Tag Archives: hedge funds

why do so many insider trading investigations involve hedge funds?

March 7, 2012 By in hedge funds, Industry Analysis, Investment firms, Trading Tags: , , , , , Leave a comment

where the money is

The diminutive Depression-era bank robber, Willie Sutton, was reportedly once asked why he chose banks to hold up.  His alleged reply:  “because that’s where the money is.”

Whether Mr. Sutton actually said that or not, the answer contains the essence of this post.  Hedge funds have more money to spend.  Until recently, they’ve been very far from the focus of regulatory and client attention to how investors spend client money;  even now, it seems to me they’re subject to far fewer restrictions on their trading activity than traditional long-only investors.

Finally–and this may just be my personal axe to grind–many hedge funds are the creations of professional traders, not researchers.  To me, this means they don’t have the experience or mindset to develop useful research conclusions by themselves.  Yet their own marketing claims put them under great pressure to produce superior results.  And they don’t have the compliance awareness that’s repeatedly pounded into every US-trained analyst’s head to make it clear what’s legally permissible and what isn’t.

Details:

“soft dollars”

Clients compensate money managers in two ways.  One is clear–they pay management fees.  The second is less obvious–they give their managers the power and influence with brokers that comes from controlling large trading commissions.  In my last job, for instance, in round numbers the firm spent $100 million a year in trading fees.

Managers who manage pension plans (subject to ERISA regulations) or or vehicles like mutual funds catering to ordinary individuals (subject to SEC oversight) have a fiduciary obligation to minimize the commissions and fees they pay for trading.

One exception:  they can pay extra-high amounts as compensation for research services brokers provide.  These services can come from the brokerage house itself.  Or, like Bloomberg terminals or copies of the Wall Street Journal, they can be paid for by the broker but provided to clients.  The commissions (or bid-asked spreads for OTC stocks) that pay for research services are called “research commissions” or “soft dollar” commissions.

clients’ money

The key benefit to the money manager is, of course, that the “extra” amount involved in a research commission comes out of the client’s pocket.  One might argue that the manager should pay for his own Bloomberg.  But that’s not industry practice.

Research commissions are a potential area (and, in the past, an actual area) of abuse.  So they are under increasing scrutiny.  A common rule when I was managing institutional and mutual fund money was that the percentage of research commissions for the overall asset management effort should be no higher than the average of all major money managers.  Five years ago, that was about 15%.

Trading frequency is also monitored carefully.  Managers who have above-average turnover rates risk losing their customers–and their jobs.

restrictions on use by traditional money managers…

Anyway, today’s traditional money managers have severe restrictions on the way they can use commissions to buy information.

…but not for hedge funds

On the other hand, to the degree that hedge funds manage money for wealthy individuals or non-pension institutions, they’re subject to neither asset turnover nor research commission limitations.

Hedge funds are Fort Knox to the traditional money managers’ kids’ piggy banks.

management fees

Yes, the famous ” two and twenty,” that is, a management fee of 2% of the assets per year + 20% of any investment gains, that hedge funds charge may well be fading out.  Nowadays, some may “only” collect 1.5% and 15%.  Compare that with the long-only manager charging, say, .75% of the assets annually with no profit participation.  I’m not saying we should feel sorry for traditional money managers.  But the comparison is Fort Knox vs. maybe a small-town savings and loan.

Two implications:  there’s much more at stake for hedge funds if they generate outsized returns, and here’s much more money potentially sloshing around inside the partnerships and in the partners’ pockets.

separation of research and trading

In the US, there’s a strict separation between the research and planning a portfolio manager does, and the execution of that plan through the trading room.

Typically, the PM designates the brokers he wants to receive research commissions over, say, a three-month period of time. He submits his trading orders to the trading room.  But he cannot direct a given order to a specific broker.

The idea is to prevent the PM from directing business to his friends or from taking a bribe to buy some dud stock a broker is trying to unload from his inventory.  This isn’t a cure-all.  The rules don’t end wrongdoing.  They shift the locus of possible wrongdoing to the traders, where there’s arguably less room for monkey business.  But, for good or ill, that’s the way the system works in the US.

