For Our Cringe Worthy Post Of The Day

I literally cringed when I read this article on Bloomberg.  I am not sure why our DNA hasn't adapted to fight against the greed that seems to totally blind us to the fact that when something is too good to be true, it is.  The article tells the story of a hedge fund in Atlanta that has generated returns of 13, 24 and 91% since 2013.  That's not all, as you read further you find this:

Meyer is so confident in his approach that he offers an extraordinary guarantee: With Arjun, you will never lose money. His price of admission is steep, however. Investors must hand over their cash for a decade. If they exit early, Meyer keeps half the principal.

If that isn't enough to make investors run, here are some more pieces of data:

  • He has no employees
  • A computer comes us with the trades, since he can't "manually do something like that"
  • He's been through 3 auditing firms
  • There are irregularities surrounding how much money they manage (anywhere from $39 million to $338 million)
  • No one seems to be able to explain how he earns these returns
  • He doesn't send audited financial statements to his investors
  • He invests in treasury bonds, which are yielding almost nothing today
  • Oh, last one…he's under investigation

But still, you have some of his investors making comments like this:

David Recknagel, a sales executive in Detroit, met Meyer when the money manager was doing consulting work. Recknagel says he invested in Arjun after losing confidence in big banks and money-management companies. He concedes he’s not sure how Meyer does what he does.  “I understand it in general, but I probably don’t understand it completely,” Recknagel says.

One more quote from another investor:

Jeff Roberts, who runs a real-estate appraisal company in Asheville, North Carolina, says he met Meyer in 1989, while the two were at First Union. They became friends after Meyer, wearing jeans and a T-shirt, turned up one day in a Ford pickup to give Roberts a lift. A 12-pack of Budweiser rested on the front seat. Roberts says he’s invested several hundred thousand dollars and Meyer has been great.

“How many hedge-fund managers can you get to call you back? The guy that’s actually the investment officer or, you know, chairing the fund? It just doesn’t happen," Roberts says.

Roberts and Recknagel say they’ve also enjoyed a Statim perk: Meyer extends inexpensive short-term loans against their investments. Recknagel says he’s used the money to invest even more with Meyer. He says he also has a Statim corporate American Express card.

I truly hope that my instincts aren't validated, but I would venture to guess that this article could be the beginning of the end for this hedge fund.  While it seems like common sense, here are some tips to make sure your investment advisor isn't running a scam:

  1. Make sure you fully understand the investment strategy your advisor is using with your money
  2. Check out your advisor on the SEC and FINRA websites- you can check to see if they have any disciplinary history
  3. If it sounds to good to be true, it is.  There is no free lunch when it comes to investing.
  4. Make sure a third party custodian holds your money if you are working with an independent advisor.  Using a Fidelity, Schwab or TD Ameritrade can prevent the outright fraud that can happen when an advisor commingles his client's assets

If it walks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.  For the investors in this hedge fund, I think they are going to find out the hard way.

 

 

Hedge Funds- Great Wealth Transfer Vehicle

Hedge funds: A way for fund managers to make unbelievable profits by convincing wealthy investors, pensions, and trusts, they have discovered a way to achieve high returns without commensurate risk. Qualifies as one of the greatest wealth transfer vehicles in modern times.

~ Dan Solin, author of The Smartest Retirement Book You’ll Ever Read

We have often written about the perils of hedge funds.  It is astonishing to us to find an asset class that has performed so poorly but still attracts so much in assets.  When we question wealthy investors why they have invested in them, often the response is "that's what all of my wealthy friends do".  Investor psychology is a fascinating thing.  I recently finished watching the Madoff mini-series.  His sales tactics were legendary.  Almost without fail, he would tell every potential investor that the fund was closed (even though he desperately needed their money to continue his Ponzi scheme).  He knew something his prey often didn't:  people want what they can't have.  I believe hedge funds are marketed similarly.  They are only available to wealthy investors and it seems like you've "made it" if you can afford to get into them.  Like you are finally part of some sort of "club".

