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You've more than likely ended up here because you were intrigued by my outrageous title. Does he really think we should shut down the hedge funds? Is he crazy? Actually, I do think we'd benefit by shutting down the hedge funds, and it's a statement I don't take lightly since I'm generally a fan of free markets.
And it's not like I see the group as crooks or anything like that. In fact, I have a heck of a lot of respect for most of the folks that work at hedge funds. It's actually that respect that makes me even more convinced that we'd all be better off if we pulled a Will Smith and zapped the hedge fund industry just like the Big Bug in Men in Black.
Getting the rocks back
In his 2005 letter to Berkshire Hathaway (NYSE: BRK-A ) shareholders, Warren Buffett told a story about a fictional family called the Gotrocks. In short, the Gotrocks family owned all the American corporations and therefore received all the profits from those corporations. One day, along come some folks who call themselves "Helpers" promising to improve individual family member returns. Before long there are multiple sets of Helpers working with family members and yet the family overall is realizing that their finances aren't improving.
Here's a bit straight from the letter:
The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.
And that's where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).
We, the American people, are all the Gotrocks family, and today Helpers are running around everywhere. They are the financial advisors at Morgan Stanley (NYSE: MS ) , the private equity partners at Blackstone (NYSE: BX ) , and the hedge fund traders at Goldman Sachs (NYSE: GS ) . While I think that one level of helpers can be beneficial -- particularly when they combine overall financial planning with investment advice -- the "2 and 20" crowd, or "hyper-Helpers" as Buffett calls them, benefit principally themselves.
Putting the kibosh on hedge funds would put more rocks back in our collective pockets. But that's not the only reason I've set my sights on hedge funds.
Financial brain drain
Buffett, in his typical folksy way, illustrated in his story that the stock market is largely a zero sum game. When one member of the Gotrocks family gets extra returns, another member of the Gotrocks family is getting lower returns, and when the Helpers take their cut, it lowers the total return that the Gotrocks family takes home.
But while the stock market is zero sum, the economy is not. When an engineer from Intel (Nasdaq: INTC ) improves a processor chip, or a chemist at Johnson & Johnson (NYSE: JNJ ) comes up with a new drug, the person benefits, the company benefits, and the economy as a whole benefits. A technological advance at Intel doesn't take away a good idea from somewhere else -- in fact, that advance at Intel could spur something new at Microsoft (Nasdaq: MSFT ) .
How does this tie into hedge funds? In many cases hedge-fund employees are not simply smart folks -- they are downright geniuses. They are doing financial market analysis and building computer models that would make the average person's head explode. And the fact that this massive amount of brain power is working for the zero-sum Helpers is a huge loss for our economy. Pushed in another direction, many of these brainiacs could be making microchips smaller and faster, expanding the use of nanotechnology, or working on a cure for cancer.
Enter your free market jibe here
Now, of course, my idea here is all about government intervention and may sound anathema to those who believe in free markets. But if we turn back to Adam Smith and his invisible hand, we find that the amazing thing about the invisible hand is that it directed people toward doing things that not only benefitted themselves, but also "[promoted] an end which was no part of his intention." What we have today is the very visible hand of money directing some of our best and brightest toward the world of finance, working toward new and innovative ways to skim a bigger share off the economy rather than helping expand the overall pie.
Further financial Foolishness: