Tactical Execution

Hello and welcome to Financial Audio, an information series providing listeners with detailed and tactical guidance on today’s complicated financial world. My name is Patrick and I’m your host. You can find written versions of these podcasts at FinancialAudio.com and I encourage your candid feedback at the same location. Today, we’ll be looking at the recent surge in hedge funds so let’s get started.

Hedge funds are a fascinating development in the financial world during recent years and they’ve made headlines in a variety of different ways. In come cases, they’ve played roles in large company buyouts and takeovers. In other ways, they’ve delivered impressive profits for large investors and in yet other ways, they’ve provided their fund managers with some incredible compensation packages. All three are true.

Hedge funds are different than mutual funds and pension funds because their compensation is performance-driven rather than transaction-driven. In other words, hedge funds take a percentage of the growth. And there’s always been a distinction in the management of money in this regard. Some people who manage money are paid based on transactions or even a salary. Others are paid on their ability to GROW the pool of money. But the latter category requires a significant pool of assets to work. Consider an example.

Let’s say a money manager wants to earn a 20% commission on the growth for a pool of capital under his or her control. Let’s also assume this top performing money manager can easily demand $200K per year to be employed by a mutual fund. Finally, let’s assume this top performing money manager can deliver 25% annual growth on the money being managed. Well, if you do the math, the pool of investment capital would have to be AT LEAST $4MM in order for the money manager to potentially make $200K per year.

Let’s walk through it. A 25% return on $4MM is $1MM and 20% of $1MM is $200K. So assuming those numbers, the money manager would earn the same managing the pool of investment capital directly as he or she would as a fund manager for a mutual fund. Now, of course, these numbers vary widely and I certainly have no idea what they are on average but I know SOME hedge fund managers deliver returns far higher than 25% and I’m sure some of them earn more than 20% on their growth. Even still, it wouldn’t make any sense for a money manager to directly manage a pool of capital smaller than $4MM.

Now, as it turns out, in the United States, the only people who are allowed to invest in hedge funds are “accredited investors” anyways. Accredited investors are those who are worth at least $1MM (NOT including the value of their home) or those who have earned at least $200K per year (or $300K if they’re married) for the past 2 years AND they expect to earn that amount again in the current year. Once achieved, such individuals become registered as accredited investors with the Securities and Exchange Commission and only then can they invest in hedge funds and other private equity investments.

Actually, in 2006, the SEC had a meeting where they proposed expanding those requirements, specifically for hedge fund investments. The proposed new rules would require individuals to meet the existing requirements PLUS have at least $2.5MM in investments at the time the buy-in takes place. And that $2.5MM number would be indexed to inflation, meaning it would grow over time. That would significantly reduce the number of people who qualify. In fact, approximately 8.5% of American households currently qualify for as accredited investors. 8.5%! That’s a lot. But if the new requirements were implemented, that percentage would drop to just 1.3%.

The point is that only a small number of individual investors are even ALLOWED to invest in hedge funds. And the reason is these funds are deemed to involve a level of sophistication and risk the average investor can not reasonably be expected to understand. So, is that fair? Perhaps. Certainly on the average. I mean; there are exceptions to all these generalizations. Like myself, I understand most of this stuff pretty well but I’m certainly not an accredited investor, at least not yet. But on the average, I think it’s a reasonable rule. Believe it or not, they’re trying to protect the average investor from getting screwed. And the problem arises because hedge funds have far more freedom with respect to their investment decisions; more freedom than traditional investment vehicles like mutual funds and pension funds.

I mentioned in a previous chapter that mutual fund managers are bound by their own constitutions. If they’re managing a technology fund, they HAVE to keep all the money invested in technology stocks – even if the technology sector is doing poorly. And in most cases, they have to stay LONG also. In other words, they can’t trade SHORT. They can’t profit on the downside. Long means the investment grows when the underlying value increases. Short means the opposite. Well for most mutual funds, the fund managers are not ALLOWED to trade short – even if the sector is trending downward.

Hedge funds have none of these restrictions. They can pretty much do whatever the like. They can trade long. They can trade short. They can buy and sell options like we discussed last chapter. They can purchase futures contracts or swaps. They can buy entire companies and liquidate them, selling off individual business units to the highest bidder. They can buy a fleet of airplanes and lease them all back to an airline company. They can provide seed money to a starting business or bail out an established business teetering on bankruptcy, paying just pennies on the dollar. Hedge funds can invest their money any place they see potential returns.

Many people think all hedge funds are highly leveraged and volatile, and that’s not actually the case. Indeed, some are. But the origin of the term “hedge fund” was coined because these funds used financial derivatives to hedge against a market downturn. In other words, they employed strategies to REDUCE risk, not increase it. In fact, many hedge funds have ‘consistency of returns’ as their highest objective, not ‘magnitude of returns’. And a lot of these funds do a great job providing respectable returns that bear no direct correlation to the greater market – and that alone can be a highly sought-after investment objective, particularly when you’re dealing with people who have tens of millions of dollars and want to PROTECT it more than grow it.

