Brad DeLong’s query

…why the extraordinarily outsized pay packets of the high financiers?
Why doesn’t competition–which sorta works elsewhere in the
economy–cause us to see greatly reduced earnings? We understand, we
think, why celebrities get paid so much–a combination of increasing
returns in distribution, being the genuinely best in the world, and
being well-known for your well-known-ness. But why financiers?

What is it that blocks effective entry and competition, exactly?

The post is here.  I see the high returns of hedge fund managers as the result of a "who moves first?" game.  Someone
is the first to buy a big chunk of an underpriced asset, and indeed the
greater liquidity of capital markets makes it possible for the first
mover to buy a bigger chunk than ever before.

The other buyers might (though might not) come only a second later
with their purchases of the same asset.  In that sense the world is
very competitive.  Entry into purchasing the undervalued asset is not
blocked.  But still someone has bought first and will earn a
huge bundle.  Highly competitive "piling on" simply speeds up the
receipt of the eventual capital gain by the first purchaser, it does
not limit the size of that gain.

Comments

Tyler,

I remember asking a question in your macro class last fall related to this topic. Maybe the MR readers can help. I asked what the barriers to entry are in high finance. I can buy a fund that is just composed of the S&P (or some other index) and I have to pay a fee to the "manager". Can anyone just pick some sort of index and charge people to "manage" it?

Given the salaries that hedge fund managers are taking home from fees, and the fact there is a large supply of people who are capable of managing funds, there has got to be some kind of barrier that is curbing competition, right?

Maybe Brad DeLong believes in the efficient markets nonsense.
And he evidently left out the effects of copyright laws on the returns to
at least some celebrities.

There is a HUGE barrier to entry. That is the chunk of money the fund manager is investing. One cannot be a successful fund manager without a large amount of money to invest. Those fund managers who have already demonstrated success handling large amounts of money in the past will have a much easier time raising more money to invest in the future, and those with no track record of investing large sums will find it difficult to raise money, even WITH a successful record of investing small amounts.

Tyler, that addresses the question "why do some hedge funds make a lot of money?" but not the question "why do hedge fund managers make 2 & 20?" The second was the question Delong asked, as you can see by following his link to the longer essay. (Actually, his question was about M&A, but it's close enough.)

Valter good point, Cowen only shows where (part) of the total earnings of the industry come from, not why some individuals consistently earn so much money, which is what Delong asked.

The answer to the question is pretty straight forward, it’s just Delongs (comically leftwing) world view that makes it impossible for him to understand. “Cute Acters are allowed to be rich, but how can some people earn so much more in the world where everyone is essentially equally talented?†. The only entry barriers Delong can understand are external. This one is internal: very few people can do it.
Regardless of whether you think the finance creates values or steals rents (I think create values, but the two questions are separate), it’s demanding, and more so in the top, and very risky. This is what restricts entry into multi-million earnings.

Some underlying facts first:

* Finance is a HUGE industry, with hundreds of thousands of high level workers in NY and Öondon alone.

* The number of applications per opening is astronomical at the highest expected return openings such as Goldman, even though the selection is already limited to a small segment of the population.

* While the latest returns may or may not be flukes, the industry as a whole has been earning
multiples of other sectors for a long time. This is not some sort of rent that will be competed away anyday
soon. Bonfire of the Vanities was published 20 years ago.

To even start at a lower level and certainly to work yourself up you need a combination of both high verbal/analytical and mathematical IQ, willingness to work ridiculous hours, stamina to actually do it, competitive or even aggressive mentality, very high risk-willingness and not the least the intangible judgment/business sense. Of course you need luck, not nearly all people with the ability make it, but luck
alone does not explain why finance doesn’t work like a lottery.

The high uncertainly itself acts as a internal entry barrier: You have to work (say) 10 years in a unpleasant job to have a (say) 1% chance of becoming a multi-millionaire, and a 99% chance of earning not much more than your present income.

This is similar to explaining why most people don’t become entrepreneurs, even though those that do are much more likely to be rich. Few can realistically do it, and even fewer of them are willing to take the chance.

Just ask yourself: if people in finance are earning above market rents, why don’t you enter finance?
If consistently beating the market is not a rare talent, why don’t you start trading? You hardly need a big initial portfolio as someone suggested. The percentage increase will be almost as high. (unless we think the minute transaction costs are the entry barrier).

Working with M&A or private equity does require start capital. But a lot of people have capital, yet few are successful as financiers.

Earnings of top managers (whether in hedge funds or as CEO's) are generally controlled by comparing to what others are making. There are even firms to do the comparison for you. Since all the players stand to win if the norm goes up they are all in favor of higher earnings. There is no one offering to come in and work for less.

Earnings of companies that market derivative instruments (in the broadest sense) have been riding a wave since 2000. Part of this has to do with the rise in the stock market, part of it has to do with cheap credit and part of it has to do with gutting firms that get taken over. But it's all a bubble.

The next-to-last guy to sell a Dutch tulip bulb still made a lot of money. But the last guy couldn't find a buyer and the market collapsed. I'm willing to bet that sometime in the next five years there will be a scholarly study done of the hedge/derivative market and it will be found that overall the returns didn't exceed those available in other investments. In general one only hears about the big winners. The funds that are quietly dissolved with big losses don't go into the averages. This may be changing since some of the losses are now too big to hide.

I don't care how you slice it you can't make more money than the underlying growth of the economy will yield. All you can do is create different groups of winners and losers. Repackaging existing instruments does not create wealth in spite of what the managers say.

