DEADLY TEMPTATION #6

Do What Wealthy and Sophisticated Investors Do

Wealthy and “sophisticated” investors actually get more wrong than ordinary investors. What they get wrong is that they think that because they’re fielding a lot of money, they can buy the best expertise—and that, of course, will get them the best return. But in the investment management business, there’s no relationship between what you pay for professional help and what you get in investment returns. We suspect it’s going to be hard to convince you how wrong this idea is.

Wealthy and sophisticated investors got wealthy somehow, right? Presumably because they knew how to make money. So is it possible that they don’t know how to make money better than the rest of us when it comes to investing?

Yes, that is exactly so. But it’s worse than that. They know how to lose money by paying the highest fees you can possibly pay. It’s understandable why they would make that mistake.

HOW SOME PEOPLE GET VERY WEALTHY

Let’s start with a humorous light-hearted fictional example, which also has an air of truth about it.

In the 1986 movie Down and Out in Beverly Hills, Nick Nolte plays a homeless drifter named Jerry, who accidentally wanders into a rich man’s backyard and somehow winds up getting intimately involved with his whole family. At one point Dave, the rich man (played by Richard Dreyfuss), proudly—but a little sheepishly—shows Jerry how he got rich: coat hangers. OK, someone has to make coat hangers. If you sell enough of them you’ll get rich. This was an ironic touch of realism in the film. It implied that many rich people get rich on what seems like a tiny little business niche—and in fact it’s true.

Now let’s take a real example. One of us (Michael) knew a man—we’ll call him Bob—who retired with hundreds of millions of dollars. What did Bob make his money on? It seems that sheet metal is produced in humongous rolls, to be used in automobile and truck assembly lines and other mammoth production processes. There are also businesses that need sheet metal for relatively smaller applications, though they still need a lot of it. The manufacturers of sheet metal in humongous rolls for automobile manufacturers don’t want to bother dealing with those customers. Bob’s business consisted of buying those humongous rolls of sheet metal, cutting them into smaller pieces, and selling the smaller but still huge pieces to customers who needed smaller quantities. On that business, Bob made hundreds of millions of dollars. Bob knew very, very well how to buy, cut up into smaller pieces, and resell sheet metal.

Does that imply that Bob knew better than less wealthy people how to invest in, say, the stock market? No, not really. Unfortunately, his knowledge did put Bob in an even better position than less rich people to be taken for a ride by someone who does claim to know better than others how to invest—and who charges a substantial chunk of Bob’s wealth for it.

Bob, like many other people who acquire a deep expertise in a narrow field and make very good money at it, probably assumes that a professional in another field, who makes very good money at it, also has similarly deep practical expertise in that field. It seems like a reasonable assumption. Unfortunately, when it comes to the investment field, it’s wrong. Almost no one, if anyone, is truly expert at investing in the stock market.

THE SEA OF HEDGE FUNDS

Bob and other wealthy investors are targets for investments called “hedge funds”—of which there have been as many as 20,000, with thousands more hedge fund employees. Of those 20,000 hedge funds, less than half are still in operation now. (Some of the 20,000 were the same person over and over again—their hedge fund performed poorly and failed, so they closed it and started another.)

It wouldn’t be so bad if hedge funds were only for people who can afford to lose the money. But increasingly, these funds have also been sold to those who can’t afford to lose it—police, firefighters, and teachers whose retirement savings are invested in public pension funds. It’s one reason why some U.S. cities are in financial trouble—because their pension funds don’t have enough money in them to make good on the retirement benefits they promised. Let’s see how hedge funds have helped to do that to them, by first explaining what they are.

“Hedge fund” is a term that does not describe the way a hedge fund invests but has to do with their history. The origin of the modern hedge fund is often attributed to Alfred Winslow Jones, who founded a fund in 1949 that bought some stocks (called “going long” in them) while selling others (“going short”), thus creating a “hedge” against average stock market movements. If Jones were good at selecting stocks that would do better than the market average and buying them, and also good at identifying stocks that would do worse than the market average and selling them, then he would do well no matter whether the market average went up or down. This kind of strategy is now called “long-short equities.”