From the investor perspective, the upside is obvious. In most cases, these funds are managed by talented money managers and often deliver market-beating returns with less overall risk but there are some downsides as well. For starters, the minimum investment can be enormous. It varies from fund to fund but a $100K minimum is not uncommon. They also restrict your ability to liquidate your investment, sometimes to 4 times each year, for example. They may also have a 1-year lockout period when you first invest.

Now, I have to mention that regular investors DO have an opportunity to participate indirectly in the hedge fund phenomenon. Believe it or not, there are actually FUNDS comprised of hedge funds. In other words, you’re not investing in the hedge funds directly but you’re investing in a fund that, in turn, invests in hedge funds. These types of funds are similar to mutual funds in the sense that there are minimum investment requirements to buy in and these minimums can also be relatively high, perhaps as much as $25K or more. But even still, these funds have become more common.

As of this recording, actual hedge funds manage an estimated $1T dollars worth of investment capital and it’s growing by about 20% each year. There are over 8000 active hedge funds and that’s growing as well. Interestingly, the sophisticated investment strategies of some hedge funds yield diminishing returns as the pool of capital grows. So while the pool has to be larger than a certain minimum threshold to make the fund worthwhile, it may also have an upper cap beyond which further investment is be turned away. Overall, the phenomenon is becoming increasingly mainstream and I would expect that to continue.

The whole thing started because certain money managers became really good at identifying profitable investments. Like anything, some people really excel while others are more average. Some people are really good at this and, not surprisingly, they get solicited by wealthy individuals to manage private money directly. Because they’re paid on growth, the financial upside is virtually limitless and the incentives between the investor and the money manager are perfectly congruent. The money manager can make as much money as his or her delivered returns justify.

I recently read an article about the growing division between the rich and the poor. The interesting thing about the article was that it made a distinction between what people THINK this division is and what it ACTUALLY is. In other words, according to this article, most people believe the division between rich and poor is the division between those who make $50K or less and those who make $150K or more when in fact, the true division is between those who earn less than $250K per year and those who earn $1MM or more.

According to this article, most salaries below $250K per year have been growing at similar rates. The average change, one year after another, is pretty consistent for incomes below $250K per year. There’s no growing division in that category. But once you get over $1MM per year, it’s a different story. Those incomes have been growing at a MUCH faster rate than all the others. THAT’S where the growing division lies and it’s getting bigger every year.

I remember in September 2003 when I first heard the Chairman and CEO of the New York Stock Exchange – Richard Grasso – was to receive a cash payout of $140MM, consisting of various compensation arrangements and incentive awards. I almost fainted. $140MM! What the hell happened to allow one person to earn $140MM in a single year?? When did that massive shift take place?? When I was growing up, someone who earned $400K was absolutely at the very top of the income scale. And now, someone can earn 350 times more. How is that possible?

Well, this shift has been taking place ever since the early 80s and it’s only accelerating. The article I read featured a 34-year-old guy living in a steel and glass monstrosity in New York City – a hedge fund manager as it turns out – who earned $100MM in 2005; performance-based compensation. So there you have it. Some young guy earns $100MM in a single year, delivering returns for other wealthy individuals; hardly slave labor. And I’m sure this young guy is extremely good at what he does. I’m sure he’s one of the best. But the tail sheds some light on what’s going on in the hedge fund arena.

There are parallel worlds out there. Don’t ever think otherwise. There’s a world with 3 or 4 zeros and there’s a world with 6 or 7 zeros and the one with 6 or 7 includes two broad camps; those who already have tons of money and those who are the very best at what they do. The investment options available within those circles are different then the ones available to the rest of us and our objective should be to learn as much as we possibly can as quickly as we possibly can and make that jump to the next level. That’s certainly what I’m trying to do and if you’re listening to this, that’s probably what you’re trying to do as well.

By using some of the tools we’ve discussed in this series so far, we can create a hedge fund of our own. We can manage our own money using sophisticated tools and strategies normally reserved for the privileged few. Believe me; most people are not doing anything special with their investment savings. Between the leveraged ETFs and the market timing systems and the optimized technical indicators in automated trading platforms, there’s no reason we can’t generate our own market-beating returns. In the next chapter, we’ll look at the different account classifications and get the process started.

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Again, you can find written versions of these podcasts at FinancialAudio.com and I do offer workshops, seminars and keynote speeches as well as a variety of more advanced information products so please email me at Patrick@FinancialAudio.com for more information. I’m also doing a series on innovative marketing and strategic business positioning. That series is called Tactical Execution and you can find it on iTunes.

Stay tuned. There’s a lot more to come. In the meantime, think big, take action and invest strategically. Bye for now.