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Brad DeLong's query
...why the extraordinarily outsized pay packets of the high financiers? Why doesn't competition--which sorta works elsewhere in the economy--cause us to see greatly reduced earnings? We understand, we think, why celebrities get paid so much--a combination of increasing returns in distribution, being the genuinely best in the world, and being well-known for your well-known-ness. But why financiers?
What is it that blocks effective entry and competition, exactly?
The post is here. I see the high returns of hedge fund managers as the result of a "who moves first?" game. Someone is the first to buy a big chunk of an underpriced asset, and indeed the greater liquidity of capital markets makes it possible for the first mover to buy a bigger chunk than ever before.
The other buyers might (though might not) come only a second later with their purchases of the same asset. In that sense the world is very competitive. Entry into purchasing the undervalued asset is not blocked. But still someone has bought first and will earn a huge bundle. Highly competitive "piling on" simply speeds up the receipt of the eventual capital gain by the first purchaser, it does not limit the size of that gain.
Posted by Tyler Cowen on August 6, 2007 at 05:55 PM in Economics | Permalink
Comments
Tyler,
I remember asking a question in your macro class last fall related to this topic. Maybe the MR readers can help. I asked what the barriers to entry are in high finance. I can buy a fund that is just composed of the S&P (or some other index) and I have to pay a fee to the "manager". Can anyone just pick some sort of index and charge people to "manage" it?
Given the salaries that hedge fund managers are taking home from fees, and the fact there is a large supply of people who are capable of managing funds, there has got to be some kind of barrier that is curbing competition, right?
Posted by: Scott W at Aug 6, 2007 6:25:33 PM
My two cents:
I view the world of hedge funds as shady, much like politics. Jim Cramer's book, "Confessions of a Street Addict" tells a bit about the life on Wall Street, and about how everybody knows everybody else. Many of the funds act in collusion to raise or lower the market prices and in doing so can make a killing. Managers are constantly on the phone to brokers and others to ask who is buying what and why.
So in essence, it is very much like lobbying in the sense that it's more who you know than what you know.
Also, there are certifications that are barriers to entry and of course finding someone that trusts you enough to handle large amounts of money.
Posted by: Stan at Aug 6, 2007 6:33:27 PM
Maybe Brad DeLong believes in the efficient markets nonsense.
And he evidently left out the effects of copyright laws on the returns to
at least some celebrities.
Posted by: Bill Stepp at Aug 6, 2007 6:35:20 PM
I am not sure how Tyler's theory works. The income of our high financier is roughly the probability of being the first to scoop a profitable deal times the value of the deal times the number of profitable deals (assume all the deals are equally profitable). If there is free entry, there would be so many other high financiers looking for profitable deals that the probability of any of them arriving first on a random profitable deal would be low enough to bring the average income of high financiers down to the competitive level (for people of the required ability and adjusting for differential income risk in comparable professions). This does not seem to be the case.
Therefore, either there is no free entry or high financiers have very high and rare skills or ... what?
Posted by: Valter at Aug 6, 2007 7:01:24 PM
There is a HUGE barrier to entry. That is the chunk of money the fund manager is investing. One cannot be a successful fund manager without a large amount of money to invest. Those fund managers who have already demonstrated success handling large amounts of money in the past will have a much easier time raising more money to invest in the future, and those with no track record of investing large sums will find it difficult to raise money, even WITH a successful record of investing small amounts.
Posted by: Doug at Aug 6, 2007 7:55:01 PM
I would put out a couple of reasons why the pay is so high.
1. The employees are almost entirely paid in equity. Bonuses fluctuate massively with how the company is doing, and much of the bonus is in stock, not cash.
2. Success depends on working incredible hours. I think this is due to more than just the culture: you are less likely to have screw ups if you reduce the number of people working on a trade book or a deal, and screw ups are very expensive.
3. If efficiency wages exit in any market, they exist here. Unlike most professions, people actually have the ability to start their own fund or company, monitoring performance is very hard, and a small difference in performance can make a big difference for both risk and return.