How many people who make big money in finance are actually trying to beat some market? I-bankers who get say, 6% of an IPO isn't making a bet on an asset at all. Same for lawyers, m&a, market makers, etc...

Let me just focus on one part of the sell side: The high financiers who make huge bonuses from their trading work at bulge bracket banks. This is not quite a direct response to Tyler, as he seems focused on trying to explain the success of certain people on the buy side. I would guess the outsized pay comes from a combination of economies of scale, tournament and network effects.

In order to earn the fees for helping a fund implement a trade the size of a few billion dollars, the business needs to be large enough to handle that kind of risk (at least temporarily) on its books. If the business is small and can't handle the risk, it is not going to be able to give a client a good fill. It also helps if they can give the customers access to quality analysis in many different areas (Research is a good that is typically bundled with trading). The people handling the relationship and the people doing the trade are going to be people who beat out many other people to get the position. The banks that already have many customers are attractive business partners to new funds as these banks can provide valuable information/credibility to the new fund. Banks that have many customers will also be able to provide their customers with better liquidity in the less liquid markets. The information flow from the network also makes proprietary trading possible. All of this results in a few people generating a lot of profit for the bank. Once they have been doing this for a while, the employees develop their own network/brand, so the bank has to pay them their market value or they will switch to a bank that does.

(After the first few years, the pay isn't that bad for people competing in the "tournament". It is actually pretty high relative to other industries. However, the amount paid isn't ridiculous when it is adjusted for the stress level and amount of hours worked.)

I'm not really wondering about the skilled managers. Their pay is more obvious. What about the managers of a fund that just buys the Dow index? You have to pay them a fee for essentially no active managing.

People, you can by index funds for 7 basis points a year, a paltry fee. Granted, incomes in finance are huge, but they are not coming from passively managed index funds. Get your facts straight.

Tyler, if your theory was true then the incomes of hedge fund managers would be correlated (positively) with excess returns. But there is little evidence of that. Even Brian Hunter, the man who brought Amaranth down, was able to start a new fund. There is still a real puzzle here.

I am not sure it qualifies as a controlled experiment, if he remembers the first post with the insult.
However I know from my own experience and from friends that Delong is likely to delete any comment that doesn't fit his ideology, including very civil ones. In my case he deleted OECD links to employment statistics that went against his post.

I always say regardless of if you agree with him Tyler Cowen has consistently shown class and good character in his blog. He allows comments that strongly go against his views, unlike other bloggers like Delong or Bryan Caplan. That way the comment section becomes less of an echo-chamber.

Lack of financial literacy.

Finance has become one of the most important sectors of the economy mediating between a lot of other sectors.

Lack of financial literacy is the primary reason we don't see a walmart of finance, with cheap IPOs to companies, cheap funds for everyone, etc. People still think that there are other people with extra-ordinary financial capability. Once they understand the issues and start asking the tough questions, then there might be a change here.

The other reason could be inadequate development of markets themselves. Maybe after the maturation of idea futures, propositions like - Are there people who can consistently beat markets - can be put to test, or atleast a probability could be obtained.

The biggest problem is essentially a political one: one of corporate governance.

All our corporate structures today give zero power to the owners unless one person, or a small cartel, has over 50% control outright. Otherwise, the *CEOs run everything*, and they *cannot be fired* because they choose their own "boards of directors". They can pay themselves whatever they want, and short of corporate bankruptcy there is no way to stop them.

What personal financial motive is there for a CEO not to loot a company this way? None. He can make enough money that even if he never works again he's still fantastically rich -- and in fact most of them carefully skip out before the bankruptcy and do "work" again.

What can shareholders do? There are only a few large companies not being looted this way -- basically family-owned companies. They, indeed, command higher stock prices than companies which are not closely held, an odd result which can only be explained by the governance issue.

This was a fundamental error in your earlier posting:
"This $300B is a tax that shareholders of growing companies think is worth paying (or perhaps cannot find a way to avoid paying) for energy in their corporate executives."

Nope. That's crapola plain and simple. Do you own any stocks? Have you ever actually voted in a contested board of directors election, a.k.a. a "proxy fight"? (I did, *once*.)

If proxy fights were easy, your statement would be true. Here in the real world, the shareholders don't think the tax is worth paying, but they *have no choice*, because the CEOs control the companies, and regulations make it nigh impossible for shareholders to sack CEOs even when well over 50% of them want to. In the world of startups, the competition does exist.... until more than one venture capitalist gets involved and the stock control gets excessively diluted.

In fact, that is one of the barriers to competition you are looking for: it is near-impossible to dislodge boards of directors and near-impossible to dislodge CEOs. Therefore both entities are not subject to competition and write their own salaries. Long-term drops in stock price mean nothing to their finances personally. (Great work has been done to "align" their interests with the shareholders, but the result has been that they boost stock prices temporarily, then sell out. And they've used it as an excuse to loot even more money.)

Now, how about fund managers? In this case, there are alternative funds for people to put money in (for instance, index funds, where there is very real competition among managers). Withdrawal of money from a mutual fund actually reduces the amount of money in a fund (unlike corporate stock, which cannot be sold back to the corporation and must be sold to third parties), so if people do flee, it hurts the manager directly. Fund managers' incentives are therefore aligned to maximize the number of people putting money into the fund -- which causes its own distortions, but different ones. Fund managers have more competition. They do get fired rather more often than CEOs, and they do make less excessive amounts of money (except when they're betting with their own money). Perhaps Ronald Cook's analysis applies here.

Comments for this post are closed