Wall Street WARZONE

Hedge Funds & Private Equity: 10 “Billionaire-Maker” Strategies That Are Sabotaging Main Street America

by Paul B Farrell, JD, PhD
| | 4/19/2010

Hedge funds and private equity firms are called the “Billionaire-Makers Dream Machine.” And it “makes” billionaires because Corporate America hates issuing new securities because they hate dealing with the public and regulators. They hate answering to their own investors and the public. Yes, they just hate the regulatory and media spotlight. So they prefer the mysterious parallel universe of unregulated hedge funds and private equity financing arranged outside the regulated banking system and with leveraged credit derivatives traded off the exchanges, funny money now totally $26 trillion. And they love the big payoffs in equity positions. In today’s era of cheap money, private equity firms soak up so much capital little is left on the table for normal channels. And that’s just fine with these highly secretive 13,000 money managers who control roughly $4 trillion and want to keep it that way.

In the wake of the 2002-2003 Enron and Putnam scandals, Congress passed the Sarbanes-Oxley Law (Sarbox) requiring more disclosure of corporate insider operations to individual investors. That triggered yet another example of the “law of unintended consequences:” The emergence of a huge increase in multi-billion deals by hedge funds and private equity deals who were helping large publicly-owned blue-chips go private and out of the limelight so the SEC and public investor scrutiny, while also substantially reducing the number of IPOs and publicly traded securities available to Main Street investors.

The Economist calls recent private equity-hedge fund actions a historic shift, a “revolution in finance.” But it’s much bigger than even they imagine. This revolution is part of a larger trend of the last decade slowly reversing the early 20th century investor protections that created the SEC, Investment Company Act, AntiTrust Laws, Glass-Steagall Act, and other laws requiring disclosure and oversight. The truth is, Corporate America, Wall Street, banks and fund companies are all working together very hard to dismantle all those laws set up protect Main Street America.

Why so secretive? What are they hiding? They’re losers!

This clandestine conspiracy prefers operating in the shadows, like mysterious aliens in a dark, parallel universe. Private equity and hedge funds are tools for the “already rich”—they make no sense for the vast majority of America’s 95 million investors, zilch, nada, zippo. Why? First off, most Americans have portfolios under $100,000. Hedge funds want you to put up at least $250,000, preferably $2.5 million or more. Private equity and hedge funds are a game for high-rollers and institutions. And even then, studies suggest that only one-in-five high net worth investors have a clue what private equity and hedge funds really do. They think they’re great investments, but that’s an illusion making both rich and average investors vulnerable to fast-talking wealth managers.

There’s an even bigger problem: They’re losers! Studies show they’ve averaged roughly 10% in the recent years. The Hedge Fund Research, Inc. reported the average hedge fund netted only 12.9% after fees in 2006, versus 15% for Vanguard’s S&P 500 index fund. And that’s less than our diversified, “Lazy Portfolios” of no-load index funds with their returns between 14-and-17% in 2006. No wonder that in 2007 Time magazine reported that Ed Thorp, a math teacher, black jack champion, author of Beat The Dealer and founder of the first hedge fund back in 1969, warned that returns will deteriorate as assets and competition increases: “Hedge funds as a group will gradually lose their edge (if they haven’t already) over other asset classes.” Why? Very simple says AIG Global Investments hedge manager Robert Discolo: “Most funds are doing things that can be replicated much cheaper.” But that hasn’t stopped them yet; they continue growing because they’re making their managers megabucks.

Total predators—you can’t beat them and the SEC is clueless

So on one hand, rich-or-average, investors are naïve. On the other, hedge managers got huge incentives to create a mystique of big investor returns. The truth is, their managers normally ask and get 2% fees plus 20% of the profits. They get filthy rich while naïve investors put up all the money and take the big risks.

“They’re total predators,” admits Mad Money’s Jim Cramer, who made hundreds of millions running a hedge fund for 14 years. “What’s important thing is when you’re in that hedge fund mode is to not do anything remotely truthful because the truth is so against your view, that it’s important to create a new truth, to develop a fiction.” And in an interview with TheStreet.com editor Aaron Task, when Cramer was explaining different examples of manipulating the market, he added that it really doesn’t matter because “the SEC never understands this.”

In fact, “if one delves into managers’ motivations for starting a hedge fund and injects them with a truth serum,” says Sam Kirschner and co-authors in The Investor’s Guide to Hedge Funds, “inevitably the discussion will reveal that his type of investment vehicle allows for payment of significant incentive fees based on performance” to the hedge fund’s managers. Translation: greed remains Wall Street’s most powerful aphrodisiac, especially when you read Alpha magazine’s report showing that three hedge managers made over $1 billion each in 2006, and the top-25 averaged $570 million each.

