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ROMNEYRATE – NEW TO THE LEXICON #2

April 15, 2012

ROMNEYRATE – NEW TO THE LEXICON #2

In yesterday’s blog which introduced the word ROMNEYRATE to the lexicon, I indicated that I would be blogging further on the mechanics of hedge and equity funds and how their managers are compensated.  Following is that effort. (Research is provided by the AR Trade Journal.)

A hedge fund is a mutual fund on steroids. It is part of a virtually unregulated industry populated by “managers” with wild west mindsets where most anything goes, where gold bugs and junk bond enthusiasts can be found in abundance. Greek bonds? Why not? The value of the assets invested in need not go up; the value can go down. The managers can bet one way or the other. If they bet right, they make money. If they don’t, they lose money – your money. It is important that values of the assets invested in move; they may appreciate or depreciate, but they must move, since profits are based on the differential in valuation of such assets.

In 2002, a hedge fund manager had to earn 30 million dollars to get into the industry’s “Top 25;” last year a manager had to earn 100 million dollars to make it to this elite group. The really top hedge fund managers make hundreds of millions of dollars a year (and, as we have seen in yesterday’s blog, pay a maximum of 15% in taxes on such unbelievable levels of compensation).

Why are these “managers” paid so well? The story is that they are incredibly smart in making investment decisions for their clients, and are therefore worth it. You cannot visit your local stock broker at the mall and buy into a hedge fund. The managers are interested in deep pockets only, and regularly require a minimum investment of at least 1 million dollars. They prefer pension funds of trade unions, teachers, police, firemen and other such aggregations of capital awaiting distribution to retirees. College endowment and state pension funds are especially welcome. With over two trillion dollars now invested in the hands of hedge fund managers by these largely institutional investors (and with government liability for some of the pension investments via our Pension Guaranty Fund in the event the hedge fund managers make the wrong call), one would think such exposure to loss would call for tighter regulation of these crap shooters – not so – apparently federal regulators feel that such deep pocketed and sophisticated investors can fend for themselves. Let’s hope they are right – remember the funny paper sales of a few years ago all around the globe which were sponsored by “sophisticated bankers” from Wall Street? Can you say “BAILOUT?”

Hedge fund managers typically charge investing clients via a formula of “2 and 20”. Clients pay 2% of the amount invested annually and 20% of any gain upon the sale of the assets in which the managers invest their clients’ money. Successful managers charge more. Tudor Investment charges 4% and over 23% of any investment profits. On the basis of his claim that his firm (SAC Capital Advisors) has returned “double-digit returns for the better part of two decades,” Steve Cohen has bragged his way into demanding (and getting) 50% of any investment profits on sale of assets! Mr. Cohen as a part of his sales pitch probably does not highlight the fact that seven of his former employees have either pled guilty to criminal charges or settled fraud charges in civil proceedings for INSIDER TRADING. (Or maybe he does talk about it in this world of getting a leg up on your fellow greed heads – after all, those investing and those who manage the investments have a common goal – making money. How do retired teachers and firemen know what is going on between their pension fund managers and hedge fund management firms behind closed doors and bereft of regulation?)

With virtually no federal regulation extant, I smell a Bernie Madoff or two in that industry. When and if the “Bernies” start showing up in the industry in plain view, expect the sound and fury of federal regulation (albeit tardy). I believe there is a giant exposure of liability to (ultimately) taxpayers, and that much heavier regulation should be required. A good start would be a limitation of liability of the Pension Guaranty Fund for pension funds which invest over a certain percentage of their total assets in hedge funds. (The California pension system has moved its holdings in private assets and hedge funds to 26% in 2010 from 16% in 2006; its 2% management fee alone is now over 1 billion dollars per annum.) Over-exposure to loss amid another general recession contains the seeds of yet another destructive bailout and accelerated descent into Third World status, an unmitigated catastrophe for all of us.

Yesterday I blogged that a hedge fund manager named Raymond Dalio made 3.9 billion dollars last year and paid no more than 15% in taxes on such a massive income. Today I report that hedge fund manager John Paulson made 4.9 billion dollars the year before, and likewise paid no more than 15% in taxes on such an even more massive income (he bet right on gold for a 35% return on investment). These two people paid taxes at a rate perhaps less than half what their auto mechanics and hedge trimmers paid for the year in question. This is a situation beyond belief. We do not need congressional hearings to determine “fairness and equality” in tax treatment; that’s obvious. Treasury rather needs a financial tourniquet to end this abuse of ordinary taxpayers. The relief can only be had by amendment to the Internal Revenue Code. Hearings on this (and only this) topic should have begun years ago, but they didn’t. We need to act on this now, Karl Rove’s paid propaganda to the contrary notwithstanding!

So Paulson (the manager who made 4.9 billion dollars in 2010) is a sophisticated investment genius who can name his own price? Hardly. Last year Paulson made a bet on Bank of America, and one of his funds took a 52.5% loss. Sophistication is a sometime thing unrelated to a throw of the dice. So what does the giant pension fund of California get for its fees alone of over a billion dollars a year? An unremarkable average return of 3.4% over the past five years – and this with 26% of their total assets in the hands of hedge and other private equity managers AT RISK. Is it worth it? Should they be invested in the regulated market you and I know instead, where some risk is present but regulated?

The fact is that as a whole and industry-wide, hedge funds LOST their clients 5% of their money in 2011, according to Hedge Fund Research Composite Index, which follows hedge fund portfolios, and FORBES  reports that “Boring low-fee-index funds continue to run circles around many investing titans.”

So where is the sophistication? The magic? It seems to me that (other than those who employ insider trading tips) the industry has no special ability to ferret out winners and losers.

Anyone can throw dice and win – or lose. Sometimes these hedge fund managers bring home spectacular returns; sometimes they return devastating losses. Trouble is – you have to pay these people big bucks to throw the dice – and it’s your money at stake on the outcome(s). How much risk can you and/ or those you represent in a fiduciary capacity tolerate in this crap shoot? GERALD E

 

 

 

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