Subsequently, the term “hedge fund” was applied to any investment fund, using any strategy, which was exempt from the rules that govern investments for the broad public, like mutual funds. The U.S. Securities Act of 1933 exempted funds that accepted investments only from “accredited investors,” who were defined as either individuals with net worth greater than $1 million or income exceeding $200,000, or institutional investors with investment assets in excess of $5 million.¹ Hence, a hedge fund is any fund that does not market itself and accepts investments only from a small number of accredited investors.

In 2000, when the broad stock market started falling, the total amount invested in hedge funds was only $200 billion, much less than 1% of all investments. But then hedge funds set about luring institutional investors like pension funds. By 2007, investments in hedge funds had increased more than tenfold, to $2.1 trillion.

Simon Lack’s Revelation

Recently, a man named Simon Lack who formerly worked for JPMorgan as a hedge fund “seeder”—that is, he selected nascent hedge funds to jump-start by seeding them with JPMorgan money in exchange for a big percentage of the hedge funds’ fees—wrote a book titled The Hedge Fund Mirage.² In it, he describes how badly investors in hedge funds have done. In fact, his data showed that over the first decade of the 21st century, hedge fund investors lost money in hedge funds. Meanwhile, according to a study by the Financial Times, hedge fund investors paid 4.3% of their assets in fees to hedge fund managers and 3% to hedge fund brokers each year.³ From 2001 to 2010, that amounted to an average of $98 billion a year—more than five times the cost, in today’s dollars, of the program that first put a man on the moon, the Apollo space program. In short, hedge fund investors paid gigantic fees to hedge fund managers and their brokers—making many of them billionaires—while the investors themselves not only didn’t get rich, they actually lost money.

Lack’s revelation that hedge funds have done very poorly was so irrefutable that even the chief executive of the hedge fund lobbying organization, the Alternative Investment Management Association (AIMA), could come up with only a lame rebuttal⁴—basically blaming the bad performance on investors for investing in hedge funds at the wrong times.

Hedge Fund Performance Measurement

You might have seen reports saying that hedge funds have performed very well, but they’re wrong. Let’s summarize some of the more blatant errors in hedge fund performance reporting.

Studies of hedge fund performance have yielded wildly divergent results. Unfortunately, the financial media uncritically pass on to the public the simple averages of reported hedge fund performance spun out by database providers, without noting the deep flaws in those figures.

First, hedge fund performance numbers are reported by hedge funds themselves to the database providers. They report their numbers only when and if they want to. It’s obvious that they’ll tend to report their performance only when it is good. So the reported figures will be on average much higher than the real ones. This is called self-selection bias.

Hedge fund databases are so full of biases, errors, and trumped-up approximations that they’re practically worthless. Among their biases that have been studied are:

survivorship bias (funds that didn’t survive—usually because of poor performance—aren’t in the database);

backfill bias (funds that have had above-average performance add their historical data to the database—that is, they “backfill” it—only after they decide that it was good enough);

selection bias (as mentioned, funds report only if they choose to); and

back-end bias (funds that crash and close in their final year don’t report that year’s data).

As a result, reports of average hedge fund performance are worthless even though they are dutifully reported by publications otherwise as upright as The Economist and the Financial Times, without appropriate caveats, when passed on by database providers.

Lack’s Other Enlightening Insights

Because of Simon Lack’s once-central position in the hedge fund industry, he is able to shed light on some interesting questions. There are too many to relay here, but we’ll highlight one: the central position of large banks like JPMorgan and why they are able to make so much money.

Lack’s JPMorgan job was selecting promising hedge fund managers for JPMorgan to invest in. The process is called “seeding” a hedge fund. If a hedge fund manager wants to start a fund, or accumulate more assets for a small fund that is already launched, the manager can go to JPMorgan (and other big seed-funders) to try to get them to seed the fund with a substantial investment.