In contrast, hedge funds haven’t typically had these safeguards.  In fact, it may well be that the chief PM is also the head trader–or sits on the trading desk right next to the head trader.  So there’s the opportunity for all sorts of under-the-table activity that would be impossible in a traditional money management firm.

PM as researcher

Scratch a successful equity portfolio manager in the US and you’ll uncover an exceptionally good securities analyst, who may have spent a decade or more polishing his craft.

In my view, the last thing a good analyst wants is inside information.  If you’re in a meeting where a company executive accidentally blurts out some piece of confidential information that you’ve already figured out for yourself, you’re stuck.  The information is suddenly transformed from the product of your creative mind to a company secret revealed.  It’s now forbidden fruit; you trade on it at your regulatory peril.

Though some hedge funds are headed by experienced analysts, others are run by professional traders or marketers.  The latter have their own strengths, but in my experience they don’t have the nerdy turn of mind a true analyst needs.  Yet they’re under tremendous pressure to come up with novel ideas to justify their high fees.  I’d imagine that this creates a big temptation to either accept–or even solicit–inside information.

compliance

Over the past twenty years or so, traditional money managers have all built sophisticated departments to supervise regulatory compliance.  Compliance rules visible every day.  Periodic training sessions are mandatory.  In my experience, emphasis is on avoiding any action that could possibly be (mis)interpreted as being intended to violate the laws.  Better safe than the subject of an SEC inquiry.

Pluck a couple of proprietary traders or a sell-side analyst out of their brokerage firms and set them up as hedge funds, and there isn’t the same awareness.  They may not know what the laws are.  They may not even see the necessity of setting up safeguards.  So the whole corporate culture may evolve into one where principals are encouraged to push the legal envelope in seeking proprietary information from third-parties about potential investments, rather than to safeguard the firm against the negative consequences of using inside information.

the SEC is looking at hedge fund performance claims

December 27, 2011 By in hedge funds, Industry Analysis, Investment firms, Private equity Tags: , , , , , , Leave a comment

the new approach

Today’s Wall Street Journal tells about current SEC efforts to scan the hedge fund universe in search of  potential civil fraud.  The idea is to use computer analysis to identify hedge funds whose results are too good to be true–where the operators rarely, if ever, have a down month, or where aggregate results are sensationally good.  This new direction apparently comes as a result of the agency’s failure to detect the gigantic Ponzi scheme that Bernie Madoff ran for many years–despite being supplied continuous evidence of the fraud by investigator Harry Markopolos.

Markopolos, a financial analyst, was asked by his employers to “reverse engineer” Madoff’s returns and create a duplicate it could market to clients.  A quick look at the numbers was enough for Markopolos to suspect fraud.  It took him less than a day to develop conclusive proof, which he then tried in vain to present to the SEC for close to a decade.

The new SEC interest in hedge funds appears to mimic the Markopolos methods.  The agency is also extending its scrutiny to mutual funds and private equity.

it’s about time

For years, academic studies have concluded that the returns hedge funds report to the public are at best implausible, and most likely false.

My favorite is one led by NYU professor Stephen Brown.  He analyzed investigations done by a hedge fund due diligence firm, HedgeFundDueDiligence.com,  which was hired by potential institutional customers to check out new managers.  It turns out that about a fifth of the hedge funds misled HFDD.com, despite the fact they knew their assertions would be checked.  It also turns out that customers generally hired the dishonest hedge fund managers, despite the due diligence warnings.  Go figure.

The biggest reasons for falsifying returns, in my view, is that reporting is voluntary and that the databases which collect the numbers make no attempt to check the figures.

an example

The WSJ article cites the case of the now-defunct ThinkStrategy Capital Management.  TSCM reported a return of +4.6% for 2008 in its Capital Fund-A, a year in which the fund actually lost 90%.  Chetan Kapur, who ran TSCM, also reportedly inflated his assets under management in reports to shareholders and wrote about non-existent team of analysts supporting him.  Kapur also continued to manufacture and report performance numbers for Capital Fund-A, even after the fund was shut down.

The article says there are lots more where TSCM came from.

I believe it.

