Why the party endedContinuing with my example, another student sees the buck I pocketed and decides to enter my space. I find out that I can no longer buy that book for $20, as I have a competitor who bought the book for $20.25 and sold it for $20.75 to the student wanting the book. The arbitrage opportunity declined by 50 cents. Since it’s still an attractive investment opportunity, eight other students also compete, and soon the arbitrage opportunity is pretty much gone.
This 10-fold increase in competition is exactly what has happened, with hedge funds growing from $200 billion in 1997 to $2 trillion today.
This presented a dilemma for hedge fund managers, who wanted to make serious money and weren’t satisfied with the paltry 2 percent annual fee. The solution? Take as much risk as possible with their clients’ money. That extra risk entailed investing more in options and futures, which are all zero-sum games and where not a penny in the aggregate had ever been made. These alternative assets had far less to do with investing and were much more similar to betting on a football game.
Why the hangover continues
With most investments, you can take you licks and move on. Not so with hedge funds. I’ve had many clients who thought they could get their money back at any time, until I pointed to page 173 of the prospectus and the section where the fund manager has the right to limit or deny the withdrawal request. In some cases, years later I’m still trying to help clients get their money back from hedge funds. Being ahead of the curve helps, as I was successful in getting clients out of The Endowment Fund sold by brokerage houses before they “gated” withdrawals.
So while hedge funds have been a disaster for most investors, managers are still raking in the fees by limiting withdrawals. In short, these funds are an outstanding gig for the manager but not so good for the investor.
As author and money manager William Bernstein says, “there is no portfolio fairy” willing to magically reward upside and protect downside. Further, he says, “if you are at the poker table wondering who the patsy is, it’s probably you.”
NO ONE can predict the future. There is also no one who can earn equity returns with treasury bill risk. Investors continue to seek out the ‘holy’ grail of investing without success.
Please comment or call to discuss how this affects you and your financial future.