Men Whose Pay is 1000 Times Higher and Whose Taxes Are 50% Lower Than Your Local Brain Surgeon

When political debates about income inequality happen in America, they almost always seem to center on CEOs. The pay gap between the company chief and the average worker has grown tremendously over the past several decades, but what if CEO pay is pedestrian compared to an occupation you’ve probably never heard of, that of the hedge fund manager. These men whose pay is 1000 times higher than many CEOS pay much lower taxes than mere millionaires. Here’s how they do it.  

How Hedge Funds Began

In the 1940s, Congress decided to put a ton of new regulations on funds available to the general public. The SEC began to enforce strict rules that limited how much risk investment managers could take with client money if the fund was available to the Average Joe investor. The government had good intentions because mutual funds would sell themselves off red hot past performance, but if that performance all came from 1 or 2 stocks then new subscribers to the fund could easily lose all their money. The limitations on risk limited pay of investment professionals and prevented concentrated bets and complex strategies from being used in most mutual funds. Slowly, enterprising men discovered they could run pools of private money only offered to the wealthy that could get around most regulation. Since there were no rules, the management fee could take any shape they wanted it to, so they charged a percent of profits along with the typical annual charge. The hedge fund industry was born.

How Much Do They Make and How Do They Make It?

In 2015, the average top 25 hedge fund manager made $467 million. The year before that, the top 25 managers made $846 million, EACH. To put things in perspective, the average wage for a neurosurgeon last year was somewhere between $400,000 to $600,000. So the most highly compensated hedge fund managers pull down compensation that is over 1000 times as much as someone who spends 60-80 hours a week in a hospital who trained for 15 years or more.

A hedge fund man (there has never been a female in the top 25) charges an annual fee, typically 2% a year, regardless of market performance. In addition to this fee, he takes 20% of the profits of the fund for his own compensation. In a world where traditional active management is dying and fees matter, hedge fund managers have convinced pension funds, endowments, foundations, and wealthy individuals that the astronomically high fees are worth it, and sometimes they are. Some of the top firms like Bridgewater Associates have delivered consistent returns that have beaten the stock market. Even though there’s no guarantee those returns will persist, the past performance is good enough to convince scores of investors to turn over billions anyway just in case. In the 1980s and 1990s, Ivy league investment offices trounced the double digit returns of even the lowest cost index funds and popularized alternative investing for the masses. So there have been firms in the past that absolutely killed it and led to a proliferation of new funds promising the same results.

The largest Vanguard index funds have over $100 billion in assets. Hedge funds are typically smaller, but if you run a fund of $20 billion and get a 25% return one year, you could get a $1 billion profit sharing paycheck plus your typical management fee of $400 million. This is how these men make so much money. They are charging really high fees and when their large funds do well, they can get unbelievably high paydays.

It’s Funny How Men Whose Pay is 1000 Times Higher Than Many CEOs Pay So Little in Taxes

I almost never agree with Bernie Sanders on anything, but one point that we do agree on is that investment managers’ fees should be treated as ordinary income. I don’t necessarily think that the rate they currently pay is too low, rather that our tax system is fundamentally unfair and deserves to be thrown out the window and promptly set on fire. It is full of so many loopholes, special giveaways, and illogical deductions it makes me crazy. A flat tax of 20% on every dollar above $50,000 would be incredibly fair and lead to less inequality than the hodge podge of secret rules we have today.

Currently, the brain surgeon from earlier would have to pay a tax rate of 43.4% if they invested their money in safe bonds that paid interest. If they lived in a high tax state like NY or California, that tax rate would approach 55%. Meanwhile, the hedge fund manager can set up their address in a lower tax state like Texas and treat their 20% profit sharing bonus as “carried interest.” What that means is that their compensation for services provided gets treated as if they risked capital and earned a capital gain. When you make money from money, you get rewarded with a lower tax rate than if you earned it through work. That’s done to encourage investment and job creation. However, the original intent got warped and now lots of people qualify for this special lower rate. That rate used to be even lower at 15% under the Bush administration.

So billionaire hedge fund managers get to risk no money and get taxed like they did, netting far more in take home pay than the average high wage earner. If you look at lists of top political donors, I doubt this provision is likely to change anytime soon. Hillary Clinton benefits enormously from hedge fund managers and I can’t imagine that a repeal of this tax treatment would get any more than lip service under a Clinton administration. Certainly, it was left alone under Bill Clinton’s White House.

Roll the Dice and Get Rich as a Hedge Fund Manager

Imagine you were at a casino and you got to keep 20% of all your winnings with other people’s money. How would you play? Would you be careful and prudently take small bets that might amount to respectable returns in aggregate? Or would you swing for the fences?

The answer is obvious. As long as you aren’t risking your own hard earned money, you go for grand slams. You take $100 and you put it on one number on the roulette wheel. You go all in on a favorable hand in poker. Namely, in the investing world, hedge fund payment structures encourage extreme risk taking. The number of managers who stay in the top 25 year after year is very low. In fact it’s not unusual for someone to go from the top of the list to losing money in the following year. However, with such generous payment structures, you don’t need to hit a grand slam more than once. If you get one big bet right, you can walk away from the game an absurdly rich person.

Even if a firm earns a ton of money, it could be as simple as random luck. If you have 100 people flipping coins all day, a few of them will flip so many heads they will look pretty special even though they actually have no special skill. It’s very difficult to separate luck from ability in performance evaluation. That means a lot of really good salesmen with Ivy league degrees and fantastic social connections get to take big bets with pension fund and college endowment money and get paid even if their good results came from luck. It’s a great business to be in if you can get it.

The most ethical managers limit the size of their funds and return money to investors in the absence of appealing investment opportunities. I admire these men because they are truly seeking out the best returns for clients. However, I suspect most hedge fund managers are in the game to get stupid rich and take big bets with other people’s money. What’s scary is our nation’s underfunded pension funds are taking big bets with hedge fund managers right now to try and get high returns with risky strategies because politicians didn’t make enough contributions. If the strategies do not work out, rich investment managers will still be made rich, the politicians who underfunded the pensions will be long gone, and teachers and public servants will see reduced pension payments and no one will go to jail.

In the Inequality Debate, Focus on the Real Rich Not the Pauper CEOs

I’m hopeful that if we focused less on wage earners like CEOs and doctors in the inequality debate and more on the real rich, we would fuel a healthy debate about the future of the tax code. I think that real work should be rewarded and not taxed the same way as it is in Europe. Being able to make an exceptionally high income for your family is a uniquely American opportunity. However, we have used our tax code to enrich a small number of investment professionals, and since these men have no websites and receive very little news coverage, the general public is unaware of them and looks at Fortune 500 CEOs as the embodiment of greed in America.

Whether you’re conservative or liberal, I think it’s safe to say that an investment guy shouldn’t be able to make 1000 times as much as your local brain surgeon and pay half the taxes. Especially if the way he’s getting rich is rolling the dice in an often random game of investing with underfunded pension funds.