 

 

Boston Consulting Group: traditional money management industry in long-term decline

July 13, 2011 By in Constructing a Portfolio, Getting financial advice, Industry Analysis, internet, Investment firms, Portfolio management Tags: , , , , , , Leave a comment

the BCG report

The Boston Consulting Group just released its ninth in a series of analyses of the global asset management industry.  This year’s is called Building on Success: Global Asset Management 2011.

BCG’s conclusion:  the industry is in long-term decline, despite a bounceback in profitability during 2010 caused by rising markets and an investor shift out of low-fee money market funds into more expensive products.

Reasons:

–the industry is mature everywhere except in emerging markets, so growth isn’t going to come from finding new customers.

–existing products aren’t good enough, with active managers typically offering one-size-fits-all products that don’t beat their benchmarks.

–competition is intensifying.  It takes two forms–price competition among industry participants; and the development of competing offerings, like hedge funds or private equity, that siphon assets under management away from the industry.

–there’s a steady flow of money away from high-fee active and equity products  and toward  lower-fee passive and fixed-income ones.

–in both the US and Europe, a small number of firms have established extremely large relative market shares.  This gives them economy of scale advantages that let them lower prices and still maintain their own income.  In US equities, for example, 5% of the funds took in 53% of the new money in 2010.  The bottom 50% of the market took in only 4%.  The European equity business is even more concentrated than that, as is the US fixed income sector.  In European fixed income, where concentration is somewhat less, the top 5% took “only” 38% of the new money.

my thoughts

I agree with BCG that we’re seeing a sea change in the asset management business.  I’d put the situation slightly differently, though.

Before Black Monday in 1987, investors tended to buy individual stocks rather than packaged products and to rely for advice on savvy registered reps employed by traditional (read: high cost) brokerage houses.  The market crash changed all that.  The antiquated NYSE system of having monopoly market makers (good for their profits, not ours) froze up; volume disappeared and bid-asked spreads became very wide.  Put in a market order and your execution could differ by 5% from the last price you saw on a screen.  And it seemed that the 5% was always in an unfavorable direction.

This experience, and the sense that the world was getting to be too complex for non-specialists to decipher, sparked a change in investor preference away from individual stockpicking toward buying professionally-run mutual funds.  At the same time, 401ks were becoming more in vogue.  Brokerage houses decided to limit their legal liability by turning their reps into marketers of computer-generated financial planning advice and mutual funds. The Baby Boom was just coming into its peak earning years.

I think the Great Recession and the accompanying sharp decline in world stock markets have triggered another sea change.  This time it’s a return to do-it-yourself for individuals, based on the assessment (right in most cases, In think, but wrong in some) that brokers are professional marketers, not trained investors, and add little value.  In any event, their firms limit what they can say and do.

The Baby Boom is starting to enter retirement.  Investment results are more critical than they were before; losses are more painful.  So boomers are dialing down their risk profiles by selecting passive products–through ETFs–and fixed income.  On top of this, on retirement Boomers are becoming their own Chief Investment Officers as they take charge of managing their 401ks or other defined contribution pension plans.

For institutions, which have long known that their favorite active managers underperform, it’s a switch to “alternative investments,” despite evidence that for the past decade managers of the latter have performed worse than traditional active managers.

For both classes of investors, it seems to me the change has the character of rejecting the devil you do know, figuring the one you don’t can’t be that much worse.

 

There are obvious issues with this change, assuming I’m correct.  Personally, I think pension sponsors are crazy to be building up their allocation to alternative investments.  The risks are high, the reported numbers aren’t that great, and there’s lots of anecdotal evidence that some of the reported numbers don’t stand up under more than cursory scrutiny.

For individuals, which is my main focus in writing this blog, the issues are somewhat different.  They’re how to get the information you need to make intelligent decisions, and who do you trust. Personally, I think that the investment management industry will follow the same pattern as traditional bricks-and-mortar retailing.  It, too, will morph (is morphing) into diffuse internet-connected collections of professional investors working in small groups and selling research or advice at reasonable prices.