4. Finance is very scalable. It's not very hard to add a couple of 0's to the end of a trade or deal. I have trouble seeing how this is much different from other superstar effects.
5. With respect to barriers to entry, I suspect a lot of it has to do with reputation. Finance is largely a relationship business, and it takes a long time to build up those relationships. This is true at both the individual and firm level.
Posted by: Kyle at Aug 6, 2007 8:03:19 PM
Tyler, that addresses the question "why do some hedge funds make a lot of money?" but not the question "why do hedge fund managers make 2 & 20?" The second was the question Delong asked, as you can see by following his link to the longer essay. (Actually, his question was about M&A, but it's close enough.)
Posted by: Douglas Knight at Aug 6, 2007 8:13:13 PM
A lot of these hedge fund manager were riding the tide of insanely cheap credit and rising market for their returns.
Now that the tide has turn we'll see clean up. Only the good ones (and lucky ones) will survive.
Some this giys were unhedged, i.e. they sod derivatives to protect againsr risk they were buying.
Posted by: David at Aug 6, 2007 8:26:34 PM
Valter good point, Cowen only shows where (part) of the total earnings of the industry come from, not why some individuals consistently earn so much money, which is what Delong asked.
The answer to the question is pretty straight forward, it’s just Delongs (comically leftwing) world view that makes it impossible for him to understand. “Cute Acters are allowed to be rich, but how can some people earn so much more in the world where everyone is essentially equally talented?”. The only entry barriers Delong can understand are external. This one is internal: very few people can do it.
Regardless of whether you think the finance creates values or steals rents (I think create values, but the two questions are separate), it’s demanding, and more so in the top, and very risky. This is what restricts entry into multi-million earnings.
Some underlying facts first:
* Finance is a HUGE industry, with hundreds of thousands of high level workers in NY and Öondon alone.
* The number of applications per opening is astronomical at the highest expected return openings such as Goldman, even though the selection is already limited to a small segment of the population.
* While the latest returns may or may not be flukes, the industry as a whole has been earning
multiples of other sectors for a long time. This is not some sort of rent that will be competed away anyday
soon. Bonfire of the Vanities was published 20 years ago.
To even start at a lower level and certainly to work yourself up you need a combination of both high verbal/analytical and mathematical IQ, willingness to work ridiculous hours, stamina to actually do it, competitive or even aggressive mentality, very high risk-willingness and not the least the intangible judgment/business sense. Of course you need luck, not nearly all people with the ability make it, but luck
alone does not explain why finance doesn’t work like a lottery.
The high uncertainly itself acts as a internal entry barrier: You have to work (say) 10 years in a unpleasant job to have a (say) 1% chance of becoming a multi-millionaire, and a 99% chance of earning not much more than your present income.
This is similar to explaining why most people don’t become entrepreneurs, even though those that do are much more likely to be rich. Few can realistically do it, and even fewer of them are willing to take the chance.
Just ask yourself: if people in finance are earning above market rents, why don’t you enter finance?
If consistently beating the market is not a rare talent, why don’t you start trading? You hardly need a big initial portfolio as someone suggested. The percentage increase will be almost as high. (unless we think the minute transaction costs are the entry barrier).
Working with M&A or private equity does require start capital. But a lot of people have capital, yet few are successful as financiers.
Posted by: Shirkuh at Aug 6, 2007 8:35:57 PM
"but luck alone does not explain why finance doesn’t work like a lottery"
Let me clarify: A lottery also has a significant number of people becoming millionaires. But anyone can enter, and the winnings attract so many people that the expected profit is zero (actually negative, as consumption, because of convex preferences or due to stupidity).
Finance however has positive expected returns, and relative to returns few entrants. If it were just a "first mover" game where someone (anyone) would get a huge return we should expect
to observe entry untill expected returns above the alternative cost fell to zero.
We don't. This is the puzzle, not where the returns to the industry come from, first mover, gains from
better allocation of resources, risk management etc.
