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Buffett Is Wrong: Money Managers Are Worth Big Paychecks

Never mind what Warren Buffett says. Money managers who earn enormous paychecks deserve what they make, according to panelists discussing the market for talent in finance at the inaugural conference at the Gary S. Becker Center on Chicago Price Theory Founded by Richard O. Ryan, ’66 at Hyde Park Center April 7.

Panelists representing investment firms fended off Warren Buffett’s recent criticism of money managers in his annual letter to Berkshire Hathaway shareholders. Buffett, in allegory form, related how various levels of “helpers,” “manager helpers,” and “hyper-helpers” (hedge funds and private equity firms) are taking away from shareholders’ profits by charging fixed fees and contingent payments. Hedge funds typically charge fees of 20 to 30 percent of earnings, which may be driving up the fees charged by other money managers such as venture capitalists.

“And that’s where we are today: A record portion of the earnings that would go in their entirety to owners—if they all just stayed in their rocking chairs—is now going to a swelling army of helpers,” Buffett said in the letter. “Particularly expensive is the recent pandemic of profit arrangements under which helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses—and large fixed fees to boot—when the helpers are dumb or unlucky (or occasionally crooked.)”

But panelists said there is evidence that talent for money management exists and that it should be fully compensated because that’s what the market allows.

“Buffett’s very confused in this regard,” said Andrew Rosenfield, managing partner at Guggenheim Partners. “Finance generates value, and it’s not full of waste.” Speculation has social value because it can make markets work better, ensure appropriate resource use, and even prevent famine, he said. People who are considered “real talent” in finance should be greatly compensated; with some $130 trillion worth of capital to invest, few people can do it exceptionally well, and a “superstar” culture emerges, Rosenfield said. How a money manager performs relative to the risk-free asset or relative to the S&P 500 are benchmarks that can be used to measure talent, he added.

From an economic standpoint, it’s easier to use statistics to determine whether there is talent in finance, although it is harder to pick out who actually has talent, observed Kevin Murphy, founding member of Becker Center and George J. Stigler Distinguished Service Professor of Economics.

“It doesn’t mean there aren’t talented people out there,” Murphy said. “It just means if you reach into a barrel of monkeys and pull out a monkey, chances are he’s not very good.”

Dick Elden, founder and chairman emeritus of Grosvenor Capital Management, facetiously called the income that money managers earn “outrageous,” but said it is justified because it is tied to results. He noted a massive shift in talent away from traditional firms such as mutual funds, investment banks, and commercial banks, and toward hedge funds, private equity funds, and real asset funds.

Rosenfield characterized this as a good development. “It’s the cutting edge of the investment business,” he said.

Hedge fund managers can lock in investors for longer periods, said Nancy Zimmerman, principal at the hedge fund Bracebridge Capital. This allows for a greater scale on returns and a better alignment of interests between investors and managers. She questioned why all investments aren’t managed by people who are better aligned with the interests of their clients.

Zimmerman said she started her hedge fund 12 years ago with $55 million; it now manages $3 billion. She said she is as proud of her firm’s exponential growth as she is of its more low-key investments.

But moderator Steven Levitt, Alvin H. Baum Professor of Economics in the College, said, “A big component of one hedge fund making money is taking money away from somebody else. Now the obvious response is, well, you’re providing liquidity for somebody else for some other purpose.”

Rosenfield said providing liquidity and risk transfer are at the heart of the hedge fund industry. Imagine regulators stepping in to create something like a ministry of risk transfer, he said. “It’d be a very frightening idea.” Statements like Buffett’s are something to worry about and rebel against, Rosenfield said. “I read it as a call for further regulation of the compensation and structure of hedge funds.”

Murphy compared the top money managers to movie stars. Consumers benefit from competition because the best actors tend to make better movies. “Ultimately, consumers are getting a lot of the value,” he said.

Buffett made his case in a section of his letter entitled “How to Minimize Investment Returns.”

“Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realize from their investments.

“The explanation of how this is happening begins with a fundamental truth: With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn ,” Buffett wrote, the emphasis his . “True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic—no shower of money from outer space—that will enable them to extract wealth from their companies beyond that created by the companies themselves.

“Indeed, owners must earn less than their businesses earn because of ‘frictional’ costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have,” Buffett wrote.

Panelists disagreed, contending that finance is not a “zero-sum game,” and that real value is being created.

Mary Sue Penn