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The politics of hedge funds

By Shawn McCoy Hillary Clinton, Bernie Sanders, and Donald Trump have little in common, but they have one point of agreement: to make hedge funds the political punching bag of 2016.

By Shawn McCoy

Hillary Clinton, Bernie Sanders, and Donald Trump have little in common, but they have one point of agreement: 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. Republican Trump claims, "The hedge-fund guys are getting away with murder. 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."

Why the bad rap? Hedge funds are simply another form of investment vehicle. They pool investors' money like a mutual fund but are free from some of the rules that constrict mutual-fund investment. Government regulations allow only wealthy individuals and institutional investors to buy into hedge funds directly, but that doesn't mean that other Americans aren't invested in them. Endowments and pensions account for two-thirds of hedge-fund assets. As a result, countless Americans benefit from these investments through government or union retirements and even college scholarships.

Some pension funds have announced divestments from hedge funds, but this is often more closely tied to politics than to investment strategy. More than half of institutional investors are increasing their investments in hedge funds. The reason? Despite high fees, the goal of hedge funds is to provide "absolute returns."

They may perform poorly versus the S&P 500 in 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 risks, but most often, pension funds and endowments rely heavily on established hedge funds with long track records of success.

There are around 11,000 hedge funds. Some of their 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.

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 lower tax rate claim, it has been debunked again and again. The so-called carried-interest loophole that politicians cite allows a 20 percent capital gains tax on what some 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 (such as 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's Booth School of Business.