Congress Beware:  We're All Into Hedge Funds

Arthur Bruzzone

August 2007

SAN FRANCISCO, Ca --- Here's the dark secret about hedge funds -- we're all addicted to them and the  returns that only hedge funds can generate.  Pension funds are at the front of the line. They're the junkies in the fund game. 

For good reason. Unfunded pension benefits are estimated to be between $600 billion and $1.3 trillion, according to JP Morgan which released the most comprehensive preliminary estimate.  No wonder those 35% average annual returns produced by hedge funds are so addictive.

So while Congress -- mainly Democrat members - is threatening new regulations and taxes on hedge fund managers, their constituents, especially their union backers are quietly warning them to tread carefully.

Now when we're talking about pension funds we're talking about the retirement benefits for millions of local, state, and private sector workers.  The City of San Francisco boasts $4.3 billion in unfunded benefits. The State of California owes billions to its workers. Illinois has the worst unfunded state pension liability in the nation, totaling a projected $42.2 billion. Among  corporations, Goodyear Tire & Rubber Co.'s pension plan assets of $4.6 billion amount to less than 60% of the plan's obligations (2005).

We've heard of the gross profits of hedge fund managers. Alpha magazine says that one year ago Edward Lampert of ESL Investments made headlines when he became the first manager to earn $1 billion in a year. This time there are two who break the billion-dollar barrier: James Simons of Renaissance Technologies Corp. and BP Capital Management's T. Boone Pickens. Rounding out the top five managers are Soros Fund Management's George Soros, $840 million; SAC Capital Advisors' Steven Cohen, $550 million; and Tudor Investment Corp.'s Paul Tudor Jones II, $500 million.

Their earnings are treated as capital gains, with the concurrent lower tax rate.  Many in Congress would like to push the extraordinary earnings of the fund managers into the ordinary income tax bracket.  But consider high water marks. Where a hedge fund applies a high water mark to an investor's money, this means that the manager will only receive performance fees when its value is greater than its previous greatest value. Should the investment drop in value then the manager must bring it back above the previous greatest value before they can receive performance fees again. 

In other words, hedge fund and its managers operate in the upper limits of the risk / reward universe.  The incentives to produce extraordinary profit are overbearing.  This may account for the fact that most successful managers are between 25 and 47 years old.  When committing hundreds of millions of dollars, sometimes in a single day, even with the aid of sophisticate computer models, the high performance fees are justified.  It's much like in professional sports.  Only a few can handle the pressure.  The fewer, the more valuable their performance, the higher their compensation.

Performance is what we expect out of our professional athletes.  We don't question the $120 million dollar salaries.   Here, performance is not for entertainment.  High performance by thousands of hedge funds is only way pension funds are going to cover their pension obligations.  Millions of American workers are also counting on hedge fund managers for their retirement future.

So Congress may bark and threaten, but in the end our elected representatives like all of us are dependent on the skills of hedge fund managers.  We're all betting on it, like a high stakes poker game.
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