker April 15, 2007 at 2:50 pm

JPC — Kabloowie!

If I follow you correctly, perhaps that “bolus” of money being pumped into hedge funds is being driven by the fact it is about the only way pension funds can apply leverage to their investment portfolios. And, if I remember correctly, one of the principal triggers for the Great Crash of ’29 was the rapid unwind of highly leveraged margin positions in equities.

Of course, because we are talking about pension funds here, collapse in that portion of their portfolios will likely lead to all sorts of lamentations in the press and on Capitol Hill about how innocent little pensioners and common folk have been fleeced, and we will see all sorts of nasty regulation piled on top of the industry, in the true American fashion.

The only ones who survive and thrive should be those hedge fund managers (and their investors) who can avoid the train wreck and find those (temporary) pockets in the global markets than offer attractive returns. This will require a measure of skill and agility. And pace Lou Gerstner, elephants do not dance well.

I draw one conclusion: the hedge fund industry cannot sustain its present size.

Any thoughts?

28 David Kane April 15, 2007 at 7:27 pm

I still would like to know why so many primary hedge funds (anecdotally, I would assert the vast majority) are able to charge what on its face appears to me to be unsustainably high prices (2 and 20) for what seem to be mediocre returns.

. . .

but to the best of my knowledge the hedge fund industry as a whole has not covered itself in glory in its heyday of the past few years.

0) The hedge fund industry operates like every other: supply and demand. The reason that a given hedge fund can charge 2 or 20 (or lower or higher) is because it can fund clients willing to pay it. To the extent that you have a complaint, then it is with them.

1) Is your hypothesis that the clients of these hedge funds are stupid? That they don’t know what they are doing? That the people who run major pension funds (think Calpers) and endowments (think Yale) are unable to negotiate reasonable fee structures? That they willing pay large fees for products that are simply levered S&P returns? If so, I disagree.

2) No one makes or loses money based on what the “hedge fund industry as a whole” has done or is doing. Is this a useful construct? Do you think that, say, the consulting industry as a whole has “covered itself in glory” in the last few years? What about elite NYC law firms?

The best analogy to hedge funds (either individual portfolio managers or entire firms) is to professional athletes because, in both cases, there are clear measures of performance and sophisticated evaluators in charge. Now, of course, every industry has its idiots. Perhaps you are much smarter than he general manager of the Dodgers. If only they listed to you! Perhaps you are much smarter than David Swensen at Yale. If only he stopped paying unproductive hedge fund managers 2/20, Yale’s endowments would be doing much better.

I will take the other side of those bets all day long.

29 steve April 15, 2007 at 10:48 pm

I’m with TED.

I think the flow of new money into hedge funds (global liquidity glut) has altered supply/demand and some guys are getting rich who don’t deserve it. Dave Kane is the real thing, but I suspect he sees the industry at its most professional and analytical (his fund is quant style, so the potential investors are probably also quantitative in evaluating PMs).

For a more cynical view, see, for example, Hedge Hogging by Barton Biggs (a well-known Morgan Stanley strategist who started a hedge fund a few years back). He has a great chapter on the fund raising process, including stuff on a fund of funds event in Miami (IIRC) in which Biggs meets with wealthy potential investors. These people are not CALPERS or Yale endowment by any means. Beyond these people are petrodollars, Asian family fortunes, etc. etc. Why would you think the industry looks any different that, e.g., the bond business that Michael Lewis profiled in the 80’s (Liar’s Poker). Lots of big money still makes decisions “by the gut” and not by statistical evaluation of risk adjusted returns, etc.

Regarding the earlier part of the thread, people are using different definitions of “efficient”. Galt meant efficient as in effective in aggregating a lot of capital. Surowiecki and Sailor want to know why 2/20 isn’t driven to zero, but I agree with TED and David Kane that the guys who get 2/20 *in the long run* really do generate alpha. But in the short run (here I side with TED and not David) there is a lot of churn, with some guys making out by merely generating beta (or worse). If you think about it as a statistics problem, it ain’t easy to know, based on, e.g., a 3 year track record, who is really a great PM and who is just lucky. I’d rather have the problem of deciding who is fastest in the 100m dash.

30 steve April 16, 2007 at 1:32 am

BTW, I think CEO performance is much, much harder to evaluate than portfolio management performance. I really cannot justify at all the recent huge run up in executive compensation.

Yes, the market caps of public companies have gone up, but I don’t see why the CEO salary should scale linearly with market cap. As far as I can tell the relation between CEO and share/earnings performance is very noisy, and I have no confidence that corporate boards are doing a particularly good job of selecting and compensating CEOs.

If you do not have a clear way to evaluate individual performance (isolate the effect that the CEO had versus market conditions, R&D, marketing, etc.), then there is no justification for star system compensation which is more appropriate to athletics (or hedge fund management). Maybe Steve Jobs is the exception, but I can’t think of that many others.

I can imagine a future/alternative world where activist shareholders reduce CEO compensation considerably. They will look back on our era with incredulity — “what, those guys gave away $150M to a caretaker CEO?!?!”

Having said all this I don’t think CEOs themselves are the cause of the runup in inequality. That effect, as noted, is dominated by a few zipcodes pointing more to tech startups and financiers than CEOs (what fraction of the S&P 500 have headquarters in Silicon Valley or NYC/CT ?).

31 Hollows May 31, 2007 at 7:47 pm

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33 不動産投資 July 13, 2008 at 11:36 pm

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