<p>Denzera, point well taken on the tax issues - it remains to be seen where that is headed. The entire tax structure in the US is frankly FUBAR and should be blown up and we should start from scratch.</p>
<p>sakky, for many of the super rich there is absolutely a Veblen Good effect at play here - no denying that. It is a status symbol to have your money invested into a hedge fund.</p>
<p>i understand your cynical points about the alternative investment space, and frankly, after the brutal last year, much of that “fake alpha” was exposed for what it was – many hedge funds were simply glorified long funds (with enormous leverage) – and you can get away with that in a bull market, and even a mild bear market, but there is no hiding in a full blown market crash.</p>
<p>in the long run though, market dynamics are not invalid here, PMs that can truly produce consistent returns will survive and those that can not will fold. plenty of blood in the water already. i agree that there will continue to be those who manage to get paid (or overpaid) relative to what they actually produce – but that’s hardly unique to the alt investment space – they are just higher profile.</p>
<p>the problem (if you want to call it that) is, again, a simple matter of supply and demand. there is way, way too much capital out there seeking above market returns (even after the crash and value destruction). let’s face it, no one is holding a gun to an investment manager or tycoon’s head forcing him to invest into a hedge fund - so can you blame the manager who takes on capital if someone is willing to pay him to invest it? call it greed if you want, because when you boil it down to its essence, that’s effectively what it is. and greed is as old as dirt, it’s not going anywhere.</p>
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<p>But they’re not hiding, nor do they have to. Cassano and others like him already got paid, having pocketed bonuses based on fictitious returns throughout the boom, and they’re not giving any of it back. They got theirs, and if the investors, and in some cases, the taxpayers are ultimately stuck with a bag of goods, that’s not their problem. </p>
<p>Again, I have no problem with fund managers earning enormous profits as long as the clients do also. But a system is flawed if the outcomes are heads: we both win, tails: you lose, but I still win. </p>
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<p>No doubt we can find overpaid employees in any field. The difference is when such overpayment becomes the prevailing behavior within a particular industry. Like I said, all evidence indicates that alternative investments produce below-market returns after fees, which therefore means that alt-investments as a whole are a poor asset class allocation choice. The implication then is that the majority of fund managers are being paid above what they actually deserve according to market forces. </p>
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<p>Certainly greed isn’t going anywhere, but again, if that greed was being directed rationally in accordance to pure economic forces, one would expect to find strong evidence that alternative investments do indeed provide exceptional returns. The evidence shows precisely the contrary. </p>
<p>Hence, one has to look for irrational reasons for investment decisions, and whenever irrationality persists in a particular market, the usual culprit is savvy marketing. Let’s face it - much (probably most) fund marketing is little more than puffery to befuddle clients with investment strategies and returns that are deliberately shrouded in secrecy and would be difficult to understand even if exposed to full sunlight. Private equity funds are paid not only 2&20 but also additional portfolio company fees that, are “…are quite opaque…contracts specify neither the amount nor when such fees will be charged” and that “details concerning the amount of fees charged in the past are never
mentioned.” (Phallipou 2009). PE firms also only selectively disclose outcomes of active funds, with poorly performing funds among the least likely to report IRR’s and successful investments far more likely to be marked to market than weak investments. Again, to quote Phallipou:</p>
<p>In 2008, a regulation was passed to enforce some common
valuation standards. The Wall Street Journal reported on May 5, 2008, that the stock price of a private equity firm called American Capital had decreased substantially (Eavis, 2008). This decline was attributed to the claim that poorly performing investments held by this firm had previously been valued at cost, but that the new accounting rule was forcing it to place a market value on these investments—which would cause the firm to report losses. Interestingly, one may interpret the decrease in stock price as indicating that loose accounting standards had benefited the buyout firm. Usually, improved accounting standards will increase the value of companies as it decreases asymmetric information. One interpretation is that private equity firms manage to trick investors thanks to loose accounting rules and, as a consequence, better accounting standards reduce the value of private equity firms.</p>
<p>Finally, PE firms will tout the past performance of the current management team, which can be easily manipulated by simply firing poorly-performing managers or otherwise reorganizing the membership of the ‘current’ team. Hence, strong track records tend to be reported more often than are poor records, in an obvious case of sample selection bias. </p>
<p>Look, I have no problem with people making poor investments as long as they know what they are buying. If some rich tycoon wants to invest in a fund because he wants to consume a Veblen good, or some investment managers wants to diversify his portfolio through alt-investment exposure, that’s fine, as long as they understand that they’re probably not going to earn above-market returns. The problem is that most of them probably don’t know. They’ve been fooled by the marketing. They would be surprised to know about the research that indicates that alt investments as an aggregate asset class do not actually produce exceptional returns. I know I was surprised to discover that. When people think they’re buying something when they actually are not, that’s a triumph of marketing over rationality.</p>