Unfortunately, we are here to tell you, that if you invest in hedge funds you may be enriching the manager instead of yourself.  From a recent blog post on the CFA website, here is a chart showing investor profits versus hedge fund fees over the last 17 years (click to enlarge):

Hedge funds

From the same article I found the following quote to be astonishing:

In fact, Lack's most recent data shows that hedge funds captured 84% of the profits and fees from 1998 through 2014; conversely, investors only 5% (fund of funds captured the remaining share).

Five percent!  Investors have risked their capital for the last 16 years and only received 5% of the profit!.  And people are still pouring their money into these vehicles.  Now I know this is the average and some have done much better, but investors need to wake up and understand how great the odds are stacked against them.  Hopefully this is a wake-up call for investors in hedge funds or those considering them.

Invest Like Norway, Not Yale

David Swenson, the chief investment officer of the Yale endowment fund, has gained notoriety over the past several decades for his management of the Yale endowment fund.  In the early 1990s he decided to place a gigantic chunk of the endowment into alternative assets like real estate, hedge funds and private equity.  The results were spectacular.  From 2000 to 2012 Yale's endowment returned about 12% annually while US stocks averaged 2% during the same period.  Not only have other institutions followed suit, but so have individual investors.  Retail mutual funds investing in alternative strategies have exploded, aided in part by the success of endowment funds like Harvard and Yale.  Instead of being some fringe investment strategy, alternatives have become mainstream, with over $300 billion in these products.

While Yale has focused on alternatives, Norway has gone the opposite direction.  Here is an article from 2013 in the WSJ:

Now, let's turn to Norway. Its huge Government Pension Fund Global keeps roughly 60 percent of its assets in publicly traded stocks (half in the U.S.), 35 percent in bonds and up to 5 percent in real estate. How much does the Norwegian portfolio hold in hedge funds? Nothing. Venture capital? Nada. Commodities? Zip. Private-equity funds? Zero.

"The Yale model would not work for us," says Norwegian spokeswoman Bunny Nooryani, because "the fund is too large to implement that type of strategy." With two-thirds of $1 trillion to invest, building a meaningful portfolio of non-liquid assets would be far too cumbersome and costly. And yet the Norwegian fund has fared quite well. It has gained an annual average of 4 percent since 2000, or double the return on U.S. stocks. Since 2009, it has earned 4 percent annually, while Yale earned an average of just 1 percent a year.

The Norway portfolio is "diversified in everything," says Antti Ilmanen, an analyst at AQR Capital Management in Greenwich, Conn., who serves on the fund's advisory board. It owns shares in nearly 9,000 companies and holds approximately 1 percent of every significant stock on earth.

The Norwegian fund has another advantage, says Elroy Dimson, a finance professor at London Business School who also is on its advisory board. "Norway is willing to suffer a lot and do worse than other major investors when markets are going down," he says. The giant fund loads up on smaller stocks and on so-called value stocks, which trade at lower prices in the short term. When markets fall, these companies tend to fall even farther—but that sets them up for higher performance in the long run, according to decades of research by Dimson and other experts.

Does anything sound familiar here?  Extremely broad diversification, focus on small and value companies, low cost.  This approach is the one touted by Greenspring on behalf of its clients.  In fact, the nearly $1 trillion Norway Pension Fund is invested almost identically to Greenspring clients.  It is somewhat comforting to us to know that the largest institution in the world has adopted the same approach.  I thought it would be interesting to go back and see how things have fared for both institutions since the financial crisis and ensuing recovering.  From the period of June 30, 2007 to June 30, 2014 the Yale Endowment has averaged 5.71% per year.  During that same period, the Norway fund has averaged 5.23%.  A nearly identical return, but the Yale endowment has experienced 34% more volatility than the Norway Fund.  

Before you take this data and assume that you can't hurt yourself by investing in alternatives, please remember that Yale has $24 billion in assets and an investment office of 28 professionals working on this fund.  That gives them significant access and leverage in pricing.  Two factors that will be working against you.  In addition, there is a train of thought that Yale's outperformance will be difficult to continue.  Because so many institutions have followed their lead, the opportunities available to them will not be as favorable due to other organizations competing for the same deals.  Conversely, it is not that hard to invest like Norway.  It can be done through mutual funds or ETFs and at a very reasonable cost.  We believe Norway's approach, which is certainly less sexy than Yale's, will be the best alternative for investors in the future. 