In Lack’s operation, seed funding was $25 million, which JPMorgan would invest to help a fund get started with a pool of assets. In return, JPMorgan would receive 25% of the fees charged by the fund. If the fund was successful, JPMorgan’s share of the fees often dwarfed what it earned in returns on its $25 million seed investment. So JPMorgan didn’t actually care very much if the fund got a good return on investment, as long as it could be sold to plenty of other investors.

Meanwhile, a large bank that seeds a fund can introduce the fund to its clients and prospects, lending the fund an imprimatur that enables it to attract investors much better than it could without the backing of the bank’s brand. As long as it abides by the legal restrictions on hedge fund marketing, a bank can leverage its brand to sell hedge funds that it has seeded to its clients, and then reap enormous fees in return. (Few are aware that Harvard University’s endowment fund, managed by Harvard Management Company, has also benefited⁵ from similar seed-funding practices.) It should be readily apparent what a conflict of interest this practice poses, as well as what enormous profits.

So again we see that investment professionals make their money chiefly on what are often slightly shadily procured fees paid by investors, not on their investment expertise.

Hedge Fund Fees

Hedge funds are a bad deal because of their fees. Typically a hedge fund charges a 2% “administrative fee” on assets invested, plus a “performance fee” of 20% of gains. Provisions vary, but usually the 20% on gains is not charged if the fund’s price has not exceeded its last “high-water mark”—the highest level it reached previously.

Several problems arise with such “asymmetric” fees—asymmetric because the manager charges you when the value of your investments goes up, but doesn’t give anything back when it goes down. In fact, he keeps charging at least the administrative fee, which by itself is very high. The biggest problem, of course, is that you could wind up paying a lot for performance that isn’t very good, because the fund’s value could go up and down like the teeth of a saw. When it goes up, you’ll pay the 2% administrative fee plus 20% of what you gain; but when it goes down, you’ll just lose and still pay the 2% administrative fee.

So you pay a lot. But this fee structure provides an incentive to the fund manager to exaggerate the heights of the saw teeth; it incentivizes the manager to take risks, because the manager makes a lot of money from investors’ performance fees when the risks pan out but doesn’t lose it back when they don’t. (Some hedge fund managers have substantial amounts of their own money invested in their funds, in which case they do have “skin in the game.”) For example, it’s possible (especially using derivatives like options) to construct a hedge fund investment strategy that posts nice gains in most years—say, 4 out of 5 or 9 out of 10—but in the 5th or the 10th year, it loses it all back and more. Meanwhile, the manager—unless he really had a lot of his own money invested—has netted a tidy sum on fees.

Not many hedge funds deliberately engage in this kind of strategy, but a lot of hedge fund strategies seem, after the fact, to have resembled it anyway. An awful lot of hedge funds did very well for a few years; then suddenly their performance was dreadful. For example, Long-Term Capital Management, the hedge fund that had two of the Nobel Prize winners who invented modern option theory and an ex-Federal Reserve governor working for it, had returns in the 30% to 40% range for a few years in the 1990s, and then it lost almost everything it had in 1998. Investors who were in the fund during its good days did terribly overall unless they were lucky enough to withdraw their money before it crashed. It was so bad (the fund had borrowed a lot of money from big banks) that the Federal Reserve worried, like it did in 2008, that the fund’s failure would cause a domino effect and threaten the financial system. So the Fed arranged to have a meeting of the big banks that had loaned to the fund to get them to buy it out.

AN ABSURD VARIATION: FUNDS-OF-FUNDS

Institutional investors and wealthy individual investors piled into hedge funds in the 2000s. A lot of them didn’t really know much about this practice, but they had heard that the “smart” money was being invested in hedge funds. Also, a lot of these people and institutions had expensive consultants who had to make it appear to clients that they were doing something special for the money they were being paid. The consultants get invited by hedge fund managers to posh conferences in garden spots like Monaco. (Michael wrote in The Big Investment Lie about a posh hedge fund conference he attended, gratis, in Geneva, Switzerland.) Not only do they get to be wined and dined in a luxurious location, but they also get infused with sophisticated-sounding jargon that they can spout to their clients, enhancing their apparent value.

