Hedge Funders Have an Achilles Heel, Pray the Public Stays Ignorant About It

Hedge fund honchos bet on stocks. They bet on gold. They bet on lawsuits. Most of all, they bet that the rest of us will never wise up to the awesome giveaway our current tax code ladles on them.

Only in America can someone make $85 million in a year and feel underpaid.  

This past Friday, USA Today’s annual corporate CEO pay survey — the first major national report so far this year on 2010 executive pay — revealed that Viacom chief Philippe Dauman earned $84.5 million last year.

But Friday also brought new numbers on annual “top 25” hedge fund manager compensation from AR magazine, the hedge fund industry’s trade journal. The hedge fund earnings needed in 2010 to make this exalted top 25: $210 million, well over double the four-score millions that went to Viacom's Dauman.

Last year’s top hedge fund kingpin, John Paulson, walked off with an astounding $4.9 billion in 2010 from his hedge fund labors. Paulson made more in a week than Dauman made for his entire year.

A decade ago, by contrast, corporate CEOs and hedge fund managers were still rubbing elbows at paycheck time. In 2002, a hedge fund manager only needed $30 million to make the industry’s top 25, almost exactly the entry ante for that year’s corporate CEO top 25.

Since then, hedge fund manager earnings have exploded spectacularly. The total compensation for the hedgie top 25 stood at $2.8 billion in 2003. This total quintupled over the next three years, to $14 billion in 2006, then soared to $22.3 billion in 2007, just before the financial industry meltdown.

That unpleasantness did put a bit of a crimp into hedge fund rewards, but only for a moment. Last year's hedge fund manager top 25 total: $22.03 billion. Six of last year's top 25 pulled in over $1 billion each. America may not yet have recovered from the Great Recession. Hedge fund managers certainly have.

How can hedge fund managers be doing so over-the-top well? Running hedge funds essentially gives these “financial wizards” a license to print money.

Hedge funds, in effect, operate as mutual funds for deep-pocket investors — and deep pockets only. The hoi polloi can’t invest in hedge funds, and this closed, private status frees hedge funds from those pesky government regulations that open-to-the-general-public mutual funds have to face.

Hedge fund managers, without regulators looking over their shoulders, can invest the dollars they grab from investors anyway they choose. Actually, “bet” might be a better word choice here. Hedge funds have zilch interest in making investments that create real economic value. Their goal instead: Find and exploit marketplace “inefficiencies” that offer the potential for quick — and enormous — killings.

Hedge fund managers make some of these killings the old-fashioned way, gambling on stocks. Sometimes they bet that particular stocks, or other financial assets, will rise. Sometimes they sell particular stocks “short,” betting they’ll sink.

John Paulson, 2010’s top hedge fund earner, placed his biggest bets last year on gold. Other hedge fund managers are chasing after far more unconventional windfall opportunities — in lawsuits, for instance.

In these lawsuit bets, hedge funds advance millions of dollars to law firms handling promising medical malpractice claims or big-time class actions against misbehaving corporations. The hedge funds then charge these law firms interest, at sky-high rates, on the mega-million-dollar loans.

The law firms, in turn, pass the interest charges onto their clients. The interest charges can add up. Clients who “win” their cases can end up owing money.