Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
AM EST Tuesday, October 3, 2006: I own several hedge
funds. Several things I note from my experiences:
1. They're more volatile than money managers or mutual funds. "Volatile"
means they go up and down faster and more violently. Some were up for September.
Some were down. Some were flat. Results later this week when I get them all
2. They're more secretive. Not only don't they tell you much, but some relish
not telling you much. It's as though their little secrets made them grander
or more in demand.
Industry specific or strategy-specific hedge funds do worse than non-specific
ones. My biotech funds, for example, are doing awfully. It's a mistake to be
in industry-specific hedge funds. As I think about it, industry-specific hedge
funds seem like a contradiction in terms -- like airline food.
Two of my hedge funds have done super well. On balance, I'm up for the year.
But it's time to reassess. Ironically, all my Vanguard mutual funds have done
better than most of my hedge funds. You'd think otherwise.
Hedge funds need constant reassessing. Those that do poorly seem to continue
to do poorly and should be chucked -- unless you have some secret knowledge
that they'll come back into vogue. Anyone for energy?
Most successful hedge funds have developed around a person. Because of their
success and the speed at which money moves around today, successful hedge funds
have attracted more money than one person can handle. The result is to hire
other managers to invest the money using mostly the same strategies. Unfortunately,
most new and particularly young money managers are often hard to control and
may not have the same instincts. This is where many hedge funds have run into
trouble. The real problem is trying to institutionalize a person. Mostly impossible
unless the fund deals in low risk, low profit investments. And then, who cares?
The Amaranth hedge
fund blew up because of a horrible, stupid gamble one trader made on natural
gas. That trader was paid $100 million in commission last year -- when he did
good. As he came into this year, he must have felt he was super-brilliant, invincible,
walking on water. Brilliant beyond brilliant.
In this week's
New York Magazine, Jim Cramer (the man on CNBC) wrote a long serious article
pointing the blame not at Amaranth's natural gas trader, but Amaranth's investors.
Read the entire piece. Cramer used to run a hedge fund. He knows more about
them than any of us:
Yes, there are out-of-control hedge-fund managers out there. But the real
problems are overaggressive marketing and overeager investors.
Never is a
hedge fund more dangerous than when its making big money. Thats
when the hubris kicks in. Thats when mistakes get made. Nobody was making
the kind of money that the high-flying Amaranthnamed, with cruel irony,
it turns out, for the mythological Greek flower that never wiltswas
generating going into May 2006. By placing giant bets on how much natural
gas the nation might draw down during the winteryes, you can wager on
silly imponderables like thatAmaranth shot the lights out. But when
a mild summer and no hurricanes hit, Amaranths hunch boomeranged, and
the $9 billion firm racked up $6 billion in losses. Now its so wounded,
someone ought to shoot it, just to end the pain.
Much of the
blame has been placed on the unrestrained nature of Brian Hunter, a 32-year-old
energy trader. His trading of natural gas, which produced phenomenal returns
for about a year and a half, dwarfed the rest of the firms other asset
investing, turning it from what was supposed to be a multi-strategy firm invested
in a variety of products into a dangerously undiversified single-strategy
firm. Dumb call? Sure. But in the end, Hunters the wrong bad guy. I
blame bigger villains.
are the hedge-fund clients themselvespension managers like those of
3M and the San Diego County pension planwho have rushed headlong into
these funds. Pensions like these are the new big fish in the hedge-fund world
because they have more money than Croesus and dwarf other investment pools.
Hedge-fund managers who land them are in clover because the pensions have
more to give than anyone. But pensions run money for everyday people. When
I got into the hedge-fund game in the eighties, the only clients who invested
in hedge funds were wealthy individuals who could lose a bundle and live to
invest another day. In other words, people who could afford to assume the
risks carried by hedge fundswhich can borrow as much money as they want
to invest in everything from long and short stocks to the raindrops meandering
down a wet window.
I know, it seems
like Im blaming the victim, but if you ask me, no pension manager in
his right mind should ever risk his capital in such an open-ended fashion.
I recall turning down a countys pension plan whose stewards had heard
I was a good manager with a great return. I told them that giving me the money
would be reckless, even though I barely used leverage and restricted myself
to equities in my own charter. Pension managers simply dont have the
sophistication and experience to properly assess and monitor hedge funds
time, institutional money, seeking greater returns than could be gained through
investing in traditional long-only funds, turned to hedge funds to bolster
returns, especially since 2000, when U.S. equities stopped generating good
numbers. Suddenly hedge funds werent exotic, highly risky investments
for the superrich. They were sexy new toys for pension managers. And billions
in everyday folks retirement funds were at risk.
Second, I blame
the investment housesthe Morgan Stanleys, Bear Stearnses, and Goldman
Sachses of the world. Hedge funds use different brokers to execute trades,
but at the end of the day the securities they handle are transferred to a
so-called prime broker and kept in that brokerages account. Most hedge
funds borrow money; they borrow it at roughly a little less than the prime
rate from whoever is prime, whoever has custody. This lending
from prime brokerage is a principal source of income, and one of the fastest-growing
sources, for just about every brokerage house (it was a main driver of the
houses huge second-quarter returns). The brokerages lend against the
stocks that are in custody. Its a great business because the prime broker
has the collateral sitting in the account, so if the fund does badly, the
repossession is simple. Its no-risk lending. What a fantastic business!
The fawning brokerages, of course, have no incentive to tell the clients that
a firm like Amaranth is wrong to take down tons of borrowed money to bet on
dubious strategies like the totally unknowable weather patterns that determine
the direction of natural-gas futures. (Amaranths huge return in 2005
that attracted so much money to the fund happened because it was luckily long
on natural gas when Hurricane Katrina, a once-in-a-century storm, slammed
the nations petroleum infrastructure and spiked natural gas with it.)
