Hedge funds

If there were ever a contest for the most misleading naming convention, the term hedge fund would be a winner. The term hedge is defined as “a means of protection or defense.” The act of hedging in finance involves risk reduction or protection against adverse outcomes. Companies producing goods or providing services that rely on certain commodities will hedge against price increases on those commodities by contracting in the futures markets to purchase inputs well in advance of production. For example, airlines will often hedge against rising jet fuel prices by contracting in advance to purchase oil in the futures markets (markets that allow investors and traders to bet on the price of commodities months or years from now). If fuel prices go up, the airline is unaffected because the cost has been agreed to in advance. This allows airlines to better manage costs, plan, and reduce risk.

So a hedge fund must be some sort of vehicle that allows investors to reduce risk, right? Hardly. A hedge fund is simply a professionally managed pool of money that is largely unregulated and can only be accessed by sophisticated investors (see the nearby sidebar).

Whoever came up with the name hedge fund was a pure marketing genius, because the goal of most hedge funds is not to reduce or limit risk, but to seek high returns by taking positions in a wide variety of asset classes. Hedge funds typically take positions in complex derivative securities and strategies involving derivatives securities and often leverage highly concentrated positions.

There are a wide variety of hedge funds that pursue many distinctly different investment strategies and styles. Although some people refer to hedge funds as an asset class, they’re more accurately defined by their strategies. The most common types of hedge-fund strategies include the following:

• Long-only: These funds are most like stock mutual funds. They buy stocks they believe are going to go up in value.
• Equity long-short: In these funds, managers purchase the securities of stocks they expect to go up in value while short-selling stocks they expect to fall in value. Often, these types of funds choose to specialize in particular sectors or geographical regions of the stock markets.
• Event-driven funds: These funds invest in securities of corporations involved in special situations such as bankruptcy, spinoffs, mergers and acquisitions, and other restructuring events. As an example, these funds buy or sell the stocks and bonds of firms involved in mergers and acquisitions — betting that some securities are overvalued while others are undervalued.
• Relative value and arbitrage funds: These funds seek to identify securities and positions that have the same risk and return characteristics and purchase the underpriced securities and sell the overpriced securities. One of the most common types of relative value funds is convertible arbitrage, which typically purchase convertible bonds and sell the common stock of the issuer.
• Global macro funds: These funds have the broadest investment style of all hedge-fund categories. They have no limitations on the asset classes, security types, or geographical locations of investments. They invest in whatever investments strike the fancy of the asset manager. They often take highly leveraged and large positions.
• Fund of funds: A fund of funds invests in many different hedge funds. This strategy can help reduce the risk of a single manager achieving poor performance or running off with investors’ funds, because the investor’s holdings are spread across many different hedge-fund managers. Although this sounds like a very prudent and risk-averse strategy, the downside is that it introduces another layer of fees — those of the manager of the fund of funds.

Managers of hedge funds are the new titans of business — the Rockefellers and Mellons of the 21st century. These new-age billionaires include John Paulson, Stephen Cohen, and James Simons, men who have amassed fortunes by achieving investment returns that often exceed market averages by wide margins.

Successful hedge funds get the headlines, but there are some major risks to investors. First, not all hedge funds do well, in fact, most do not. And if a hedge fund is on a hot streak, the managers know it and demand to be paid accordingly. Running a hedge fund is a lucrative business — fees paid to managers are typically 2 percent of assets under management annually, as well as a cumulative payout of 20 percent of the profits of the fund. This fee structure is often referred to as “two and twenty” and means that considering these fees, hedge-fund managers must really bring home the bacon to earn their keep. And some certainly do. For instance, from 1988 through 2018, James Simons’ Medallion Fund at Renaissance Technologies has returned an average annual compound return (after fees) in excess of 39 percent. (Before you go running out and try to invest some money in Medallion, realize that the fund has been closed to new investors for many years.)

Hedge funds have even captured the imagination of the entertainment world. The popular Showtime series Billions has as its protagonist, Bobby Axelrod, a fictional character based loosely on S.A.C. Capital Advisors’ hedge fund manager Stephen Cohen, right down to the firms’ names. Axelrod’s firm is Axe Capital, while the name SAC Capital Advisors is derived from Mr. Cohen’s initials. Cohen amassed an enormous fortune but then later suffered a fall from grace as he was implicated in an insider trading scandal. While Cohen wasn’t personally charged, S.A.C. Capital Advisors pleaded guilty to insider trading charges and paid $1.8 billion in penalties. Cohen no longer runs a hedge fund, instead operating Point72 Ventures, a venture capital firm. (More on venture capital later in this chapter.)