Hedge Funds Close Up Shop

The New York Times has a story about hedge funds closing their doors over the past year or two.  When asked why, many claim that the hassle of dealing with investors or regulations is just too cumbersome.  Instead, they'd rather just manage their own money and not deal with all the red tape. Here is an excerpt:

Others are more direct. For Gideon King, of Loeb King Capital Management, running a hedge fund had just become "too cumbersome."  Mr King, who has been managing money for 21 years, informed his investors in a letter in January that he would be closing the doors.

All three have chosen instead to invest their vast personal wealth through so-called family offices, which means fewer regulatory hurdles and compliance costs. As a family office, each will not have to register with the Securities and Exchange Commission.

And if you believe that, I have a bridge to sell you.  Regulations and compliance costs are a drop in the bucket when it comes to hedge fund revenues.  Think about a fund managing $1 billion.  In a traditional 2% of assets and 20% of profits setup, in a good year, that fund might generate $20 million in asset management fees plus $20 to $40 million in performance fees.  Does anyone really believe they can't handle the "cumbersome" regulation with that kind of budget?  So why would anyone want to kill that golden goose?  The likely reason…they aren't earning those types of fees.  The dirty little truth that most won't tell you is that hedge fund managers often take extraordinary risks, and if those risks don't result in profits they will shut their fund down.  Why?  Because they can't make any money.  Investors pull their money which limits their ability to earn asset management fees.  In addition, their lack of performance negates any substantial performance fees.  When that happens, yes regulation and compliance costs do become an issue, solely because of the fact that their is so little revenue to pay for it.

So why is this an issue now?  Mainly, performance has been so abysmal that the fees I mentioned above have been decimated.  During the last 10 years (ending 4/30/2015) the HFRX Global Hedge Fund Index has returned 1.21% per year.  As you can imagine, it is hard to generate huge fees from returns as small as these.  As an investor there is no reason to take these kinds of risks and pay these kinds of fees with your money.  Put the odds back in your favor by minimizing costs and broadly diversifying.  It is a much better strategy than trying to pick a winning hedge fund.  

Warren Buffet’s Big Bet Against Hedge Funds

Seven years ago Warren Buffet threw down the gauntlet.  He bet any hedge fund that a simple Vanguard S&P 500 index fund would outperform the fund(s) of their choosing over a 10 year period.  The wager?  One million dollars would go to the winner's charity of choice.  Each put up half the money of the bet.  So where do things stand now, with only three years left on the bet?  Buffet is way ahead.  Fortune writer and Buffet biographer Carol Loomis sums it up:

Under the terms of the wager, Buffett is betting (with his own money, not Berkshire’s) on the stock market performance of an S&P 500 index fund while Protégé Partners, a New York money manager, is banking on five funds of hedge funds (the names of which have never been publicly disclosed) that Protégé carefully picked at the outset. Through the seven years, Vanguard’s 500 index fund, as represented by its Admiral shares, is up 63.5%. That’s the portfolio carrying Buffett’s colors. Protégé’s five hedge funds of funds are, on the average—the marker the bet uses—up an estimated 19.6%. (The “estimated” takes into account that not all of the five funds have final figures for 2014).

What's interesting about the bet is that it started in 2008.  Buffet was way behind from the onset since the S&P 500 lost 37% in that first year.  And there lies the genius behind Buffet's bet.  He knew that by making the bet a 10 year horizon, the odds were massively in his favor.  Why?

  1. Equity markets lose value about one of every three years, but when you go out to 10 years, they have a greater than 80% chance of gaining more than 5% and a greater than 50% chance of making more than 10%.  Buffet knew that time was his friend.
  2. Fees for the hedge funds would eat into returns- when you are paying management fees, performance fees and heavy trading fees the hurdle rate to keep up with the market can be difficult to overcome.  While anything can happen in one year, Buffet knew that if given enough time, the fees would prove to be their undoing.

There are many lessons that can be learned from this bet.  Probably the biggest one is that if you ever have the opportunity to wager $1 million with the greatest investor of all-time, you should probably pass.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.