The Mathematical Sciences Research Institute (MSRI) is a wonderful Berkeley organization dedicated to the advancement and celebration of Mathematics and its beauty and its application in every day affairs. For example on October 26th (two weeks from today) they are convening Celebrating the Mind to honor the life and works of Martin Gardner who has delighted so many of us with his math puzzles and games.
I have been a sponsor of MSRI in past years and am very grateful to my friend, Elwyn Berlekamp, for getting me involved. Elwyn has written some great books on mathematical games that I have loved reading. At a gathering of MSRI not long ago I had a great time meeting some wonderful math enthusiasts – many teachers, researchers, entrepreneurs and authors with delicious insights into all aspects of pure and applied math – like chaos theory, logic games, nonlinear algebra and information encoding.
I also met a gentleman who had used his considerable math prowess to built some pretty effective quant (or quantitative) models to simulate the financial markets and exploit minute inefficiencies in high frequency trading for impressive profits. He told me about his Hedge Fund which he runs from the Bay Area and which has a direct computer line to the financial markets in New York and other locations. He had encoded his quant model into computer software that trades without active human intervention automatically, swiftly and emotionlessly using the direct access to the Exchange computers. From what he told me I was able to piece together some of the salient features of Hedge Funds that use this method of trading and their characteristics.
I am providing below a narrative of a hypothetical fund, a composite similar to the one run by this gentleman in some aspects. The names and figures have been changed and many aspects such as taxes have been generalized from what I was told.
John Q. runs a limited partnership Hedge Fund for which he has formed an entity, Quant Investments, (QI) to act as a General Partner. The Hedge Fund has 25 limited partners who have contributed $900 million for the Fund. These limited partners are high net worth individuals as well as other pools of money, such as Pension Funds or Managed Wealth portfolios. The Fund does high frequency trading using a proprietary mathematical or quant model. It turns over its portfolio several times in a month, sometimes in days, exploiting inefficiencies. This year the fund is up 40% or by a whopping $360 million. John Q.’s compensation consists of a 1.5% management fee plus 20% of the profits above a threshold. This amounts to about $65,000,000 in the year after all his expenses!
John Q., if he treated the entire compensation of $65 million as ordinary income would have to pay 35% in Federal Taxes. It turns out that most Hedge Funds’ General Partners (GP) can treat their compensation – the part that is 20% of the profits – as Capital Gains. This brings the federal tax rate down to only 15% if the gains were fund on assets held for more than a year. How this direct income from investing by the fund manager can be capital gains boggles the mind. Also utilizing the margin rules of the exchanges he can borrow against his equity, increase his bets and make even a larger profit – all Capital Gains!
But John Q. does not want to pay any taxes that he can legitimately avoid. (it’s his responsibility and duty as a businessman, as Mitt Romney said). So he sets up a Cayman Island shell company that he owns indirectly. Let’s call this company Quant Investments, CI Ltd. (QIC). This company buys (from QI) the quant software, as Intellectual Property, for $65 million, say. (Paid using the $65 mill first year’s profit, which John Q. defers to himself, thus incurring no personal taxes). This creates a one-time long term gain for QI and John Q. taxed at a rate of 15%. Every year thereafter QI pays royalties to QIC roughly equal to John Q’s compensation and so has no net profit and no net taxes from American operations. QIC, of course has obscene income from its Intellectual Property holding but that is not subject to taxes, Cayman Islands being a tax haven.
So John Q., who makes 8-figure incomes, pays virtually no taxes! He is classified as a “Small Business” and a job creator in the Romney/Ryan lingo. Maybe this is one of the loopholes they will close that will make their tax cuts revenue neutral. Don’t count on it – there are donor lobbies here pulling the strings.
I asked the Hedge Fund guy I met how many people he employed and he said, “Six”.
That’s it. 6 people and a small offshore group of programmers to provide updates and maintenance to his software. Some Jobs Creator for a small business with revenues of hundreds of millions, wouldn’t you say!
Truth is that many small businesses that earn more than, say, 1 million are hedge fund types. They play zero-sum games with our financial system where they have a special advantage through special access or fancy quant models. They move large sums of money from A to B and keep a cut, producing no new product or service. Since the game is zero-sum you wonder who the counter parties are that are taking the losses. They also employ very,very few people.
For last year (2011) here are the statistics:
- The top 25 hedge fund managers took home an average of $576 million each.
- And that was a down year.
- Last year’s total compensation for the top 25 hedge fund managers dropped 35% … to $22 billion.
These guys feel entitled to their riches. They feel they are smart. After all they can build sophisticated data-mining models of the complex economy and financial markets that no one else can. They see themselves as hard working geniuses, deserving, self-made millionaires. And they whine like hell when they have to pay anything in taxes. They scream of Socialism, Class Warfare and job-killing government interventions!
I asked the fund manager I met what real product his small business produced for America. His answer was typical: By filling inefficiencies in the market we are creating a more rational marketplace. Further we are creating liquidity by increasing the volume of trades. And finally, we are providing for the hedging of risk – our counter parties are using us to reduce their risks.
The feeding frenzy on Wall Street today is so fast and intense that few appreciate it – until something goes wrong and we hear about it. A couple of months ago a high frequency institutional trader called Knight Capital had a glitch in its automated trading software.
It started making erratic trades.
Immediately the market plunged about 10% (in a matter of minutes). This created inefficiencies that other computer trading software spotted and they had a buying spree. The loss to Knight Capital was estimated at around half a billion! The market went back up, but Knight almost went bankrupt and had to get an infusion of money from (presumably) a white knight. Also if you were a small investor with a stop loss order at, say, 10% below the day’s market price, you got stopped out and did not participate in the correction. You were scissored by a shark infested feeding frenzy! Welcome to the furious and fraudulent poker game we call Wall Street!
The truth is that, despite all the wailing by the special interests, the current administration has done nothing to regulate Wall Street. The pathologies that gave us the $30 Trillion dollar mugging of 2008 continue. The collective howling about “too much government” etc. has had its desired effect.
Obama has been cowed (if he ever intended otherwise) to make only cosmetic changes to a very dangerous crooked game being played with naked greed on Wall Street. A simple fix, which would not even require any complex legislation, would be to limit all stock transactions to be cleared at the closing price of each day – a Dutch auction, such as is held for the direct sale of U. S. Treasuries.
Meanwhile our dishonest debates go on. The real issues are not even on the table.