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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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8:30 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 in.

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.

3. 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.

4. 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.

5. 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?

6. 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:

After Amaranth
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 it’s making big money. That’s when the hubris kicks in. That’s when mistakes get made. Nobody was making the kind of money that the high-flying Amaranth—named, with cruel irony, it turns out, for the mythological Greek flower that never wilts—was generating going into May 2006. By placing giant bets on how much natural gas the nation might draw down during the winter—yes, you can wager on silly imponderables like that—Amaranth shot the lights out. But when a mild summer and no hurricanes hit, Amaranth’s hunch boomeranged, and the $9 billion firm racked up $6 billion in losses. Now it’s 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 firm’s 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, Hunter’s the wrong bad guy. I blame bigger villains.

First, there are the hedge-fund clients themselves—pension managers like those of 3M and the San Diego County pension plan—who 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 funds—which 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 I’m 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 county’s 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 don’t have the sophistication and experience to properly assess and monitor hedge funds’ performance.

Still, over 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 weren’t 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 houses—the 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 brokerage’s 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. It’s a great business because the prime broker has the collateral sitting in the account, so if the fund does badly, the repossession is simple. It’s 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. (Amaranth’s 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 nation’s 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 don’t understand how the returns are generated or can’t 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 Bayou—until Bayou collapsed in 2005—consultants often don’t 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 can’t be counted on to do that job, even as they take huge fees to allegedly do just that.

The final element that plays a role here is the funds-of-funds element. That’s 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 can’t understand the hedgies’ strategies either. Most funds-of-funds people would not be smart enough to run hedge funds, yet they’re happy to take the money of those who want to invest in them.

That’s 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 shouldn’t 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 “I’d Walk a Mile for a Camera” Blumenthal, Connecticut’s 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 aren’t rich or your clients aren’t rich (as defined by a simple suitability rule—do they have more than, say, a million dollars?), they shouldn’t be in hedge funds. That’s how the law was for years. It was changed under Clinton because of heavy lobbying—and giving—by hedge funds, and that’s how Amaranth happened. The other way to regulate hedge funds is to say that you can’t 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 isn’t about a sole runaway manager who made bad bets on the weather. It’s about broad institutional problems—how hedge funds are run and monitored, and who’s 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 won’t generate the huge returns that hedge funds do in good times, but more important, they won’t 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 caution.

InSite's annual meeting is today: InSite Vision's annual meeting starts today at 1 PM EDT. We should hear more on their plans for finding a big pharma marketing partner.You should be able to attend via a webcast. Click here.

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."

The upcoming marriage
Jim-Bob returns to the family cabin in Squirrel Hollow with an ear-to-ear grin.

"Daddy", 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 . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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