 

 

 

two famous investment professionals, two embarrassing moments: Paulson and O’Neill

June 26, 2011 By in Current Market Thoughts, emerging markets, Getting financial advice, Recent Market Action, Stock ideas Tags: , , , , , , , , , , , , , 2 Comments

Every well-known person in the investment world, from Warren Buffett to Donald Trump (including DT may be like calling Paris Hilton a hotelier), is some combination of talent, drive, self-promotion, and right-place, right-time.   Normally, a highly crafted public persona is all the public is permitted to see.  Occasionally, though, an event occurs that gives us a chance to see behind the veil.  Two such moments have caught my eye recently.

Jim O’Neill and the A-list

1.  Jim O’Neill invented the term BRICs while he was the chief economist at Goldman.  He’s now the head of the firm’s wealth management division, and one of the celebrity columnists the Financial Times’ has grouped together under the rubric “A-List.”

In an A-List contribution this week, Mr. O’Neil wrote that a contact of his in Japan had just tipped him off to the existence of Renesas, a semiconductor company whose loss of production capacity in the March earthquake/tsunamis is a key factor in subsequent supply chain disruptions throughout the world.  Had he known about Renesas, he would have taken a less optimistic view of near-term global economic growth.

It’s hard to know what to say.

First of all, Mr. O’Neill apparently doesn’t read the newspaper–at least, neither the Wall Street Journal nor the Financial Times.  In both, Renesas was quickly identified as being a key element in many supply chains and as having lost a very large amount of production capacity due to the March 11th disaster.

Also, in the early 1980s the Japanese technology industry took a disastrous wrong turn by deciding to concentrate its efforts on commodity semiconductors like memory, rather than to branch out to areas like logic, which have higher design content.  This saddled Japan with a bunch of MUs rather than INTCs or TXNs.  It also left the country vulnerable to price competition from emerging economies–first Korea and later China, when it designated semiconductors as a critical focus for industrial development about a decade ago.  You’d think even a macroeconomist might know about that.

Finally, even if we say that it really isn’t part of Mr. O’Neill’s job to know much himself about technology or Asian industrial development, you’d hope that someone in the wealth management division would be up to date on stuff like this.  There’s apparently no communication between Mr. O’Neill and whoever it is who’s actually steering the ship.

Strange.

the story of Sino-Forest is another bizarre one.

2. John Paulson runs the hedge fund Paulson & Co, which has $38 billion under management.  The firm made its reputation by betting heavily against the housing market from 2007 on.

If we take the assets under management and assume a 2% management fee, then the firm is generating annual revenue of about $700 million, even without considering the 20% of profits it potentially earns.  Subtract $100 million for marketing and administrative expenses–I’ve just plucked that number out of the air.  I think it’s much too high, but that doesn’t matter.  What’s left over is $600 million, which pays for the investment research prowess of the firm’s professionals.

That’s a ton of money.  It’s more than all but a handful of investment organizations globally have to fund their research organizations.  It’s more than most buy-side firms have; its more than most sell-side firms allocate to research.  It’s enough the Paulson should be better informed about the areas he chooses to invest in, and the securities he elects to hold, than anyone else on the planet.

I don’t know the Paulson managers, but it seems their expertise is in the US, the global bond market and in financial stocks.

Why, then, would they buy 14% of Sino-Forest, an obscure Chinese forest products company, using 1%+ of their clients’ capital to do so?  And why would they know so little about the company that as soon as short-seller Muddy Waters issues a negative report on the company they sell the holding, taking a $100+ million loss (over $500 million, based on the opening stock price this year).

I’ve glanced at the Sino-Forest financials.  They look ok to me.  They’re audited by a major accounting firm, which gives them an unqualified opinion (in other words, a clean bill of health). The Wall Street Journal reports that Paulson looked at the financials, too, listened to management conference calls, had follow-up phone conversations with management and had an analyst visit the company in China.

For a $600 million a year research operation, that’s not doing much.  And it’s certainly not enough when dealing with emerging markets.  After all, too, that’s probably what the average investor with Bernie Madoff did.

Paulson also seems to have ignored a number of red flags.  In particular:

–although it’s a mainland Chinese company, Sino-Forest isn’t listed on any mainland stock exchange, nor is it traded in Hong Kong.  These are the natural destinations for a Chinese firm.  Maybe Sino-Forest couldn’t meet the listing requirements, or withstand the informed scrutiny of local institutional investors. That would be my first assumption, and a major source of risk in the stock.

