Bastiat’s Bastions

The last real job I had (before I entered the academic realm) was in a consulting firm that did research on hedge funds. I came across an interesting article in Slate on hedge funds. It seems another hedge fund has gone belly up. Not exactly LTCM, but still a meaningful chuck of investor cash.

The article highlights a potential incentive problem for hedge fund managers.

For those of you who don’t know, hedge funds resemble mutual funds to a large extent. Both take investments from investors, pool them, and invest in stocks, bonds, and other financial securities (derivatives, options, etc).

There are two notable differences between hedge funds and mutual funds. First, hedge funds are typically limited to what is called “high net worth individuals”. A typical minimum investment for access to the fund would be on the order of $500,000.

Second, hedge funds managers earn compensation for their efforts in a very different fashion than their mutual fund counterparts. While a mutual fund manager (and their staff) would typically receive a percentage of the assets under management as a fee, a hedge fund manager will typically receive a fraction of the hedge fund’s profits. Typically, this “incentive fee” is on the order of 20% of profits, usually only earned on the profits above and beyond some benchmark. However, these terms vary considerably across funds. (Regulations concerning mutual funds prohibit managers from receiving a portion of the investment profit.)

The differing compensation gives the managers different incentives, hence the article. The appeal of the hedge fund would be that because the manager has a large monetary incentive to do well, he or she (and their staff) will put forth a large amount of effort. As the manager earns a large chunk of the profits, the incentives are said to be alligned. These incentives will attract top investment talent into the hedge fund sector.

But often, the hedge fund manager has relatively little of their own equity in the fund. It’s not too difficult to come up with a situation where the manager may make very risky investments. The thought would be if they pan out, the manager has just earned a large incentive fee. It if doesn’t work out, the manager will lose his/her job.

How much is too much? Difficult to say. If there is no profit sharing, there is less incentive to put forth effort. But too much, and the manager may be too risky. Does this sound similar to the story you’ve heard about in your finance classes about debt holders vs. equity holders?

Where the article misses a crucial point is in regard to what happens if a fund does poorly. It seems to suggest that if the managers of a firm lose investors money at Fund A, they’ll just move to Fund B or start Fund C. I think this gives hedge fund investors too little credit. You can’t make a career out of betting the farm (actually other people’s farm) and losing it half the time.

–CT

If you haven’t heard, there was a coup in Thailand. Check out the attached picture of the stock market index in Thailand.

I would have expected a negative reaction. Investors are not fond of uncertainty, and political upheval is certainly a major source of uncertainty.

But stock markets are forward looking. News that is expected does not alter markets – this information is already priced into the market. News that is unexpected does move the market.

Did the market expect the coup? Or is that the market likes the coup – thinking that the next political regime will be superior for the business environment?

Stay tuned. The exchange is closed tomorrow, but may open again as soon as Wednesday.

–CT

Previously, I wrote a post on NBC’s show, Deal or No Deal. If you haven’t seen it, you’ll love it – check the old post for the details. The season premier is tonight, 7 pm CT on NBC. I believe there is a $5 or $6 million dollar top prize tonight.

Beside finding it absolutely hilarious (I still think it belongs on Fox), I wrote about it because I thought folks might find it interesting or suprising that some economists pay attention to this show and games shows in general as a way of learning about people’s attitudes toward risk. Unlike the experiments economic researchers can afford to set up in the lab, the show provides big time real money choices for people to make – choices that involve substantial risk.

Given that we know the probabilities associated with the outcomes, and the choices the players make (the often repeated “deal or no deal”), we can learn much about risk tolerances and preferences of people.

However, in my perusing of the Deal or No Deal website, I found a link (a dead link actually) for “casting calls” for future Deal or No Deal shows. While I realize that they have to get people to come on the show (how hard would it be?), it was the particular term “casting calls” that made me pause.

Do you think this is problematic for any conclusions reached from such research? Say the research makes a claim about people’s risk attitudes in general – would you believe it?

–CT

The politics of the minimum wage debate are fascinating to me.

There was an article in the USAToday the other day that compared minimum wage laws across states. The article is fairly typical.

I’ve alleged in class that democrats are typically associated with supporting minimum wages, and therefore trumpet the increased wages that come with them.

Republicans, however, claim that firms that hire these workers will be harmed and note there will be fewer people hired.

Which states have residents that are willing to (rightly or wrongly) transfer wealth from firms to low-skill workers, and in the process eliminate a few jobs?

