Saturday, September 09, 2006

Warren Buffett is being left behind

The traditional purpose of the American financial system is to redistribute wealth from feckless Aristocrats to the thrifty middle class. A patient and intelligent middle class, well schooled in common sense and value analysis, would methodically and unimaginatively accumulate stock in reliable companies headed for long-term success. Meanwhile, the scions of the elites would "play the market", introducing noise that would allow members of the middle class to get stocks at attractive prices. Warren Buffett is, of course, the paragon of the middle-class investment philosophy, and his efforts to retain a middle class life despite stratospheric wealth underline that a fundamentally middle class attitude is essential for success in the markets.

Or is it? It is hardly a secret that Berkshire Hathaway hasn't done terribly well in the last five years, but the reason is not simply that Warren Buffett is "getting old" or "losing his touch" -- the diminishing returns of Buffett's portfolio relate to a fundamental change in the balance of market participants in financial markets and the reduction of opportunity for the entire thrifty middle class. While Buffett's returns have stagnated, the number of hedge funds has exploded. Many of these funds are highly leveraged long short books that crunch statistically sound models, and arb away the gap between "value" stocks and "bullshit" stocks. The fact that many long-short books are leveraged at 4 to 1, 8 to 1, or even 11 to 1, means that the net returns captured from statistically valid and intelligent strategies (traditionally passed on as "common sense" in the middle class) and pursued without any leverage are being crushed.

So, in a very concrete way, the SEC's refusal to level the playing field between hedge funds and regular investors makes the rich richer at a much faster rate than the middle class. Insofar as there is genuine opportunity remaining the traditional middle-class approach to equity markets, the leverage permitted to hedge funds allows the capital growth rate for the wealthy to exponentially outpace the capital growth rate for the middle class. This is beyond Henry George's worst nightmare, and suggests that any analogies to the broader social implications of the last great period of capital accumulation are not likely to hold.

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