What can these consultants recommend to their clients? If they recommend one hedge fund, it might go sour. Better not to take that chance. Also, there’s the “diversification” thing that we talked about in Deadly Temptation #5. So they might recommend a “fund-of-funds,” a kind of mutual fund of hedge funds—it combines several hedge funds in one investment vehicle.

Of course, the funds-of-funds have to charge a fee. We’re already in the stratosphere as far as fees go, so what’s a little more stratospheric? Funds-of-funds fees make it, frankly, almost impossible to make any money in hedge funds—for the investor. Of course, for the hedge fund and funds-of-funds providers, the whole setup is a wonderful blessing, remuneratively speaking. These people are not necessarily consciously corrupted—though surprisingly often they are. They may be just sifting through numbers, doing analyses, trying to find a hedge fund manager or an investment strategy that works.

And some hedge fund managers are actually onto something from time to time. The now-famous hedge fund manager John Paulson and his deputy Paolo Pellegrini correctly assessed the overvaluation of mortgage funds in 2006 and 2007 and made “the greatest trade ever” by betting against them, earning several billion dollars. But after that, Paulson’s next bet went sour and the fund lost half its value.⁶ If, impressed by his 2007 trades, you had put your money in his fund, you’d have lost half of it.

Sometimes even the investor is corrupted—well, not exactly the investor; in the case of pension funds, it is the fund administrator. The administrator doesn’t actually have money on the line—she’s just the agent. If the administrator runs, say, a public pension fund, the real investors are the taxpayers and the pensioners. The administrator also gets wined and dined by the hedge fund coterie; they imbue her with lingo that makes the administrator sound sophisticated to her bosses and her constituency. Who could argue with that? She gets sucked in.

Then, if you know the real situation, and you try to tell it to the actual investors, it’s almost impossible to convince them what a bad deal they’re getting. It’s hard for them to believe that all those sophisticated winers, diners, and jargon speakers are putting such a colossal one over on them. The odd thing is, it’s right there on the bottom line, as Simon Lack showed—their investment performance has been terrible. And still people can’t believe it.

All this said, some hedge funds do perform very well occasionally, as do some mutual funds and even some novice home traders, but we’ve seen that the performance may be merely due to chance and may not last. Goldman’s Global Alpha hedge fund did very well for a while, too, luring new investors—but we’ll see in Deadly Temptation #7 what happened.

HELP WANTED: MANAGING PENSION, ENDOWMENT, OR FOUNDATION FUNDS

Suppose you were suddenly put in charge of the teachers’ pension fund in your city. You discover it has $2 or $3 billion in it. What would you do?

Probably you would panic. You would think, “I’ve got to get help!” No one wants to be held responsible in a situation like that. If the market drops more than 40% as it did in 2008, the fund might lose a billion dollars. Do you want to risk being blamed for that? But if you hire a consulting firm that tells you to do what most other consulting firms would tell you to do, and it loses a billion dollars, at least you can say, “Well, it’s what the consultants advised, and they’re an established and well-regarded firm and everybody else did it, too.”

Now suppose you run a firm that consults on the investment of pension funds. What are you going to do? Will you recommend to your clients a course of action that’s completely different from what other pension consulting firms recommend? No, you could get unlucky, and that course of action might cause your clients to do worse than anybody else. If your advice isn’t much different from the advice that competing consulting firms give, your business will survive. So after a while everybody does the same thing. Whatever has evolved becomes standard practice—even if it makes no sense.

That’s what has happened. Investment consulting to large institutional investors has become a Rube Goldberg machine, going through a whole series of ridiculous contortions to arrive at a simple end result—but for high fees, of course. (Rube Goldberg [1883-1970] was a cartoonist who drew incredibly complicated machines that did something very simple, like light a match.)

