Where are those vast rivers of wealth flowing?

I have sensed for some time that there are great rivers of wealth flowing through a few key chokepoints in our society, presenting great oppurtunities for amassing enormous individual wealth, but who's movements are something of a mystery. Where are they? What is the job title for those people who go to work, produce no products, but come home with millions (or billions) in compensation?

One of those titles is "hedge fund manager", according to a recent article by the NY Times. Some excerpts:

The rewards for managing hedge funds — lightly regulated private investment pools for institutions like endowments and wealthy individuals — have been lucrative for some time. Yet the survey also shows that for the hedge fund elite, the rich are getting much richer in a hurry.

To make Alpha’s list, a manager needed to earn at least $240 million last year, nearly double the amount in 2005. That is up from a minimum of $30 million in 2001 and 2002. Combined, the top 25 hedge fund managers last year earned $14 billion — enough to pay New York City’s 80,000 public school teachers for nearly three years.

“You had railroads in the 19th century, which led to the opening up of the steel industry and huge fortunes being made,” said Stephen Brown, a professor at the Stern School of Business of New York University. “Now we’re seeing changes in financial technology leading to new fortunes being made and new dynasties created.”

For its rankings on compensation, Alpha magazine includes the managers’ share of the firm’s management fees, usually 2 percent, and performance fees, or a share of the profits, which typically start at 20 percent.

That structure means that some hedge fund managers can still earn a huge income even with mediocre returns because of the huge size of the assets under management. Raymond T. Dalio, head of Bridgewater Associates, which has more than $30 billion in hedge fund assets, for example, took home $350 million last year even though his flagship Pure Alpha Strategy fund posted a net return of just 3.4 percent for the second consecutive year.

I found this article deeply disturbing, and suspect that there is a huge breakdown of the market at work here. What is happening is that large numbers of individuals like you and me, are contributing relatively small amounts to investments like 401(k)s, and then that money is invested in various "funds", which in turn make other investements, and so on. The problem is that each time the money moves through another middle man, a moral hazard is reached - the investor is not investing their own money, and so is less likely to behave correctly. And we, the "first order" investors, can't be bothered to investigate where our own money is going. Investment is a black box into which money goes, and more money comes out. The less we know about how that happened, the better.

We don't know if our money is going to produce guns or medicine, we don't know if 2% or 5% is being paid to someone for simply moving the money from A to B (and even more if there's a profit). And we like it that way.

There's an effect here, too, that I mentioned in my book review of "The Age of Turbulence": creative destruction is all well and good keep money liquid, but problems arise when there's a huge incentive to artificially keep that process going. If someone can profit tearing down a working business to make another business that works only just as well as the first, and they make their 5%, then it will happen. But after 20 times, the broker will have all the money and there will be no business.

This effect is seen at the poker table. For each hand of poker, the table takes a "rake" - basically a flat-fee paid to the casino for the priviledge of using their table and dealer. Typical rakes come out to about $.50 a player. 30 or 40 hands an hour are dealt. That's $15 to $20/hour per player. With 9 players per table, that's $135 - $180 per table per hour. (And these numbers get much higher when you factor in tipping, and the ridiculous "jackpot" fee some casinos have taken to collecting)

At a $100 table, the HOUSE is consuming the buy-ins of 1.5 players per hour. But the players are generally not aware of it because it looks like small money compared with the big stacks of chips they have in front of them. "Constant and small" events will always be ignored for "Random and big" events. And that sets the stage for a market breakdown. Casinos and hedge fund managers have cashed in on this effect, big time.

The solution is simple: don't play poker at a casino. And don't make investments that you can't control. Diversification may be a good idea - but you've already made a few percent in saved fees by NOT investing in a fund.

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