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April 25, 2008

Lack of a financial education hurts the super-rich, too

Conventional wisdom holds that the ultra-wealthy have many more investment advantages than you or I. After all, they have access to highly selective hedge funds. It’s an exclusive club where the stakes are high and the rewards are out of this world.

Or that’s what they want us to believe.

The big hedge funds claim to offer much higher returns than what the normal investor can get through mutual funds. That’s why the buy-in is so high. But it turns out, hedge fund performance isn’t much better than that of run-of-the-mill mutual funds. What’s more, the incentive programs given to the managers leave hedge funds open to fraud and chicanery.

As with so many problems on Wall Street, this has to do with the compensation system. The manager of an ordinary actively managed mutual fund may take a fee of 1-2%. That’s bad enough, but it’s chump change compared to what the hedge fund manager gets. The typical fee arrangement for a hedge fund manager is usually 1 or 2% of the assets PLUS 20 percent of the returns that exceed some benchmark. So let’s say a fund has $200 million in assets and has a benchmark rate of return of 7%. After the first year, the fund was up 10%, or worth $220 million. The manager would earn $4.4 million for the management fee, plus $1.3 million for beating his benchmark (20% of the 3% extra gain).

You can imagine how this incentive arrangement just invites manipulation – and leaves hedge fund investors exposed to tremendous risk.

According to a study from the University of Pennsylvania's Wharton School:

…[I]t is very hard to set up an incentive structure that rewards skilled hedge fund managers without at the same time rewarding unskilled managers and outright con artists. Furthermore, any incentive scheme that does not directly penalize underperformance can be gamed by the manager so that his expected fees are at least as high, relative to expected gross returns, as for the most skilled managers.

The authors show how an enterprising hedge fund manager can use the derivatives market to generate what look like above-average returns. By placing highly leveraged bets on unlikely events, the manager can generate enormous amounts of cash. If his bets are right, the fund investors are very happy. If he's wrong, the fund collapses and the investors lose almost everything. Either way, the manager stands to make a fortune regardless of how the fund performs. This is a process the authors call “piggy-backing.”

In mutual funds and hedge funds, the term “alpha” is used to explain the part of a fund's performance that isn't explained by market forces. In other words, it's the result of the manager's supposed skill. By piggy-backing, an unskilled manager can fake alpha. By writing a number of covered calls using his investors' money as collateral, “it allows an unskilled manager to mimic a target series of excess returns without having the slightest idea about how a skilled manager would actually generate them.” [emphasis in original]

Dean P. Foster, one of the authors of the study, gives an example of this strategy at work:

An enterprising man named Oz sets up a new fund with the stated aim of earning 10 percent in excess of some benchmark rate of return, say 4 percent. The fund will run for five years, and investors can cash out at the end of each year if they wish. The fee is the standard '2 and 20': 2 percent annually for funds under management, and a 20 percent incentive fee for returns that exceed the benchmark.

Although he has no investment track record, Oz has a smooth manner, a doctorate in physics and many rich acquaintances. He raises 100 million and opens shop. He then studies the derivatives market and finds an event on which the market places fairly long odds, say 9:1. In other words, it costs .10 to buy an option that pays 1 if the event occurs and 0 otherwise. The nature of the event is unimportant: it might be a large fall in the stock market, Florida getting hit by a Category 5 hurricane or Russian President Vladimir Putin dying before the end of the year.

Next Oz writes some covered options on this event and sells 110 million of them in the derivatives market. This obligates him to pay the option holders 110 million if the event does occur and nothing if it does not. He collects 11 million on the options. To cover his obligations in case the 'bad' event occurs, he uses the investors' money plus the proceeds from the options to buy 110 million in one-year Treasury bills yielding 4 percent, which he deposits in escrow. This leaves 1 million in "pocket money," which he uses to lease some computer terminals and hire a few geeks to sit in front of them, just in case his investors drop by.

The probability is ninety percent that the bad event does not occur and Oz owes nothing to the option holders. With a gross return (before expenses) of 15,400,000, the investors are thrilled, and so is Oz. He collects 2 million in management fees (of which he has only spent 1 million), plus a performance bonus equal to 20 percent of the 'excess return', namely, 20 percent of 11,400,000. All in all, Oz nets over 3 million for doing absolutely nothing.

Foster says Oz can repeat this scheme next year. If his bets continue to pay off, he'll attract more investors and pocket more money. If the fund collapses, Oz can simply close the fund early and start a new one next year.

This scheme is not illegal, but it is risky – risky for his investors, but not for himself. In no scenario will Oz actually lose money. Actually, the more risk he takes with this investors' money, the more he stands to profit. That's the way his incentive structure works. You may get screwed if the fund collapses, but he walks away with millions.

This is yet another example of how Wall Street’s compensation system puts the interest of brokers and fund managers ahead of the investor. No matter how much money you’re working with, unless you know what’s really going on, you’re just asking to be taken advantage of.

That’s why it pays to learn as much as you can about how Wall Street really works, and why you ultimately should be in control of your own investments. Wall Street is set up to take advantage of the little guy, even if that little guy has millions and millions of dollars.

SOURCES:

1. Foster, Dean P. and H. Peyton Young, “The Hedge Fund Game: Incentives, Excess Returns, and Piggy-Backing.” March 2008. http://www.brookings.edu/~/media/Files/rc/papers/2007/1114_hedge_fund_young/1114_hedge_fund_young.pdf (Accessed April 23, 2008).

2. Foster, Dean P. and H. Peyton Young, “Hedge Fund Wizards,” Washingtonpost.com, December 19, 2007. http://www.brookings.edu/opinions/2007/1219_hedgefunds_young.aspx (Accessed April 23, 2008).

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Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Tags: fees, hedge funds, mutual funds

Posted by Kim Snider on April 25, 2008 | Permalink