In fact, the brokerage houses have every reason not to discourage, say, the
San Diego public employees fund from investing in hedge funds.
Third, I blame
hedge-fund consultants. Because the pension-fund clients themselves are too
understaffed and unsophisticated to act as a check on the hedgies, they rely
on consultants to recommend and monitor hedge funds for them. These consultants
are supposed to be experts at analyzing returns, but they, too, either dont
understand how the returns are generated or cant do the necessary due
diligence because the nature of so many hedge funds changes over time. As
we saw with Hennessee Group, which had been among the largest consultants,
and had shoveled tens of millions to Bayouuntil Bayou collapsed in 2005consultants
often dont know nearly enough. To me, these consultants are the ones
most culpable, because their whole sales pitch is about ferreting out the
rogue and poorly returning funds from the good ones, and they simply cant
be counted on to do that job, even as they take huge fees to allegedly do
The final element
that plays a role here is the funds-of-funds element. Thats where a
manager decides to build his own stable of funds by analyzing hedge funds
and pooling them. These funds-of-funds can be diversified among many hedge
funds to spread the risk, but, like consultants, their managers charge a buck
or two for their trouble, and mostly they cant understand the hedgies
strategies either. Most funds-of-funds people would not be smart enough to
run hedge funds, yet theyre happy to take the money of those who want
to invest in them.
the establishment I blame for the hedge-fund debacles, not the managers at
Amaranth, who were, in the end, just doing their job, albeit (very) poorly.
Sure, you could say that the marketers of Amaranth got out of hand, telling
prospective clients at a meeting at The Four Seasons in New York that they
were doing just fine, thank you, even as their bets went sour. But anyone
who sought audited results before coming in would have known better. Indeed,
the Blackstone Group, one of the most sophisticated investors, by my measure,
in the United States, pulled out of Amaranth before the meltdown, assessing
correctly that the fund took way too much risk to generate its gaudy returns.
Blackstone shouldnt have been the only one, though, to be wise to such
a Hail Mary strategy. Others who invested should have known that any fund
that could be up $2 billion for the year going into May and then drop 10 percent
in a month was being reckless in its bets.
Of course, various
state-government officials, led by Richard Id Walk a Mile for
a Camera Blumenthal, Connecticuts attorney general (Amaranth and
many other funds are headquartered there), now want more regulation to stop
future Amaranths from blowing up. I am sure we will have the usual federal
hearings, and an SEC investigation is already under way, but these are all
a waste of time. The only government regulation we need is a prophylactic
one: If you arent rich or your clients arent rich (as defined
by a simple suitability ruledo they have more than, say, a million dollars?),
they shouldnt be in hedge funds. Thats how the law was for years.
It was changed under Clinton because of heavy lobbyingand givingby
hedge funds, and thats how Amaranth happened. The other way to regulate
hedge funds is to say that you cant borrow more than, say, 50 percent
of the money you have under management to leverage up, if you are running
pension money. Either way would be better than trying to police the funds.
The government would be even more inept than the consultants and brokers and
funds-of-funds people in monitoring funds performance.
In the end,
the lesson to be learned from Amaranth isnt about a sole runaway manager
who made bad bets on the weather. Its about broad institutional problemshow
hedge funds are run and monitored, and whos investing in them. Hedge-fund
strategies have become so obtuse, their sales pitches so aggressive, and their
monitoring so lax that one could question whether anyone should be in these
funds, let alone pension-plan managers who have no ability to judge what these
funds are doing and are supposed to invest regular folks money in relatively
safe places. Sure, pension funds that opt out wont generate the huge
returns that hedge funds do in good times, but more important, they wont
get crushed in the bad ones. The simple truth is that only the rich, who can
take the hit, belong in these funds. And even they should proceed with extreme
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God Loves Blondes, too
A blonde finds herself in serious trouble. Her business has gone
bust and she's in dire financial straits. She's so desperate that she decides
to ask God for help. She begins to pray..."God, please help me. I've lost
my business and if I don't get some money, I'm going to lose my house as well.
Please let me win the Lotto."
Lotto night comes, and somebody else wins it.
She again prays..."God, please let me win the Lotto! I've lost my business,
my house and I'm going to lose my car as well."
Lotto night comes and she still has no luck.
Once again, she prays..."My God, why have You forsaken me? I've lost my
business, my house, and my car. My children are starving. I don't often ask
You for help, and I have always been a good servant to You. PLEASE let me win
the Lotto just this one time so I can get my life back in order."
Suddenly there is a blinding flash of light as the heavens open. The blonde
is overwhelmed by the Voice of God Himself.. .
"Sweetheart, work with Me on this... Buy a ticket."
Jim-Bob returns to the family cabin in Squirrel Hollow with an ear-to-ear
he says gleefully to his father. "I've met the girl I'm gonna marry. And
guess what, Daddy - she's a virgin!"
His father throws
down his pipe and says "No son o' mine ain't gonna marry no virgin. If
she ain't good enough for her own family, she sure ain't good enough for mine."
This column is about my personal search
for the perfect investment. I don't give investment advice. For that you have
to be registered with regulatory authorities, which I am not. I am a reporter
and an investor. I make my daily column -- Monday through Friday -- freely available
for three reasons: Writing is good for sorting things out in my brain. Second,
the column is research for a book I'm writing called "In Search of the
Perfect Investment." Third, I encourage my readers to send me their
ideas, concerns and experiences. That way we can all learn together. My email
address is .
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