–the forest products industry in Asia is highly politically charged and has had, to my mind, more than its share of stock market scandals.  So it’s not the first place I’d look to invest.

–ownership of anything in China is, in my opinion, a slippery concept.  It takes a lot more than listening to management to figure out what’s going on.

–China has no structural advantages in  forest products vs., say, Indonesia, Brazil or even New Zealand.So Chinese forest products isn’t even the best of a bad lot.

–the Sino-Forest story, as I gather from press reports, is that the company uses semi-legal means to acquire access to forest lands, and sells the wood it harvests through other semi-legal channels.  Not a great concept.  When you think about it, if the company makes its money by manipulating the laws to the disadvantage of its suppliers, what makes you think the company won;t do the same thing to you?

If we figure that the Paulson research budget was spread evenly over the positions it holds based on their size, then the company spent over $20 million since acquiring the stock in 2007 on the portion of the portfolio that Sino-Forest represented.  This was the best it could come up with?

My hunch is that selling the stock when it did was the right thing for Paulson to do.  But selling also seems to imply that Paulson knew nothing in-house that would refute the Muddy Waters’ research.  In other words, Paulson didn’t know much at all about its close to billion dollar position.

On rare occasions, stuff like this happens, even to professional investors.  Once you realize you’ve made elementary mistakes, cutting your losses is the best option.  But it’s still extremely embarrassing.

 

speculation: stabilizing or destabilizing?

May 18, 2011 By in commodies speculation--stabilizing or destabilizing?, Current Market Thoughts, economics, Margin, Securities regulation, Trading Tags: , , , , , , , , Leave a comment

In the Panglossian world of academic finance, all markets are self-regulating and all participants are rational economic agents with the same information and motivations.

Commodity trading, where there are two different classes of market participant, with different knowledge levels and goals, really doesn’t fit in this model,.  On the one hand, farmers and miners, who are typically large corporations, want to guarantee a minimum level of cash flow for their operations.  They do so by selling a certain portion of their output for future delivery through any of a variety of kinds of commodity contracts.  The firms are deeply knowledgeable about the products they produce and sell, and they employ highly paid professional traders to do their commodity trading.  These are the hedgers.

And then there’s everyone else.

An obvious question is why someone would take the other side of the hedgers’ trades, given their superior information and high degree of trading skill.  Clearly, however, someone does, since we know that companies are routinely able to hedge their output.  Academics call these counterparties speculators.

To the academic world, it follows that speculators are a stabilizing influence.  They help to regularize the cash flows of potentially highly cyclical companies; commodities futures/forwards prices would also be higher than they are if speculators didn’t step in to take the other side of the hedgers’ trades.

In its most basic form, that’s the academic theory.

One trouble with the theory is that it’s just a generalization of the way commodities markets worked a generation ago, mixed in with the semi-religious belief in an “invisible hand” that ensures a favorable outcome in economic affairs. Worse, the basic metaphor no longer fits the facts–if it ever did.  Two examples:

1.  the silver market.  The broadening of commodities trading access to large numbers of private individuals, and the rise of commodities-oriented ETFs that give indirect access to a larger, less-affluent group, mean that some commodities markets are no longer dominated by hedgers. The “other guys” are now running the show.  And their recent behavior in silver is, to my eye, anything but stabilizing.

2.  the oil market.  Oil is an extremely economically important commodity.  Demand is highly inflexible.  Supply and demand are finely balanced.  As a result, it’s possible for speculators–whether private individuals, hedge funds or the commodity trading arms of commercial and investment banks–to be only a small fraction of all trading but still exert enough upward pressure on prices to make them, say, 10% higher (or lower) than they otherwise would be.  Prices might be stable in the sense that they don’t fluctuate much.  But a movement of this size means a major redistribution of wealth around the world.  Great for oil-producing countries, not so hot for everyone else.

In these instances, at least, speculators are a destabilizing force.

The recent ad hoc action of commodities exchanges in raising margin requirements appears to have pricked speculative bubbles in a number of commodities.  But I think it would be better for all of us if we had better regulation and a coherent framework for action.