Shut Down All the Hedge Funds

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:

Johnson & Johnson is a Motley Fool Income Investor pick. Berkshire Hathaway, Intel, and Microsoft are Inside Value recommendations. Berkshire Hathaway is a Stock Advisor recommendation. The Fool owns shares of Intel and Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Blackstone and Berkshire Hathaway, but does not own shares of any of the other companies mentioned. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants...


Read/Post Comments (20) | Recommend This Article (48)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 11, 2009, at 4:39 PM, colleran wrote:

    I agree completely with what you are saying about Hedge Funds and similar institutions. They have no benefit to society as a whole. It most certainly a zero sum game and I suspect that those of us who invest for the long term are some of the losers to their shenanigans.It is another case of the rich just trying to get richer at our expense.

  • Report this Comment On March 11, 2009, at 4:44 PM, TMFHelical wrote:

    Matt,

    Interesting article.

    One aspect of tax rates that has always flummoxed me is the consideration that the marginal tax rate on income should not be below the corporate tax rate. Ignoring which rate is arguably too high or low, this imbalance is potentially a conceptual disincentive to build a business rather than wealth.

    Now the hedgies try to play it even looser, arguing for a capital gains rate rather than income rate for their earnings (you did say they were bright), but in either case their focus is on building wealth over value.

    TMFHelical

  • Report this Comment On March 11, 2009, at 4:49 PM, TMFHousel wrote:

    Good article, Matt. I've always wondered so many think the "brain drain" from Wall Street would be a bad thing. Heaven forbid our best and brightest stop trading derivatives and start curing cancer.

  • Report this Comment On March 11, 2009, at 5:08 PM, Observer310 wrote:

    Perhaps we should think about producing more "downright geniuses" instead of taking from Column A and shifting them to Column B....

  • Report this Comment On March 11, 2009, at 5:24 PM, rockyamerica wrote:

    This is the dumbest article i have ever read on many accounts...

    lets shut hedge funds down so these geniuses can start doing other things. give me a break! they have the right to do whatever they want and make money where they can. Most hedge funds are doing much better then the overall market and some were even up in 2008! oh and by the way many are up in 2009 while the market has tanked, i would rather pay money to these guys and have a chance then to be in something else that is down 50%! The press bash these guys because they are jealous and havent a clue. Go bash barney frank instead...

    ROCKYAMERICA

  • Report this Comment On March 11, 2009, at 5:25 PM, TMFAleph1 wrote:

    Matt-- I mean no disrespect, but I think shutting down hedge funds is an absolutely awful idea. The value that hedge funds create may not be as visible as that created by pharmaceutical companies, for example; however, they participate in the capital allocation process, which is vital to a well-functioning economy and they provide liquidity for other investors. The fundamental problem isn't hedge funds per se, it's hedge fund investors, who continue to chase the holy grail of alpha despite all the available evidence that (a.) very few managers are able to produce alpha and (b.) identifying those managers ex-ante is very, very difficult. If people were more sensible, there would be less demand for hedge funds and, hence, fewer hedge funds. However, banning hedge funds outright looks terribly misguided to me.

  • Report this Comment On March 11, 2009, at 5:25 PM, rockyamerica wrote:

    oh and by the way...HOWS HAS WARREN BUFFET DONE LATELY?

  • Report this Comment On March 11, 2009, at 5:27 PM, rockyamerica wrote:

    By the Way : HOW IS WARREN BUFFET DOING?

  • Report this Comment On March 11, 2009, at 6:58 PM, TMFHelical wrote:

    And by the way, did I mention that I work on heart disease?

    No reason not to straddle both worlds.

    TMFHelical

  • Report this Comment On March 11, 2009, at 7:05 PM, TMFDiogenes wrote:

    I don't know if an outright ban would be appropriate, but it's a tough sell to say that increased "liquidity" and improved "capital allocation" are significant enough benefits to the economy to justify these funds' existence. Basic financial instruments -- stocks, bonds, and so forth -- have plenty of liquidity. The stock market's turnover is in excess of 100% per year, but you could still find shares to buy if turnover was 40%. Many of the less liquid financial instruments (CDOs and so forth) shouldn't exist in the first place. Regarding capital allocation, it doesn't seem to me like 2 and 20 is a particularly effective way for our country to spend its money in order to finance new and innovative ways to leverage 30x and arbitrage bond spreads from, say 10 to 6 basis points. Or to write leveraged credit default swaps that are sold off to a third party and can't be collected on anyways unless the government bails out the system. I just don't see how these sorts of activities are worth anything, much less 2 and 20 plus all the volatility and leverage they force upon the system.

  • Report this Comment On March 11, 2009, at 8:41 PM, vker77 wrote:

    Interesting article and interesting take. Why do most individual investors believe that Hedge Funds engage in collusion, company stock attacks, as well as the control and dissemination of information, including unreleased or inside information. There also seems to be a belief that hedge funds can create trends in stock prices and control order flow, and price movement.

