The big lie that makes them rich

The big lie that makes them rich

11 Oct 2013

Last week, one of the most successful hedge funds apologised to its investors.

“The Pershing Square funds declined by more than 5% during the third quarter of 2013 generating flat performance net of all fees for the first nine months of the year.”

This is an unaccustomed setback for Bill Ackman, the founder of the fund, whose personal net worth, according to Wikipedia, is $1.2bn. It is not news that the most successful few hedge fund managers make money on this scale, nor that the fees charged by hedge funds are high (typically, 2% of funds under management and 20% of gains, sometimes above a benchmark level, annually). So it’s turning out to be a bum year for Bill.

To mitigate his shame and sorrow, Mr Ackman includes the performance of his fund since inception on 01/01/2004. Its gross return is 780% which is very impressive but less striking than its net return, after fees. That is 433%. Mind the gap. Every time that the investor, who is putting his money at risk, has made a dollar, Mr Ackman has made 80 cents.

Never mind. Investors since inception have had a wonderful performance and would probably have bitten your arm off if offered those returns and those fees at the beginning. But that’s not quite the end of the story. Were a terrible and unimaginable financial event (say, a default by the USA) to happen, resulting in a devastation of the fund’s performance, that 433% return after fees could start to shrink rapidly. But the fees themselves are safe. They have been paid, in cash.

The last paragraph of my last investment rule states:

Always be thinking about how and when you are going to get paid out.

Mr Ackman is a highly talented investment professional, who, like all hedge fund founders, probably thinks about this question a great deal. He is all over it. I fear that one cannot say the same for his investors. The dollars they have made are accounting profits whereas the fees they have paid are in cash.

I have picked on Pershing Square because it has been very successful. Most hedge funds are not. A paper last year from Imperial College which seeks to analyse data about hedge fund performance reveals that two out of three have closed, presumably because they have made money for no one.

Overall, we find that the aggregate data set consists of 24,749 unique hedge funds that report at least 12 return observations. For these hedge funds, 8,512 are active, while 16,237 are not providing any data to vendors, thus, we classify them as defunct.

So it seems likely that statistics about hedge fund performance, though far from impressive on average, are flattered by the fact that most of the numerous poor ones are excluded.

It seems to me that people who invest in hedge funds are, to varying extents, wealthy, lazy and foolish. As long as their wealth greatly exceeds their laziness and their stupidity, I guess it doesn’t much matter.

Compared to the investors in the next story, they are ultra-sophisticated. This is from a Bloomberg story.

During the decade ended in 2012, more than 30,000 investors entrusted Morgan Stanley with $797 million in a managed-futures fund called Morgan Stanley Smith Barney Spectrum Technical LP. The fund already had $341.6 million invested during the previous eight years.

Top fund managers speculated with that cash in a wide range of asset classes. In that period, the fund made $490.3 million in trading gains and money-market interest income.

Investors who kept their money in Spectrum Technical for that decade, however, reaped none of those returns — not one penny. Every bit of those profits — and more — was consumed by $498.7 million in commissions, expenses and fees paid to fund managers and Morgan Stanley.

After all of that was deducted, investors ended up losing $8.3 million over 10 years. Had those Morgan Stanley investors placed their money instead in a low-fee index mutual fund, such as Vanguard Group Inc.’s 500 Index Fund, they would have reaped a net cumulative return of 96% in the same period.

I have nothing to add to this story except to recall my second investment rule: Never invest in anything that you know that you don’t understand.

How does the financial industry continue to persuade people to trust it with their money, despite mountains of evidence that it is the agents and not the investors who get rich? “Where are the customers’ yachts?” was written in 1940. (It’s still in print and worth reading).

In my view there is one big lie, perpetrated by all personal financial advisors and largely supported by financial legislation, which treats financial advice as if it is a loaded gun being passed around a room of half-wits.

As an investor, one of the biggest mistakes you can make is attempting to time the markets.

(Source: investment fund promotional literature ad nauseam)

Over the last 10 years, the FTSE has risen from 4344 to 6470, a 49% gain, which sounds pretty good, though it is in fact compound growth of just a fraction over 4% p.a. On the basis of this typical performance, investment managers want to you save regularly with them and to skip the financial section of your newspaper.

Of course, using judgement and great luck, you could have taken a 55% gain after four years and avoided the 48% stock market decline that surrounded the memorable year of 2008. Then, with inhuman foresight, you could have reinvested and ridden the recovery that so far amounts to 83%. On the basis of your original investment, fully reinvested (including its initial 55% gain), that’s a ten year return of 283%. But don’t worry your pretty little head about that.

The Sunday Times reported this interview on 1 October

Trying to time financial markets in these volatile times would be foolhardy, according to a leading fund manager in the region. Retail investors should, instead, adopt a dollar-cost averaging method of regular investing, with a balanced and diversified approach, said Mr Jed Laskowitz, the chief executive of JP Morgan Asset Management Asia-Pacific.

He told The Sunday Times: “Timing the markets doesn’t work… individual investors tend to become too euphoric in the good times and too negative in the bad times.”

That leads them to sell at the bottom and buy at the top, Hong Kong-based Mr Laskowitz added.

If you like being talked down to and ripped off, managed funds are just what you might be looking for.

Or you might consider the big picture for yourself.

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