Posted by: Shirkuh at Aug 6, 2007 8:43:44 PM
Earnings of top managers (whether in hedge funds or as CEO's) are generally controlled by comparing to what others are making. There are even firms to do the comparison for you. Since all the players stand to win if the norm goes up they are all in favor of higher earnings. There is no one offering to come in and work for less.
Earnings of companies that market derivative instruments (in the broadest sense) have been riding a wave since 2000. Part of this has to do with the rise in the stock market, part of it has to do with cheap credit and part of it has to do with gutting firms that get taken over. But it's all a bubble.
The next-to-last guy to sell a Dutch tulip bulb still made a lot of money. But the last guy couldn't find a buyer and the market collapsed. I'm willing to bet that sometime in the next five years there will be a scholarly study done of the hedge/derivative market and it will be found that overall the returns didn't exceed those available in other investments. In general one only hears about the big winners. The funds that are quietly dissolved with big losses don't go into the averages. This may be changing since some of the losses are now too big to hide.
I don't care how you slice it you can't make more money than the underlying growth of the economy will yield. All you can do is create different groups of winners and losers. Repackaging existing instruments does not create wealth in spite of what the managers say.
Posted by: robertdfeinman at Aug 6, 2007 9:48:07 PM
Shirkuh,
You'll be amused to know that I posted your comment of Aug 6, 2007 8:35:57 PM on the thread at the original DeLong post, and he seems to have censored it! :-)
Brad is well known for doing this to comments he doesn't like. See, for instance,
http://infoproc.blogspot.com/2005/09/pc-censorship.html
Posted by: steve at Aug 6, 2007 11:24:18 PM
How many people who make big money in finance are actually trying to beat some market? I-bankers who get say, 6% of an IPO isn't making a bet on an asset at all. Same for lawyers, m&a, market makers, etc...
Posted by: tc at Aug 7, 2007 12:50:00 AM
All true but the typical worker in finance (say your stockbroker in you saint louis strip mall) earn well, average wages.
The same is true in all professions--they are segmented. D.C. law top firm associates/partners earn a multiple of what your average lawyer earns. Economists at top ranked universities earn a multiple of what their counterparts at southwest state jerkwater U earn. Its misleading to talk about earnings in a sector rather than the range of earnings within a sector. Typical barriers to entry, social networks and even some returns to productivity apply to the top of any game. Why
is it o.k. for a guy who bounces an orange ball to earn $50 million a year, but heaven forbid a Harvvard MBA earn the
same for putting together a deal--beware this sense of outrage, let the market do its thing guys......
Posted by: Robert at Aug 7, 2007 12:50:58 AM
Let me just focus on one part of the sell side: The high financiers who make huge bonuses from their trading work at bulge bracket banks. This is not quite a direct response to Tyler, as he seems focused on trying to explain the success of certain people on the buy side. I would guess the outsized pay comes from a combination of economies of scale, tournament and network effects.
In order to earn the fees for helping a fund implement a trade the size of a few billion dollars, the business needs to be large enough to handle that kind of risk (at least temporarily) on its books. If the business is small and can't handle the risk, it is not going to be able to give a client a good fill. It also helps if they can give the customers access to quality analysis in many different areas (Research is a good that is typically bundled with trading). The people handling the relationship and the people doing the trade are going to be people who beat out many other people to get the position. The banks that already have many customers are attractive business partners to new funds as these banks can provide valuable information/credibility to the new fund. Banks that have many customers will also be able to provide their customers with better liquidity in the less liquid markets. The information flow from the network also makes proprietary trading possible. All of this results in a few people generating a lot of profit for the bank. Once they have been doing this for a while, the employees develop their own network/brand, so the bank has to pay them their market value or they will switch to a bank that does.
(After the first few years, the pay isn't that bad for people competing in the "tournament". It is actually pretty high relative to other industries. However, the amount paid isn't ridiculous when it is adjusted for the stress level and amount of hours worked.)
