Hillary Clinton, Bernie Sanders and Donald Trump collectively have little in common, but one point of agreement is to make hedge funds the political punching bag of 2016.
Democratic Socialist Sanders offers an “average folk vs. hedge fund manager” dichotomy at his rallies. “Frankly, if I were a hedge fund manager, I would not vote for Bernie Sanders,” says Sanders.
“The hedge fund guys are getting away with murder,” claims Republican Trump. “They make a fortune, they pay no tax. It’s ridiculous, OK?”
Democrat Clinton, whose daughter is married to a hedge fund manager, complains, “There’s something wrong when hedge fund managers pay less in taxes than nurses or the truckers I saw on I-80.”
Politicians trade on ignorance. And their strength in this case is that most voters don’t know much about hedge funds. Hedge funds pool investors’ money, like a mutual fund, but they are free from some of the regulatory constraints that constrict mutual fund investment.
So why the bad rap? Americans saving for retirement were likely overwhelmed when they first started studying stocks, bonds and mutual funds. Hedge funds are simply another form of investment vehicle, but government regulations allow only wealthy individuals and institutional investors to buy into them. Because most investors don’t have the option to invest in hedge funds directly, they remain a bit mysterious.
The truth is, many Americans, regardless of their personal wealth, are invested in hedge funds and probably don’t know it. The top hedge funds aren’t focused on bringing in wealthy individuals as investors. Instead, they work with endowments and pensions, which account for two-thirds of hedge fund assets. Countless Americans benefit from hedge fund investments providing a return for their government or union retirements or even college scholarships.
Some pension funds, most notably the California Public Employees’ Retirement System, have announced divestment from hedge funds, but this is often closely tied to politics rather than investment strategy. More than half of institutional investors are increasing their investments in hedge funds. The reason is that, despite high fees, hedge funds set out with the goal of providing “absolute returns.”
They may perform poorly versus the S&P 500 some years, but they continue to deliver positive returns even as the market falls. Eighty percent of institutional investors say their hedge fund investments perform as expected, which may be a lower return than the S&P, but it is risk-mitigated.
This doesn’t mean some funds don’t take unnecessary risk, but most often pension funds and endowments rely heavily on established hedge funds with long track records of success.
This brings us back to some of the political rhetoric Americans are hearing right now. There are around 11,000 hedge funds. Some managers make a lot of money. Most do not. The top earners in almost any industry make far more than the average worker. But few politicians take to the campaign trail to rail against the evil billionaires of Silicon Valley. The difference is clear. We constantly feel tangible benefits of services offered by Google and Amazon, and few begrudge Mark Zuckerberg for making billions on his startup.
Hedge funds provide a more obscure, but essential, windfall. They bring liquidity to markets by buying distressed assets when most investors want to sell. Activist funds also help small investors by forcing management changes in companies that underperform. When a top activist fund takes a large stake in a company, the stock will rise because investors know the company will be more responsive to shareholders.
As for the claim that hedge fund managers pay a lower tax rate than the rest of us, the claim has been debunked again and again. The so-called “carried interest loophole” that politicians often cite is rarely used by hedge fund managers.
Essentially, the “loophole” allows a 20 percent capital gains tax on what some people consider to be income. Hedge fund fees are based on a 2-and-20 structure. Managers receive 2 percent of assets under management, taxed as ordinary income, and 20 percent of returns that exceed a certain threshold (like beating the S&P).
Any money earned from the 20 percent fee is a capital gain, but because hedge funds rarely hold a position for more than a year, their short-term capital gains are taxed as ordinary income. The carried interest loophole is more relevant for the long-term investments of private equity and venture capital fund managers. Even then, basic deductions leave middle-class families paying lower tax rates than anyone relying on the carried interest loophole.
Of course, none of this matters in the world of political rhetoric. Hedge funds are nuanced. And when something isn’t easily understood at first glance, politicians will exploit it with fear and loathing.
Shawn McCoy is the publisher of InsideSources.com and has an MBA from the University of Chicago Booth School of Business.