How the world's biggest hedge funds became unkillable

The hedge fund industry appears to be unkillable.

Of course, some hedge funds do perish. Last year was tough, after all, what with the slowdown of the Chinese economy, rock-bottom oil prices, and other fiscal turmoil. A few major hedge funds closed their doors entirely, and others suffered steep losses. And still, the hedge fund industry just keeps growing, from $539 billion in 2001 to $2.9 trillion today.

Even more spectacularly, the 25 most highly paid hedge fund managers earned a collective $12.94 billion in 2015, reports Institutional Investors Alpha. As Matt Yglesias points out, that's more than all of America's 158,150 kindergarten teachers combined. On top of that, five of those 25 managers made it onto the list even though their hedge funds lost money.

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The biggest hedge funds just keep expanding their portfolios and solidifying market clout, while funneling ever-bigger payouts to the people who run them.

Remember, hedge funds are just companies that store rich people's money in various financial instruments for them. Think of them as holding tanks for their clientele's surplus cash. The money gets held in stocks, bonds, newfangled securities, and other complex financial vehicles. Hedge funds take their clients' money and buy those instruments up, then manage them in large portfolios and aim to get as big a return for their clients as they can.

In a healthy economy, most of these financial instruments would wind up funding actual real-world economic activity. Most of the stocks would be new stocks issued by companies to expand their business; most of the bonds would be debt taken out to fund future productivity; and so on.

The point of the financial sector, which includes hedge funds, is ostensibly to facilitate new growth and activity in the real economy; to get money where it needs to go. Crucially, this dynamic should keep a lid on how big hedge funds can get and how outlandish their profits can become. If jobs are plentiful and workers have bargaining power and pay is rising, then inequality will be low. And that will limit how much money rich people actually have to sock away in their hedge fund holding tanks.

So in a healthy economy, hedge funds will certainly make a profit, just like any other enterprise providing a useful service. But primarily they'll be financing new jobs and higher wages for working Americans.

We're not in a healthy economy. These days, the vast majority of capital gains earned each year are from rich people buying and selling existing stock back and forth — comparatively little is going into new business investment. Similarly, most corporate debt seems to be taken out to fund payouts to shareholders. And all that money just gets caught up in the ceaseless churn of the financial sector, only occasionally trickling back down into real investment.

Worker bargaining power is low, wages are stagnant, job growth is sluggish, and inequality is high and still rising. So the rich clientele find themselves with ever-more money on their hands to store in hedge funds, the hedge funds wind up mainly financing more payouts back to that same class of rich clientele; wash, rinse, repeat.

Hedge funds are inevitably a risky business. Some will go bust. But with this kind of economy-wide money hose, it's no surprise the hedge fund industry as a whole just seems to keep growing.

This also explains the seemingly unstoppable rise of compensation for hedge fund managers. Generally, they're paid 20 percent of the fund's profits — but they're also paid a fee equal to 2 percent of the collective value of all the assets they manage. This means hedge fund managers do great when their fund is profitable — and just slightly less than great when their fund loses money. They get a 2 percent cut of the assets, even when the assets' value shrinks. Combine that pay structure with the flood of money into the financial sector, and you have a system effectively designed to shower these money managers in cash even when their hedge funds take a dive.

Ultimately, the massive rise of hedge funds is a symptom of the fact that workers no longer have the power to claim their share of the money. And there are plenty of policies for addressing that.

But we can also go after the hedge funds directly: mainly with tax reform to increase the rates their managers and clientele pay, which would create barriers to prevent as much money flowing to them. Hedge fund managers enjoy a loophole in the tax code that allows them to treat all their pay as capital gains, which are taxed at lower rates than wage income. We could also raise tax rates on capital gains and dividends in general.

Runaway hedge fund manager pay may be a symptom of the disease, rather than the disease itself. But sometimes symptoms are also worth treating.