<p>sakky, why do people gamble? or more specifically, why do people gamble at casinos knowing full well going in, the odds are in the house’s favor?</p>
<p>its a rhetorical question of course (could be for fun, could be out of boredom, desperation, etc.) but i would submit that for your more than average gambler or perhaps even a professional gambler, he believes that he can beat the house – perhaps he has before – and even in the face of a running tally which has him in the red – there is a certain arrogance (or irrationality) or simple greed that keeps them coming back to the table.</p>
<p>simply put: these are people at the higher end of the risk tolerance spectrum. they may not know ALL of the risks 100% of the time, but they aren’t “babes in the woods” – they’d rather roll the dice and try to grab a 100% return on capital with 10% probability vs. a 10% return with 100% probability – notice that the expected return is the same – the risk tolerance / variance is what sets them apart.</p>
<p>again, for the average HF investor, they know the risks – no one is forced to invest into a hedge fund. the AIG situation is not really a fair example – this is a proprietary risk taking group that went wrong (not to mention a serious failure of oversight and risk management on AIG’s part).</p>
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<p>Professional gamblers actually do make money, either through games of skill such as poker in which he doesn’t need to beat the house (who takes a cut of the pot), he just needs to beat the other players at the table, or through exploiting quirks in the odds through card-counting to shift the odds against the house, which is legal (although casinos reserve the right to expel you). Hence, professional gamblers do actually earn a positive rate of return on average, and do no conform to the theme of this thread. </p>
<p>The example of casual gambling is more interesting, for it obviously does not offer a positive rate of return for the consumer. Society has recognized through thousands of years of painful history the severe social costs that gambling imposes, which is why gambling is among the most heavily regulated industries in the country. Few if any other industries would stand for laws that specifically dictate how much profit can be generated from each individual customer transaction, yet that is precisely the regulatory regime under which gambling operates, when, for example, the Nevada Gaming Commission specifically dictates the average payout each registered slot-machine must provide and has the legal authority to impound machines to verify that the regulations are being followed. Gambling profits are nevertheless deemed suspect enough that gambling is one of the few industries - and arguably the only profitable industry - in which the government itself provides the service, via a state lottery, where the justification is that while the expected profit for each customer is negative, at least the profits will flow to the government. </p>
<p>Alternative investments, on the other hand, are characterized precisely the opposite with their light-touch regulatory regime that is far less stringent than that of ordinary investments, not the heavy regulatory regime characteristic of gambling. From a regulatory and compliance standpoint, it is far easier for somebody to start their own private equity or hedge fund compared to starting even a simple neighborhood bank. It is precisely that relative lack of regulation that attracts fund managers and fund investors alike. Similarly, unregulated (and therefore illegal) gambling establishments continue to flourish throughout the country. But they’re illegal, and if I start one, I can be imprisoned. </p>
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<p>But that’s not the risk profile that most alt-investment funds are marketing. Surely you know as well as I that most alt-investment funds were marketing above-market returns in all markets, meaning that even if the markets turned sour, those funds would still profit, or at least lose less than the market would. In fact, that was supposedly the raison d’etre of hedge funds specifically - to hedge your risks, not to amplify them. Now of course they don’t actually promise anything, but they hint, they imply, they invoke misleading accounting schemes that Phallipou enumerates, such as not disclosing certain fees, or providing multiples but not the time period over which the multiples are earned, or marking to market only their strong investments but not their weak ones, or reconfiguring ‘current’ management teams. </p>
<p>For risk-loving gunslingers, we already have investments traded on open exchanges or through traditional brokers. They can buy out-of-the money options. They can buy deeply distressed debt or the equity of stressed firms such as Fannie or Freddie, both of which have vastly beaten market returns over the last month. Hence, investors already have the ability to construct their own high-risk, high-reward portfolio. As you said, the rationale for the very existence of alt-investment funds is that they provide alpha, but that is predicated on the notion that the alpha they provide is genuine alpha, not fake alpha. But as the empirical research, the aggregate alpha over the entire asset class is actually negative. </p>
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<p>But that’s precisely the question: do they know the risks? If they really do know the risks, then why do funds need to market themselves, and in particular, why do they need to market themselves using the underhanded tactics enumerated by Phallipou? If the customers really truly understand the risks, then there is no reason to conceal those risks from them through clever marketing. Why bother hiding something that everybody supposedly knows about anyway? </p>
<p>The very existence of those sorts of marketing techniques speaks to the lack of rationality in the market: either the marketing works, in which case customers are being fooled into making irrational choices, or the marketing doesn’t work, in which case the funds are irrationally wasting money on ineffective marketing. Either way, somebody is behaving irrationally.</p>
<p>You don’t have as many IB jobs available now. In addition, you have a lot of VC and PE firms that are attracting those individuals who had planned on going into IB after MBA. At the end of the day, it will only get more competitive.</p>