Enough. – Part II – Heads I Win, Tails You Lose

According to the New York Times, the highest-paid hedge-fund manager for 2007 was John Paulson – he made $3.7 Billion that year. His firm is reported to have made 6 times that amount for its investors in that year – around $20 Billion.

There is a lot of talk about how much is too much compensation for one individual to earn, and as I continue in my reading of John Bogle’s new book titled Enough, I think I agree him. It seems to be becoming an unwritten rule that since so many have been paid so much without having deserved it, that in all cases it must be wrong to earn a huge sum of money in one year.

I disagree! I am convinced that if someone can rightly and equitably earn over $3 billion in one year – then they should get paid that amount! If they have added $3 billion in value then they should be paid commensurately. I’ll be the last to say its inherently wrong. Afterall, this is America – if it’s not possible here, where is it possible?!

But I do have some issues with the compensation in this case and would not recommend these investments to my clients – I speak specifically as an investor myself and as a coach to many clients whose trust I cherish – for the following reasons:

First, managers on the winning side of the equation win big, but those managers who lose, don’t “pay up” on that percentage loss.

As an investor, let’s say I invest in two hedge funds. One wins big and the opposing bet loses just as big. So my money earns on the one side, say 30%, and then loses on the other side of the same bet, 30%. I’ve diversified and I broke even, right? Wrong. On the half of my money where I made 30%, the hedge-fund manager kept 6% of that gain plus his 2% management fee (8%). On the half where I lost 30% – I still had to pay the losing hedge-fund manager’s 2% management fee. So in the end, my investments lost 5% in value (8% on half and 2% on the other half) – ALL COST and no value.

Second – and this is a “by the way” issue but important to note none-the-less – the way the money is earned is less than equitable from a tax standpoint. The fund managers are actually earning what is called “carried interest.” This allows for their income to be taxed at a maximum tax rate of 15%. That is not equitable when many hard working Americans are paying much more as a percentage of their earned income. I’d rather not contribute to that arrangement.

In the end, it is neither the compensation nor the taxation in such an investment that causes me to stay away, but the high level of risk. The risks are so great that to even call this an investment is a stretch, in my opinion. It’s speculation at best, and at worst it’s out-and-out gambling. I’m just not willing to put myself in that kind of situation and don’t recommend that you do either.

It isn’t because of the inequity in the income and taxation that causes this to be a bad risk, but neither is it uncommon to find both present. So when you see one, look for the other. Misery loves company.

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