Venture capital

Venture capital is money provided to startup companies and young firms that don’t yet have a track record that would allow them to tap the more traditional sources of funds, such as bank loans or initial public offerings (IPOs). Anyone who has watched the reality TV show Shark Tank is getting a glimpse into the world of venture capital financing.

Essentially, venture capital is the place where the entrepreneur with a great idea and a solid business plan gets seed capital or working capital from sophisticated investors who are looking for the next big thing like Microsoft or Cisco Systems — two companies that were financed by venture capital investment.

Venture capital firms are generally structured as partnerships. The limited partners are the investors and provide the capital. The general partner manages the investments — essentially figuring out which companies to invest in.

Unlike traditional stocks and bonds, investment in venture capital is very illiquid — the commitment of funds is generally for a fairly long time period (generally five to ten years) and cannot be readily bought and sold. In contrast to investing in traditional stocks and bonds, venture capitalists typically take a very large ownership position in a company and play an active role by providing management expertise and closely monitoring the company’s progress.

The fee structure in venture capital is similar to that in the hedge fund industry. The two and twenty compensation scheme described in the preceding section is standard fare in the venture capital world. So, for the investment in a venture capital fund to prove to be profitable, the underlying investments must collectively perform at a high level to provide both the return to the investor and cover the management fees.

Venture capital investing is a risky endeavor — the average investment proves to be unprofitable. Most young firms simply don’t make it and only a select few make it big. So successful venture capital investing is a numbers game. To justify the risks taken, the returns expected by investors are much larger than those on traditional investments that involve less risk of failure. Many venture capital investors target returns of over 30 percent per year. To hit such a lofty target and to mitigate their risk, venture capital funds often invest in a large number of young firms. If a venture capital investor provides financing to ten firms and only one of them is successful — but that one is wildly successful — the investment can be a major success.

Success for the individual firm that receives venture capital financing — and for the venture capitalist that provided the financing — is realized when the firm goes public via an IPO or is sold to another company for a huge price. That’s the ultimate dream of both the entrepreneur and the venture capitalist.

Commodities

The commodities asset class includes a wide variety of goods, ranging from agricultural commodities (such as corn, soybeans, and cattle) to precious metals (like gold, silver, and platinum). While assets such as stocks, bonds, and real estate are purchased for the expected stream of revenues that will come from owning the assets, commodities don’t provide such cash flows and are purchased and sold on the basis of their consumption and speculative values.

Many firms buy and sell commodities in order to hedge their natural positions in commodities — airlines buy oil in the futures markets and farmers sell wheat in the futures markets. However, many investors buy and sell commodities as investments — in effect, speculating on future prices. One of the attractions to commodities as an asset class is that commodity prices and stock and bond prices generally don’t move together. This quality helps to reduce risk of a portfolio that includes commodities along with stocks and bonds.

Investors can take positions in commodities either by purchasing the physical commodity — taking delivery of 5,000 bushels of corn or 1,000 barrels of crude oil — or by agreeing to buy or sell claims to these assets in the futures markets. Investors can buy or sell futures contracts based on many commodities, and these markets are global in nature. As you may suspect, transacting in the futures markets is the preferred method because these contracts are liquid (they can be readily bought and sold), and the investor doesn’t have to find a place to store all that corn or crude oil.

Investors generally invest in commodities either passively or actively. Passive investment is often done by taking a position in a commodities index. A commodities index is much like a stock index, and the value of the index rises and falls as the value of the individual commodities rises and falls. One of the most popular ways to gain broad exposure to commodities is to purchase a futures contract on the Goldman Sachs Commodities Index.

If investors want to attempt to beat the market and earn rates of return that exceed that of a simple index of commodities, they may look to the services of a commodity trading advisor (CTA; a professional money manager who specializes in commodities and, for a fee, will provide individualized advice for investors) or may invest in managed futures (funds of futures contracts where the typical fees are similar to those in the hedge fund and venture capital industries — that is, you guessed it, two and twenty).

