A regular blog reader calls me a “gloom and doomer” because of my often cautious outlook on the economy and markets. This issue has less to do with viewing the glass as half empty rather than half full. As an investment advisor my duty is to maintain an alert and watchful perspective like a sentinel in a watchtower. In that light if from that vantage point the glass is filthy, it matters little how full it is. This consistent, healthy skepticism arises from my upbringing. My mother seemingly had advice for every difficult situation I found myself in as a young lad. Her admonition that “It’s better to be safe than sorry” corresponds with the Servant Financial’s investment management philosophy.
Recent developments in the financial and hedge fund industries prompted these additional maternal words to live by – “The exalted will be humbled and the humbled will be exalted.” The exalted (people of great wealth, power, prestige and celebrity) are being humbled in the hedge fund and financial industry due to mediocre performance and blatant ethical lapses.
Hedge funds are private pools of capital actively managed by investment advisers. By regulation hedge funds are reserved for wealthy individuals and sophisticated institutions. Most hedge funds are marketed as having proprietary investment strategies and deep investment expertise. These competitive advantages purportedly allow the funds to achieve positive returns whether markets are rising or falling. The volatile trading ranges of 2011 would arguably be an optimal performance environment for hedge funds. Such has not been the case as the hedge fund industry has fallen short of their lofty sales and marketing assurances. In fact, the average individual investor may be outperforming the hedge fund industry in 2011. This revelation was discussed in a recent global market commentary from The Mad Hedge Fund Trader investment research report written by John Thomas.
Although I don’t have the hard data to back it, I bet the average individual investor is outperforming the average hedge fund in 2011. With such heavy weightings of bonds and cash, how could it be otherwise? While the current yields are miniscule, the capital gains have to be humongous this year, with yields plunging from 4% to 2%... (When bond yields drop bond prices increase generating unrealized capital gains.)
Thomas believes the average investor has benefitted from more conservative asset allocation decisions in the aftermath of the 2008 financial crisis. Individual investors have shifted more of their assets into cash and fixed income securities from equities. John Q Public has also done well by paying down debt and deleveraging rather than keeping funds in the market.
Increased market efficiency is due in part to intense competition within the hedge fund industry as Thomas explains.
The problem is that hedge funds are no longer peripheral to the market. They are the market, and therein lies the headache. How are you supposed to outperform the market when it means beating yourself? As a result, hedge fund managers have replaced the individual as the new “dumb money, buying tops and selling bottoms, only to cover at a loss,” as we witnessed on Monday (November 28, 2011).
Hedge fund returns have been declining for a decade. Hedge fund industry returns have been pathetic in 2011 with Barclays Hedge Fund Index declining an estimated (4.8%) through the end of November. This hardly justifies the 2% management fee and 20% share of investment profits paid by hedge fund investors.
The growth in hedge fund industry assets under management supports Thomas’s observation. Industry assets mushroomed from $118 billion in 1997 to $1.7 trillion at the end of the third quarter of 2011.
Source: Marc Faber, Limited; GloomBoomDoom.com
Coincident with the enormous growth and influence of the hedge fund industry, the correlations (measurement of the relationship of interdependent variables) of global equity markets have almost doubled from about 50% in 1997 to more than 80% today.
Please allow me to introduce myself I'm a man of wealth and taste.
Rolling Stones
Source: The Trends Journal, August 2011 www.trendsjournal.com
Like other walks of life where the economic payoffs and the egos are inflated the human weaknesses of greed and pride have led to cheating in the hedge fund industry. Cheaters in the hedge fund industry do not use steroids or human growth hormones as was common in professional football, baseball, and the Tour de France. Rather illegal trading on insider information was used to “juice” hedge fund performance.
Reuters reports that since October 2009 there have been 50 people in the industry who have been convicted or pleaded guilty to insider trading charges. Hedge fund billionaire Raj Rajaratnam is perhaps the most infamous hedge fund manager implicated in the probe. Rajaratnam was convicted in May of trading on illegal stock tips that produced fantastic results for his Galleon Group. He was sentenced to 11 years in prison.
The recent highly speculative collapse of MF Global, the largest Futures Commission Merchant in the U.S., is another example of ethical lapses in the financial industry. Readers interested in a no holds barred discussion of MF Global’s collapse should read the following transcript at Financial Sense. In this interview host Jim Puplava is joined by Ann Barnhardt, who recently closed her commodity brokerage firm Barnhardt Capital Management after the MF Global collapse. Barnhardt believes that her client monies were no longer safe in the futures and options markets, and that the integrity of this market has been 'utterly destroyed' by the MF Global collapse. I had similar concerns and sold the sole ETF in client portfolios with any commodities futures or options exposure on November 27, 2011. Any future investments in commodities within Servant model portfolios will be limited to physical markets until appropriate regulatory and exchange actions have been taken to restore the integrity of the system. An example of a physical commodities market would be shares of the Central Fund of Canada (CEF) which holds physical gold and silver in a secure vault rather than paper futures contracts.
What does this all mean for the hedge fund and financial industry and you as investors? Thomas expects that individual investors will flee markets dominated by hedge funds and migrate to those markets where hedge funds are not present, such as smaller, less liquid and more pedestrian markets. Hedge fund managers will continue to slug it out in liquid equity and debt markets until their investors abandon the rich fee structure and take their capital with them.
This dynamic is already in motion. One of the most lucrative investment markets today is the purchase of hedge fund limited partnership interests in the secondary market. Hedge fund secondary interests trade at discounts of up to 40% or more of managers' net asset or carrying value, return investor capital fairly quickly, and generate net returns of 30% plus. This attractive opportunity set was identified in the course of providing investment advisory services to a Chicago family office. Unfortunately by regulation this market is restricted to accredited investors – wealthy individuals and institutions. Nevertheless we will remain alert for other attractive investment opportunities that may arise from positions contrary to Wall Street and take advantage of dislocations in the hedge fund and financial industry. Potential examples include investment funds that directly provide liquidity to stressed and distressed sellers or lend to small borrowers with limited access to traditional financing sources.
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