July 5, 2007
Economic Scene
A Career in Hedge Funds and the Price of Overcrowding
By ROBERT H. FRANK
Whatare the career aspirations of the nation's most accomplished andambitious students these days? I haven't seen a formal survey, but arapidly growing percentage of the best students I teach say they wantto manage hedge funds or private equity firms.
Little wonder.According to Institutional Investor's Alpha magazine, the hedge fundmanager James Simons earned $1.7 billion last year, and two othermanagers earned more than $1 billion. The combined income of the top 25hedge fund managers exceeded $14 billion in 2006.
Thesemanagers also enjoy remarkably favorable tax treatment. For example,even though “carried interest” — mainly their 20 percent commission onportfolio gains — has the look and feel of ordinary income, it is taxedat the 15 percent capital gains rate rather than the 35 percent toprate for ordinary income. That provision alone saved Mr. Simons severalhundred million dollars in taxes last year.
Congress is nowconsidering a proposal to tax carried interest as ordinary income. Tono one's surprise, private equity lobbyists were quick to insist thatdoing so would cause grave economic damage. The deals brokered by theirclients often create enormous value, to be sure. Yet the proposedlegislation would not block a single transaction worth doing. What ismore, economic analysis suggests that it would actually increaseproduction in other sectors of the economy by reducing wastefulovercrowding in the market for aspiring portfolio managers.
Thismarket is what economists call a winner-take-all market — essentially atournament in which a handful of winners are selected from a muchlarger field of initial contestants. Such markets tend to attract toomany contestants for two reasons.
The first is an informationbias. An intelligent decision about whether to enter any tournamentrequires an accurate estimate of the odds of winning. Yet people'sassessments of their relative skill levels are notoriously optimistic.Surveys show, for example, that more than 90 percent of workersconsider themselves more productive than their average colleague.
Thisoverconfidence bias is especially likely to distort career choicebecause, in addition to the motivational forces that support it, thebiggest winners in many tournaments are so conspicuous. For example,N.B.A. stars who earn eight-figure salaries appear on televisionseveral nights a week, whereas the thousands who failed to make theleague attract little notice.
Similarly, hedge fund managerswith 10-figure incomes are far more visible than the legions ofcontestants who never made the final cut. When people overestimatetheir chances of winning, too many forsake productive occupations intraditional markets to compete in winner-take-all markets.
Asecond reason for persistent overcrowding in winner-take-all markets isa structural problem called “the tragedy of the commons.” This problemhelps explain, for instance, why we see too many gold prospectors, anoccupation that has much in common with prospecting for corporatedeals. In the initial stages of exploiting a newly discovered goldfield, adding another prospector may significantly increase the totalamount of gold found. Beyond some point, however, additionalprospectors contribute little. The gold found by a newcomer to acrowded field is largely gold that would have been found by existingsearchers.
A simple numerical example helps illustrate whyprivate incentives often lead to wasteful overcrowding under thesecircumstances. Consider a man who must choose whether to work as anengineer for $100,000 or become a prospector for gold. Suppose heconsiders the nonfinancial aspects of the two careers equallyattractive and expects to find $110,000 in gold if he becomes aprospector, $90,000 of which would have been found in his absence byexisting prospectors. Self-interest would then dictate a career inprospecting, since $110,000 exceeds the $100,000 engineering salary.But because his efforts would increase the total value of gold found byonly $20,000, society's total income would have been $80,000 higher hadhe instead become an engineer.
Similar incentives confrontaspiring portfolio managers. Beyond some point, adding another highlypaid manager produces little increase in industry commissions onmanaged investments. As in a crowded real estate market, the additionalmanager's commissions come largely at the expense of commissions thatwould have been generated by existing managers. So here, too, privateincentives result in wasteful overcrowding.
MatthewRhodes-Kropf, a finance professor at Columbia Business School, hasargued that higher taxes on hedge fund and private equity firm managersare bad economic policy. “Private equity is a very important part oureconomy,” he said, adding that higher taxes will discourage it. Othershave characterized the proposed legislation as envy-driven classwarfare.
Both observations miss the essential point. No onedenies that the talented people who guide capital to its most highlyvalued uses perform a vital service for society. But at any givenmoment, there are only so many deals to be struck. Sending ever largernumbers of our most talented graduates out to prospect for them has ahigh opportunity cost, yet adds little economic value.
Bymaking the after-tax rewards in the investment industry a little lessspectacular, the proposed legislation would raise the attractiveness ofother career paths, ones in which extra talent would yield substantialgains. And the additional tax revenue could pay for things that clearlyneed doing. For example, we could reduce the number of children whocurrently lack health insurance, or reduce the number of cargocontainers that enter our ports without inspection.
Opponentsof higher taxes often invoke the celebrated trade-off between equityand efficiency. But that objection makes no sense here. Endingpreferential tax treatment of portfolio managers' earnings would serveboth goals at once.
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RobertH. Frank, an economist at Cornell University, is the author of “TheEconomic Naturalist” and the co-author, with Philip Cook, of “TheWinner-Take-All Society.” His “Falling Behind: How Rising InequalityHarms the Middle Class,” will be published next week. Contact:www.robert -h-frank.com.
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