Thursday, September 16, 2010

Are Hedge Fund Managers Underpaid?

Last weekend, the Financial Times referenced a study by Rick Sopher, the chairman of Leveraged Capital Holdings. Apparently the study makes two important observations: First, the ten most successful hedge fund managers have made ridiculous amounts of money for their clients.  Second, these amounts compare favorably to the earnings of some arbitrary household name public companies.

The conclusion, I will guess, runs something like: The CEOs of these public companies make a fortune relative to earnings, but the hedge fund managers make a pittance.  Therefore, hedge fund investing (presumably with the author's firm's help) is a good idea because you too can make heaps of money, and you're not getting taken to the cleaners.

[Why the speculation on my part?  This study is not particularly easy to obtain, so I haven't seen it.]

Three comments:

Professionals are supposed to be, well, professional.  How often do investment professionals confuse the observation of outliers with the ability to predict outliers?  Does anything in this study give evidence of predictability?  I can't say for sure, but I think you know the answer.  However wealthy Mr. Sopher is today, he'd be far wealthier, and probably on the top ten list if he could predict outlier success.

Moreover, why wouldn't a professional choose to compare, say, the 10 greatest hedge fund managers of all time with, I don't know, the 10 highest earnings companies of all time?  Hmm...maybe that would be interesting, but...

...lastly, the comparisons make no sense.  Comparing hedge fund returns to corporate earnings is, well, difficult.  Equity investor value creation has to do with past and future earnings.  It's a bit subtle, but he's actually compounding his misunderstanding of observing outliers versus predicting outliers!  Tallying historical earnings of companies (public, hedge fund or otherwise) is an exercise in observing outliers.  Equity market value of public companies is about predicting outliers.

Apple is not worth $250 billion based on its historical earnings.  This bold valuation reflects the market's view of future earnings accruing to shareholders.  Similarly, no one would pay 20 times earnings for Paulson & Co. based on 2008 earnings because his future prospects probably aren't so good.

Take ESL, cited in the article, as an extreme example.  It's not too far off to say ESL performance mirrors holding Sears Holdings stock, less fees and expenses.  In Sopher's context, Sears Holdings cumulative earnings would be compared to Sears Holdings cumulative stock return.  We'd then say Eddie Lampert the hedge fund manager beats Eddie Lampert the chairman of Sears!

So, why aren't we comparing hedge fund gains to public company market value gains?  I'll tell you why: It's probably not very exciting.  We already know Bill Gates and Larry Ellison have more money than everyone else.

[No, I'm not saying hedge fund managers are underpaid!]

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