The Standard Method of Consulting to Institutional Investors

The method that investment consultants use with institutional investors such as pension funds resembles not so much a scientifically derived procedure but a set of practices of a cult religion that the cult’s adherents assume must have some reason for them, but nobody knows or remembers what the reasons are.

Here’s roughly how it works in a typical case. The consultant, after meeting with fund administrators to determine the fund’s needs, runs a “mathematically optimized” asset allocation to come up with a recommended division of the fund among several asset groups. Keeping it simple for now, let’s suppose these asset groups include some bonds and some stocks. The stocks are typically divided into about four or five equity-style categories such as large growth stocks, small value stocks, and so forth. We’ve already examined in Deadly Temptation #3 what running an asset allocation model using investment styles means—it means rigging it with inputs that will make it produce acceptable outputs.

Once the recommended portfolio has been divided into style categories, the process begins of selecting an investment manager for each style. The consultant supplies several potential managers for each style. Each of them is sent a lengthy questionnaire about their investment performance, their employees, how long each has been with the firm, any legal scrapes the firm has gotten into, and on and on.

After these questionnaires are returned, the field of possible managers for each style category is narrowed down to about three. The remaining candidates are asked in for an interview, a major event for investment management firms because they stand to make a lot of money if they win.

With the help of the investment consulting firm, the fund selects an investment manager for each style category. Then, as each investment manager proceeds to invest its portion of the funds over the next year or two or three, the consultants help monitor its performance to see whether it is experiencing “style drift.” A manager’s portfolio exhibits style drift if it starts to look different from the style the manager was supposed to manage. Suppose, for example, the manager was hired to manage a large-value portfolio. The portfolio exhibits style drift if its periodic returns have a high “tracking error” as compared with returns on a large-value equity index.

It’s a no-no for investment managers to exhibit style drift. If they do, then the firm’s managers are called on the carpet by the pension fund administrator and the consultant to explain why.

WHAT’S WRONG WITH ALL THIS?

In the investment field, the right way is the simple way. The complex way is so complex that it is nothing but a Rube Goldberg machine. In fact, the complex way turns out to be the same as the simple way, except that it is made to look more complex—and of course with much higher fees charged by all.

As we explained in both Deadly Temptations #3 and #4, the chances are good that the way the style allocation divides the equity portfolio is almost the same as the way the whole equity market is divided. A large institutional investor can invest in the whole global stock market using one or two index funds for an extremely low fee. In fact, the largest pension fund in the United States, the $270 billion California Public Employees’ Retirement System (CalPERS),⁷ is moving toward indexing almost all of its investments, having decided on “just dropping all pretense that beating the market is a worthwhile goal and taking its tens of billions’ worth of retirement investments mostly, if not entirely, passive.”⁸ By contrast, if an institutional fund does not index, then between the consultants and the managers the consultant helps the fund choose, the charges can easily be 10 times as much.

It’s even worse than that. A recent study by three Oxford professors showed that managers chosen with consultants’ help do significantly worse than if the fund had no consultants.⁹

Then why go through the charade of breaking the market up into style categories, screening, interviewing, and selecting a manager for each category and then making sure the manager adheres to its style? Think about it: who benefits from this process?

The managers, the consultants, and the fund administrator do. The managers and consultants benefit because they’re paid very, very well. The fund administrator benefits because he appears to be going through a proper due diligence process: it makes him look smart, and he can blame the managers and consultants if things go wrong.

Who does not benefit? The employees, the retirees, and the taxpayers—that’s who. They pay 10 times too much to get the same result they could have obtained for one-tenth the cost.

SUMMARY OF DEADLY TEMPTATION #6

1. Hedge funds for wealthy investors and institutional investors do not perform better than low-cost index funds, and they charge outrageously high fees.

2. The only people who really benefit from the Rube Goldberg-like complexities of the management of most institutional investment funds are the fund managers, consultants, and fund administrators—certainly not the target beneficiaries of these investments.