This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Wednesday, April 21, 2010

Trimming the Hedges

Investment vehicles, just like cars, clothes, moves and music, go through fads. In the 1980s leveraged buyouts (LBOs) were the hottest thing on the street. That all ended around the time Drexel Lambert blew up as a result of fraud, thanks to insider trading by Dennis Levine, Ivan Boesky, and Michael Milken (the inspiration behind the movie Wall Street).

[Quick note: The Drexel Burnham Lambert blow-up in the ‘80s was not unlike the current situation for which Goldman Sachs now finds itself making headlines. Both cases involved all-out frauds perpetrated by or through major investment houses, in which securities were structured for the sole purpose of defrauding investors.]

After LBOs in the ‘80s there was the wave of initial public offerings (IPOs) of the 1990s, riding the coattails of the tech and dot-com booms. We all saw how that one ended: the stock market lost around 40% in about two years, waves of bankruptcies ensued for tech companies, fortunes were lost, so on and so forth.

Then, the late 1990s saw the beginning of a new beast, which rose to prominence in the early 2000s: hedge funds. Originally created to allow wealthy individuals to pool large investments while avoiding regulatory oversight, hedge funds use leverage place a large number a ‘hedged’ bets, thereby [theoretically] maximizing returns – thanks to leverage – with limited downside risk.

In order to invest in hedge funds, which operate for the most part outside the control of regulators, clients are required to qualify using guidelines established for the SEC. While many clients include ‘institutional investors’ (banks, pension funds, etc), many are wealthy individuals who meet the criteria established for minimum net-worth and are able to come up with the minimum allowable investment.

When they started out, hedge funds proved to be a great way for money managers to achieve higher-than-average returns – and fees. However, fund managers have, over the years, discovered the difficulty that comes with trying to guard against a wide variety of nearly unforeseeable risks. Those few that have been able to guard against the widest array of risk have had to sacrifice substantial returns in order to do so.

Take, for example, Long Term Capital Management (LTCM), which was established in the early ‘90s by about a dozen partners. Among LTCM’s founders were two Nobel Laureates, more than a half-dozen PhD’s, and approximately two centuries of combined experience in finance.

The founders of LTCM were, put simply, the smartest guys in any room they entered. They were the who’s who of academia, Wall Street, and K-street. Yet even this group was totally unprepared for the Russian financial crisis in the last ‘90s, and after losing investors billions – thanks in large part to the leveraged used in their trading – LTCM was forced to fold.

In last week’s article we discussed the fact that people are rarely hit by the truck they see coming. In other words, it’s what we don’t know that can hurt us. Long Term Capital Management was crippled by its inability to predict the exogenous shock from the Russian crisis. In this case, investors were unfortunate enough to have a bad investment. Others are not so lucky.

A common saying we have around the office is that investors can recover from a bad investment. Getting into the wrong investment at the right time can cause losses, even serious losses; but as long as money remains, a portfolio can be built back. Get hooked up with a crook, on the other hand, and investors can lose everything; and unfortunately the only thing to do after a 100% loss is to start from scratch.

It’s a sad fact, but that is what faces nearly all the victims of both Bernie Madoff and Robert Allen Stanford. Once again we see cases of investors failing to protect themselves from risks that were very real and foreseeable, but completely ignored. Bernie Madoff, as the former head of the National Association of Securities Dealers (NASD, now FINRA), was one of the brains behind NASDAQ and was among the financial world’s elite. No one ever would’ve thought he had the audacity, the ruthlessness, to perpetrate the biggest Ponzi scheme in history.

R. Allen Stanford represents a similar case, wherein regulators, namely the SEC, ignored several red flags, even tips from insiders in Stanford’s operation, for nearly a decade. As detailed in “The SEC’s Impeccable Timing” (April 20, 2010, Wall Street Journal), securities regulators dropped the ball repeatedly with Stanford’s case, and there lack of action ultimately cost investors about $8 billion.

Many of the biggest underlying problems with hedge funds can be found in these cases. First and foremost, hedge funds require a hedge fund manager (investment advisor) to have custody of client assets. Once an advisor has custody of those assets, investors are totally unprotected from fraud, as Madoff clients now know. The second biggest concern: Leverage; while specifics can be difficult to digest, suffice it to say that when investing with borrowed money, even a small loss can wipe out an investment.

Another consideration to make with regard to hedge funds, or any investment for that matter, is the fee structure. After a decade a hedge fund prominence in the world of finance, it is safe to say that the only people getting rich through hedge funds are their managers. The management of investments brings us to our last concern with hedge funds and many ‘exotic’ investment products. The last twenty years have seen a growing trend in finance: the use of mathematics in trading. Many traders utilize “black box” systems, which are basically computer programs that track market moves and place trades according to proprietary programming.

What this means for traders is that now they don’t even need to sit at their trading desk, scouring the markets for opportunities. Instead, they can spend more time on the golf course or the beach, while their money machines do the leg work for them. Unfortunately for their clients, markets are not based on numbers, but emotion; trading involves the study of behavior psychology, not mathematics.

Yet, the wave of exotic investments continues, thanks in great part to the great sales pitches employed by hedge funds, collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), and credit default swaps (CDS). The problem is that none of these investments are transparent; quite often clients involved in these vehicles have no idea what they’ve just purchased, no more than advisors pushing these products know what they just sold – just ask Lehman Brothers and its clients, namely the pension funds around the world that invested in mortgage-backed securities, only to be wiped out in the crash of 2008.

Perhaps the biggest problem with these exotic investments, both vehicles and strategies, is the inherent trust given to so-called professionals in finance. There seems to be a belief by clients that regulators like the SEC wouldn’t let anyone in finance sell a fraudulent security, much less take off with client assets. The perception is that it’s on the regulators to weed out bad apples.

Did the SEC protect investors from Bernie Madoff? How about Allen Stanford? What about all those debt-backed securities that were sold in the early 2000s to fuel the housing bubble, only to blow up in ’08? The role of regulators is commonly misunderstood to be preventative; it is not. The role of regulators is, in the event of wrongdoing, to come in afterward, clean up the mess, and decide who to prosecute.

Investors around the world need to return to self-reliance. Don’t trust regulators; trust common sense and due diligence. Consider each and every possible risk before deciding on an investment advisor, a system, or a security. Remember that all of these are only as transparent as their designer intends. Ask questions, do research, and know that if you want to keep your hard-earned money, then it’s worth your time and effort to do so.

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