Posted by: agent00yak at Aug 7, 2007 1:09:04 AM
It's not so hard to "complete the model." You need only that investors regard some money managers as better than the others. Fixed costs don't hurt any either.
Posted by: Tyler Cowen at Aug 7, 2007 7:49:08 AM
I'm not really wondering about the skilled managers. Their pay is more obvious. What about the managers of a fund that just buys the Dow index? You have to pay them a fee for essentially no active managing.
Posted by: Scott W at Aug 7, 2007 10:15:32 AM
Steve,
I re-posted the comment, but minus the insult to Delong at the beginning. It will be interesting to see if that one survives. I have seen non-insulting comments deleted on his blog in the past, so that one may also get flushed.
Posted by: Yancey Ward at Aug 7, 2007 10:42:48 AM
People, you can by index funds for 7 basis points a year, a paltry fee. Granted, incomes in finance are huge, but they are not coming from passively managed index funds. Get your facts straight.
Posted by: DerekChang at Aug 7, 2007 10:59:04 AM
why are there only a few investment banks on wall street? if it is so easy then we would simply see someone like blackstone become a investment bank.
i did see an interview with taleb where he talks about how a lot of funds just trend follow and hope it continues. for them upside is big bonus and downside is they go bust but so does the competition in their particular breed of fund. one could assume that those that survive for years have taken a different path than "all in" and from a policy standpoint be against the moral hazard of rate cuts to ease their pain (and those that recklessly chose to invest with them)
Posted by: oops at Aug 7, 2007 11:09:22 AM
Tyler, if your theory was true then the incomes of hedge fund managers would be correlated (positively) with excess returns. But there is little evidence of that. Even Brian Hunter, the man who brought Amaranth down, was able to start a new fund. There is still a real puzzle here.
Posted by: Barry Ickes at Aug 7, 2007 11:10:37 AM
Yancey,
I'm glad you did a controlled experiment to back me up :-)
Posted by: steve at Aug 7, 2007 1:05:30 PM
I am not sure it qualifies as a controlled experiment, if he remembers the first post with the insult.
However I know from my own experience and from friends that Delong is likely to delete any comment that doesn't fit his ideology, including very civil ones. In my case he deleted OECD links to employment statistics that went against his post.
I always say regardless of if you agree with him Tyler Cowen has consistently shown class and good character in his blog. He allows comments that strongly go against his views, unlike other bloggers like Delong or Bryan Caplan. That way the comment section becomes less of an echo-chamber.
Posted by: Shirkuh at Aug 7, 2007 2:27:54 PM
http://mahalanobis.twoday.net/ posts the following thoughts
Why do Financiers get so much money?
Brad DeLong asks why financiers get so much money. I think the answer is that the barrier to entry is the reputation of having alpha, and alpha generally belongs to individuals, not companies. Alpha is like creativity in anything else, and goes to zero with diversification like idiosyncratic risk. It is very costly in terms of time and money, to signal good alpha. The handful who were lucky enough to have the opportunity to create a track record, and then have it work, is small. The track record is key because most people can't evaluate strategies without them, and 'back tests' are too often biased. That leaves a relatively small set of managers who are able to get 2 and 20 on funds they manage (2% of assets, 20% of profits).
Posted by: Ronald Cook at Aug 7, 2007 6:30:09 PM
Lack of financial literacy.
Finance has become one of the most important sectors of the economy mediating between a lot of other sectors.
Lack of financial literacy is the primary reason we don't see a walmart of finance, with cheap IPOs to companies, cheap funds for everyone, etc. People still think that there are other people with extra-ordinary financial capability. Once they understand the issues and start asking the tough questions, then there might be a change here.
The other reason could be inadequate development of markets themselves. Maybe after the maturation of idea futures, propositions like - Are there people who can consistently beat markets - can be put to test, or atleast a probability could be obtained.
Posted by: Prakash at Aug 10, 2007 10:49:27 AM
Posted by: 鑽石 at Apr 2, 2008 9:35:24 PM