The greater fool theory says that the prices of some assets aren’t determined because an investor thinks it’s worth the price but because the investor thinks he can sell it to someone in the future at an even higher price — that is, sell it to a greater fool. The greater fool theory explains speculative bubbles through time from tulip mania in the Netherlands in the 1600s to the Internet bubble in 2000 and the residential real estate bubble of the last few years. Many people believe that the price of some commodities like gold are largely determined by the greater fool theory. In October 2010, Warren Buffett told Ben Stein that if you put all the world’s gold together, it would form a cube about 68 feet per side. For the value of that cube of gold, Buffett notes you could buy all the farmland in the United States and about 16 Exxon Mobils, and you’d have $1 trillion left over for walking-around money. What would you rather have?

Real estate

It’s ironic that real estate is referred to as an alternative asset, given that home equity is often the single largest investment position that many investors in the United States hold. Generally, though, when investors refer to investing in real estate, they’re considering any holdings beyond their personal residence.

Real estate has traditionally been very difficult to invest in for several reasons, chief among them illiquidity, large minimum investment, the unique nature of properties, and monitoring and upkeep required. Investment bankers are a very creative lot, and over the years, they’ve developed methods for investors to more easily access the real estate markets. The two major methods are through real estate mortgage investment conduits (REMICs) and real estate investment trusts (REITs).

REMICs purchase mortgages on both commercial and residential properties, place them in trust, and then issue interests in these mortgages to investors. Essentially, they allow investors to invest in a diversified portfolio of real estate mortgages. The securities issued by the REMIC are called mortgage-backed securities because the collateral or backing of the securities is the real estate that the mortgages were issued on. REMICs can be designed in many different ways, and some mortgage-backed securities are much riskier than others as investors found in the financial crisis.

REITs are publicly traded closed-end investment funds that invest in real estate directly or through mortgages on real estate. REITs trade just like shares of stock on major stock exchanges. Investment bankers have created three types of REITS:

• Equity REITs: Equity REITs purchase commercial, industrial, or residential real estate properties. Income is derived primarily from the rental on the properties, as well as from the sale of properties that have increased in value. Many equity REITs specialize in a particular market segment; some specialize in a particular geographic area.
• Mortgage REITs: Mortgage REITs invest in property mortgages. They may make original mortgage loans or purchase existing loans or mortgage-backed securities. The income is primarily from the interest that they earn on the mortgage loans.
• Hybrid REITs: Hybrid REITs invest both directly in property and in mortgages on properties.

Many people believe that buying a home is a good investment, falling prey to stories of individuals realizing substantial gains by buying a home and selling it for a much higher price years down the road. What many fail to realize are the attendant costs of homeownership beyond the mortgage payment: property taxes, insurance, and upkeep. Even before all those extra costs, homeownership has not proven to be a very sound investment over time. Noble laureate economist and Yale Professor Robert Shiller makes a compelling case that real estate, particularly residential real homes, is a much inferior investment when compared to stocks. Shiller finds that on an inflation-adjusted basis, the average home price has increased only 0.6 percent annually over the past 100 years. Contrast that with the inflation-adjusted return of 7 percent annually realized by the stock market.

Currencies and cryptocurrencies

Most investors would be shocked to learn that the biggest financial market in the world is the currency, or forex (FX) market. The FX market does not set a currency’s absolute value but rather determines the value or one currency relative to another. You can take a position in virtually any major currency against another major currency in the FX market. For instance, you can take a position in the U.S. Dollar versus the British Pound or a position in the Yen versus the Australian Dollar.

While most of the activity in the FX market involves multinational corporations hedging natural positions, some FX market activity involves institutions or individuals speculating on currency movements. The U.S. dollar is the most traded FX currency in the world (88 percent of all FX transactions), followed by the Euro (32 percent of all transactions). Because each FX transaction involves two pairs, the grand total of all transactions equals 200 percent and not 100 percent as in every other financial market.

Investing in currencies, whether traditional currencies or cryptocurrencies, is fundamentally different than investing in stocks, bonds, or real estate. Over the long-term, investing in the stock market is a positive-sum game. That is, over the long run the value of stocks, both individually and collectively, generally rise. On the other hand, over both the short and long term, investing in currencies is a zero-sum game. That is, when the U.S. dollar strengthens versus the Yen, those holding U.S. dollar positions win and those holding Yen positions lose an equal and opposite amount. If you want to build wealth over the long-term, the stock market is the place to be.