    Being an individual investor, are these myths and a witch hunt vs. hedge funds, or are there kernels of truth to this. Are hedge funds the robberbarons and vampires of the US economy sucking the marrow. When the shortban was enacted in Oct. or Nov. of '08- who exactly was the SEC protecting the banks from? Who was it that was attempting and succeeding to profit from the destruction of decades old established US businesses?

  • Report this Comment On March 11, 2009, at 8:58 PM, Varchild2008 wrote:

    I completely disagree with you and Warren Buffet.

    The Stock Market is not a ZERO SUM game because the economy itself isn't a ZERO SUM game.

    But, excuse me for being born a "conservative" rather than a Warren Buffet / Obama style "Marxist."

    Sure... The Hedge Funds pile into a stock.. Push the price up.. and then Pop out grabbing profits for itself and sending the stock price diving down into oblivion. We saw that with the Steel Stocks in 2008 to my consternation.

    However.... What all of that boils down to for long term investors is that if you missed the opportunity in 2008 to sell off your Oil & Nat Gas stocks and Steel Stocks at the Peak.... Not a big deal when you can now buy these stocks at such an insanely cheap price... that by the time of the next PEAK... You will most definitely be floating in so much profit that you'll sell off your shares well before we hit the PEAK.

    A long term investor needs to focus on the accumulation of shares at the bottom and not worry about the missed opportunities in the past to sell at the top. The market will always give you another chance even if that chance is 20 years away.

  • Report this Comment On March 12, 2009, at 12:58 AM, rockyamerica wrote:

    They should shut Matt Koppenheffer down for writing articles that make zero sense. Dont quit your day job buddy...

  • Report this Comment On March 12, 2009, at 2:36 AM, guidothekp wrote:

    Whatever happened to the free market figuring out where the value is. If hedge funds are able to make money by ripping off the investors, why is the market not able to figure it out? Aren't the markets efficient?

    If people don't want to be engineers and instead work for hedge funds, there must be a reason. They are either not compensated commensurately or there is too much inefficiency in the traditional systems or something else. Whatever it is, the hedge funds are winning. In this sense, hedge funds may be lesser of the two evils.

  • Report this Comment On March 12, 2009, at 7:40 AM, KWT8011 wrote:

    I liked the article but my only disagreement is the assumption that a successful hedge fund manager or analyst would be a successful computer scientist or cancer researcher. Maybe some aspects of those fields overlap, but in my opinion the makeup of a successful scientist and professional investor are drastically different.

    TMFHelical does both, and maybe I'm biased since I'm a research chemist, but perhaps the transition is easier the other way (science - > investment) :)

  • Report this Comment On March 12, 2009, at 8:11 AM, Guthree wrote:

    Great piece. In the Middle Ages, the oligarchy just outright took what they wanted. That won't fly today, so they come up with schemes like hedge and private equity funds (and bailouts) to "redistribute" the production of the workers to the oligarchy. As Buffett's example makes clear, the paper shufflers don't really do anything remotely industrious (so to say).

    I suppose, at one time, you could say the money changers were a net positive to the United States because they preyed on third world nations, but now financial sophistication (i.e., how to get rich without being productive) is common the world over, and the U.S. is almost as likely to be the prey as the predator.

    We all know the money changers pad the pockets of politicians. And in return, they are left to prey on society. And pay 15% tax rate on hundreds of millions per year of individual income. 99% of Americans know that tax rate is wrong, but the oligarchy divides the populace in two based on faux issues like men kissing each other, or three flags being burned in a year and -- voila! -- 15% tax rate on the money changers.

  • Report this Comment On March 12, 2009, at 9:05 AM, rockyamerica wrote:

    No New Earmarks! Yeah Right!

  • Report this Comment On March 12, 2009, at 9:34 AM, jimialvin wrote:

    After reviewing the article and all of the pro and con comments , I tend to lean toward shutting hedge funds down . Regardless , though , if hedge funds should be allowed to continue on , I think some kind of paper trail ( like buy or sell confirmations ) be enforced upon them . No matter how fanciful the trades may be ( credit swaps , etc. ) , there should be some enforcement of paying up . If I would buy or sell short some stock on margin and it fell below the required maintenance , I would receive either a margin call or a fed call . The big boys shouldn't be able to just say to "I trust that you have the funds to cover your positions" to their partners from other investment firms and get away with it . Whatever kinds of fancy investments goes on in hedge funds , there should always be some kind of trade language to identify it and paper work to confirm it .

  • Report this Comment On March 12, 2009, at 9:52 AM, chali2na wrote:

    I agree with the author. It has gotten so complex that no one even knows how much money they're really gaining (or losing) and who knows how many of these "geniuses" are defrauding thousands of us because we don't understand a thing they're doing (i.e. Madoff). But there are those ignorant folks who don't want to use their own brains...and that is another story. If we want more transparency, this would be an area to address. Thanks for keeping us on our toes Fool. Have a good one.

  • Report this Comment On March 12, 2009, at 9:57 AM, chali2na wrote:

    rockyamerica = internet tough guy. look, these articles are there to help us use our brains and think about things in different ways. Agree or not, discussion breeds new ideas. Add one.

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