10 strategies make hedge managers super-rich

Nevertheless, let’s say you still want to beat the averages, you believe hedging is the solution. Here’s a test: Pick one of the following 10 key strategies explained in exquisite detail in Kischner’s bible. Assume you had the $1 million to ante up and play the hedging game. Ask yourself: which one do you pick? Why? And how will that strategy help you build retirement wealth? Is this a game you want to play, or would you rather reinvest in a small business or some local real estate? Ask yourself, do you have a clue about what these managers are doing—other than making themselves very rich?

One. “Equity long/short” strategies
Start with the granddaddy: Kirschner says the “progenitor of all hedge funds” goes back to 1949. “The principle was very simple, a portfolio of stocks (longs) would be hedged by a portfolio of shorts.” That’s great if you’re a fulltime player with hundreds of millions at risk and trading for short-term gains. But most small investors are lucky to have 10-20 securities and less than $25,000 to “play” with. They’re not traders. Warning: Small investors have trouble picking one portfolio of “good securities” to start. in for the long-term picking solid “longs.” Now you’re told to pick a second portfolio of “relatively unattractive” stocks to balance the good one? Sure sounds like a dumb strategy for the average Main Street investor. Fugetaboutit.

Two. “Managed futures” strategies
Call a registered Commodities Trading Advisor. Give him a piece of your portfolio and he’ll manage your “assets using commodities, futures and options … taking long and short positions in more than 100 different markets throughout the world.” Confused? You bet, and it gets even more complicated!

Three. “Global macro” strategies
These managers are “students of central government financial policies and of global economic trends.” They’re in major markets all over the world and into “equities, bonds, currencies, and commodities … and often use leverage and derivatives to amplify the impact of market moves.” Highly volatile and risky. Think George Soros, think spooky.

Four. “Merger arbitrage” strategies
High-stakes gambling here: “Profit opportunities hinge on the amount of merger and acquisition activity and the ‘spreads’ available in the market after a deal is announced.” You have to be clairvoyant, tracking them in advance.

Five. “Distressed securities” strategies
Now you’re really in the Twilight Zone: “All of a sudden what’s good is bad and what’s bad is good, if not extremely good,” says Kirschner. These managers look for under-priced values that other pros have overlooked (and Main Street will never see till after the fact).

Six. “Equity market neutral” strategies
The next three “relative value arbitrage” strategies are similar in that they all “make bets on the pricing relationship between two related securities, one believed to be overpriced and the other underpriced.” The first, the “market neutral” strategy is similar to the “equity long short,” except the latter is net long or net short, rather than a neutral balance of positions in overvalued and undervalued securities. And by now most average investors have tuned out!

Seven. “Convertible arbitrage” strategies
These managers spend all day tracking convertible bonds: The most common play is to “go long the bond and hedge the specific risk by shorting the underlying stock.” How do you make money? On the coupons, credit arbitrage, trading and leverage. Warning, this strategy has “produced distinctly subpar returns in recent years.”

Eight. Fixed Income arbitrage strategies
Another “simple” strategy: You “exploit small discrepancies in fixed-income securities,” which one Noble Economist has compared to: “A vacuum sucking up nickels that no one else could see.” Unfortunately, Main Street investors have trouble understanding a “simple concept” like the inverse relationship between fed rates going up and falling bond prices—so how’s he going to pick the best bonds out of a million different bonds in the world?

Nine. Hedge funds of (other) hedge funds
These managers are cowards at heart, hedging their hedges, spreading their risks across several hedge funds, which is both humorous and pathetic. The big “objection to FOFs is invariably the extra layer of expenses,” yet there are 2,000 of these hucksters sucking in clueless investors.

Ten. New hedging strategies
Kirschner says there’s so much money to be made that “both new and existing managers are looking for new and novel ways to invest using the hedge fund structure.” To do so they need a marketing edge that sets them apart in the over-crowded competitive field. He says it could be real estate, insurance, energy, even emissions trading as the new hot plays for hedging.

Selling steak’s sizzle—delivering burnt hamburgers
 
It gets worse: In early 2007 Deutsche Bank announced the results of its Fifth Annual Alternative Investment Survey. They polled over 1000 representatives from almost 700 investors controlling 70% of the world’s hedging assets: Banks, pension funds, blue chips, institutions, governments and the wealthy individuals. One conclusion in Deutsche Bank’s study stands out like a sore thumb: About three of four “investors are finding it more challenging to find managers who satisfy their performance objectives [and] live up to their expectations.” Get it? If 73% of these insiders and professionals cannot find a good deal, do you really think you’ll do any better? Bottom line: Forget all those fancy esoteric losers, invest in a simple well-diversified portfolio of low-cost, no load index funds and you will beat the indexes … and most hedge funds.
 
FirstPubDate: Feb’07

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