Without question the biggest development in the financial markets in the past few years has been the rise of cryptocurrencies, particularly bitcoin. Bitcoin is a specific type of cryptocurrency: a decentralized digital currency that isn’t backed by a central bank. Users send each other payments via cryptocurrencies on an electronic peer-to-peer network. Bitcoin is created by a process known as mining. But unlike gold and silver miners, bitcoin miners use computers instead of picks and axes to mine bitcoin.

In some respects, referring to bitcoin as a currency is misleading. Sure, some people will take payment in bitcoin, but one of the fundamental characteristics of a good currency is stability of value. And bitcoin takes it on the chin with respect to price stability, as the chart of the price of bitcoin resembles a ride on a wild roller coaster. In January of 2017, a single bitcoin could be purchased for under $1,000. In December of that year, bitcoin nearly reached the $20,000 level. It subsequently fell below $3,300 by December of 2018. Are you dizzy yet?

For a period of time, you couldn’t browse a financial website or tune in to financial news without being inundated with analysis and opinions on bitcoin. Stories of cryptocurrency millionaires pocketing obscene sums of money, purchasing Lamborghinis with bitcoin and retiring to island mansions captured the imagination of many “investors.” Bitcoin frenzy was everywhere, as people didn’t want to get left behind and many clamored to participate in the 21st century gold rush.

The problem is that purchasing bitcoin isn’t an investment; it is speculation in an unproven commodity. You see, the crypto markets do not lend themselves to fundamental analysis as there is no intrinsic value to these supposed assets. But don’t take my word for it. Listen to Warren Buffett’s sidekick and Berkshire Hathaway Vice Chairman, Charlie Munger. Munger said, “I think it is perfectly asinine to even pause and think about them (cryptocurrencies). It’s bad, crazy people, bad idea, luring people into the concept of easy wealth without much insight or work.”

Warren Buffett suggests that investors should stick to investing in businesses they understand. In fact, he avoided technology stocks in the late 1990s — and missed the dotcom bubble — because those stocks weren’t in his circle of competence. Straying outside that circle is pure speculation. To paraphrase Stevie Wonder, “When you invest in things you don’t understand, then you suffer.” Just how many bitcoin investors can explain what they are investing in?

Attracting investors to asset management

Investment banks often employ armies of analysts who follow the economy, firms, and industries. These analysts craft research reports and make recommendations regarding virtually everything from the direction of the stock or bond market, to the value of individual companies, or the attractiveness of investments in certain regions of the world or industries.

Analysts typically are assigned specialty areas — specific asset classes or industries — and produce research reports with buy, sell, or hold recommendations. These research reports are distributed to both buy- and sell-side clients. Investment banks compete on the basis of their research quality and eagerly await the rankings such as Institutional Investor’s All-American Research Team and Zack’s All-Star Analysts Ratings. Many analysts become stars themselves and command multi-million-dollar compensation packages. Internet analysts Jack Grubman, Henry Blodget, and Mary Meeker became famous (and later infamous) in the dot-com bubble in the mid to late ’90s.

Be careful when listening to the recommendations of Wall Street analysts. Research analysts are presumably giving advice to investors on whether to buy or sell securities. But remember that they’re working for the investment banking firms, which make huge amounts of money for selling securities. Both Grubman and Blodget are barred from being involved in the securities business for allegedly violating their duty to investors and placing their firms’ interests over their own.

These analyst reports serve functions beyond simply helping clients make investment decisions. They assist traders of the firm’s own proprietary accounts in making decisions, help the firm’s sales force in suggesting new investment ideas to clients, as well as provide coverage to the companies whose securities the investment bank has assisted in recent IPOs.

Creating asset management tools

In Chapter 1, we explain that some investment banking firms actually make more money on asset management than on traditional investment banking functions. To become a full-service, one-stop shop for everything financial, investment banking firms have developed a plethora of asset management tools. We cover three of the most common — stock mutual funds, bond mutual funds, and exchange-traded funds — in this section.

How asset management can cause conflicts

The lifeblood of investment banking is information. Managing who has that information, how that information is disseminated, and who can act upon that information is central to mitigating the conflicts of interest created from having an investment banking operation that serves so many masters. The following represents a sampling of the conflicts that exist in investment banking firms.

How to eliminate and manage conflicts

We know that conflicts exist in investment banking, but how can they be eliminated or managed? The following are methods that investment banks use to both eliminate and manage conflicts.