Unfortunately, by following the link, you don’t get the graphic. So below, I’ve made a list of states that have a state minimum wage higher then national minimum wage.

Washington 7.63
Massachussetts7.50
Oregon 7.50
Connecticut 7.40
Hawaii 7.25
Vermont 7.25
Alaska 7.15*
New Jersey 7.15
Rhode Island 7.10
DC 7.00
Michigan 6.95
New York 6.95
California 6.75
Maine 6.75
Delaware 6.65
Illinois 6.50
Wisconsin 6.50
Florida 6.40*
Arkansas 6.25*
Pennsyvania 6.25
Maryland 6.15
Minnesota 6.15
North Carolina 6.15*
West Virginia 5.85*

Spot a trend? It turns out that every state that Kerry carried in the 2004 election is on this list with the exception of New Hampshire. There are only 5 states on the list that were carried by Bush – they are indicated with the asterisks.
–CT

Those of you in my classes know I recently went to Las Vegas to do some gaming. It reminded me about a common mistake people make in assessing the probabilities of random events – called “the gambler’s fallacy”.

If you have ever played or seen a roulette wheel, it is very simple. There is a wheel with 38 numbered compartments, numbered 0, 00, and 1 – 36. The 0 and 00 are green, while 18 of the remaining numbers are black, and 18 are red. A ball is spun, and people bet on what number, or what color they think will occur.

In statistical jargon, we say that spins of the roulette wheel are independent events. The probability, say of the wheel landing on a red number, is the same for each spin, slightly less than 0.5 (actually 18/38). The result of the last spin of a roulette wheel has no bearing on any future spins. The roulette wheel has no memory. In fact, casinos have an incentive to ensure this.

Do all gamblers understand this? If you happen to be sitting at a roulette table after say, red, has come up 6 times in a row, do people go on calmly about their business? I can tell you from my personal experience the answer to this question is no. Some people think that black is “due” – or more technically, they think the probability of the next spin coming up black is larger than 18/38.

Those doing so are wrong – and are committing the gambler’s fallacy. There are still 18 black numbers on the wheel, 38 spaces, and are all equally likely to occur. Hence the probability that a black number will come up on the next spin is still 18/38, regardless of how many times red has come up. The wheel has no memory.

Could simple economics have told us the answer to whether or not people understand the gambler’s fallacy (without having to watch people gamble)?

Almost all of the roulette tables in casinos have an electronic board that displays the results of the last 10 or so spins. You see the number that came up and whether it was red or black.

If the casino management thought people understood that spins were independent, would it be profitable to spend money on these signs? Based on the fact that casinos do spend cash on these signs, what does this suggest happens about how people change their bet (bet more, bet less) after 6 red spins show up on the roulette wheel?

–CT

A few days ago, the city council in Chicago passed an ordinance requiring a so called “living wage”. This ordinance mandated a wage of $13 an hour (wage and benefits combined) for all employees, but only pertained to employees at so called “big box retailers”, stores with 90,000 square feet or more operated by companies with at least $1 billion a year in sales. These are stores like Target and Walmart.

Mayor Daley vetoed the ordinance, and the city council fell just short of overriding the veto. There will be no living wage in Chicago.

This proposal would have been a large increase in the minimum wage, the economics of which are well understood. Many low wage workers at big box retailers would get higher wages, but big box retailers wound respond by hiring fewer workers. Wage increases will cause prices at big box retailers to increase, thereby harming consumers.

What makes this one more interesting is that by raising the wage only at certain firms, and only in certain locations (Chicago), there are additional implications.

As the proposal only affects big box retailers, might this create a competitive advantage for firms that are competing against the big box retailers? Not mentioned in the article, but surely noted by Walmart’s competitors.

And as this proposal only affects firms within the city limits, might this create a competitive advantage for firms that are located in the suburbs? If the business environment in Chicago proper is unfavorable, firms will locate elsewhere (suburbs). This would affect the tax base, with which parks and social services are funded.

This is why Mayor Daley suggests that for a living wage proposal to be acceptable, it has to be state wide. A Chicago living wage may move jobs to the suburbs, but a state wide law wouldn’t presumably cause large job movements within the state. Might it move jobs to Wisconsin and Indiana, though? I think this is politics with Daley – he knows that state wide proposal won’t fly.

Why do people hate Walmart so much? I love it, as I am fan of low prices. Don’t people have the ability to shop at firms that pay their employees living wages (and charge high prices)? Why hasn’t this business model caught on?

–CT