Hedge fund phobia

Back in the 1990s, Warren Buffett was asked why he wasn’t investing some of his money in the burgeoning information technology sector. His answer was simple: “Never invest in a business you cannot understand.”

I couldn’t agree more and I have tried to use the same philosophy throughout my career as a writer and investor. There are millions of places where you could put your money. Why would even consider securities that you can’t wrap your mind around?

That’s how I feel about hedge funds. I really can’t come to grips with them. There are two reasons for this. First, they are incredibly opaque. I like securities that are transparent, which means you can easily see what strategies the managers are using and how well they are succeeding (always assuming they are being honest with us, of course).

Second, hedge fund managers can use a wide range of techniques, including selling short, arbitrage, currency speculation, options and futures trading, leveraging, purchase of distressed securities, and more. Some funds focus on just a few of these strategies, others employ the full assortment.

In theory, these techniques are supposed to allow hedge funds to profit en when stock markets are plunging. In some cases, they do. But the reality is that many of these strategies are high-risk in nature and some hedge funds have run into serious problems. The classic case was the collapse of Long-Term Capital Management in 1998 which almost led to a meltdown of the entire U.S. financial system. Only a rescue mission orchestrated by Federal Reserve Board Chairman Alan Greenspan prevented a real disaster. (For all the scary details, read Bob Woodward’s terrific book on Greenspan titled Maestro.)

More recently, we’ve had two nervous experiences with hedge funds right here in Canada. The investigation into Portus by the Ontario Securities Commission continues while in the meantime the assets of the fund remain frozen and investors are left in limbo. Then came the announcement by Montreal-based Norshield that it has suspended redemptions on its hedge funds. The two events are very different in nature but the end result has been to cast a dark shadow over the entire sector.

Geared towards ultra-rich
Hedge funds were originally created for ultra-rich and, supposedly, highly sophisticated investors. Some of their successes were widely reported in the business press and George Soros became something of an icon though the success of his Quantum Fund. That whetted the appetite of less affluent investors, who became more interested in hedge funds during the stock market crash of 2000-2002.

David Brown, the out-going Chairman of the Ontario Securities Commission, spoke to this issue directly in a speech to the Toronto CFA Society. It’s worth quoting his remarks in some detail.

“Investment products are becoming more diverse, more sophisticated, and more complex,” he said. “That’s partly the result of the larger and wider market, demanding that financial products be tailored to individual needs. And of course it is enabled by advanced technology, which makes formerly complex and even unfeasible tasks practical and popular…

“Many investment tools that used to be available only to the very wealthy are now available to average investors; for example, the increasing popularity of alternative investment funds. It’s not that long ago that these were seen as exclusively for institutional investors and high net worth individuals.

“When formerly elite investment instruments become more widely available, the industry has to take a good, hard look at them to determine their suitability for the average investor.”

Referring specifically to the Portus case, he went on: “Approximately $750 million worth of complex products were sold to about 26,000 retail investors. That’s a broad investor base when you consider the nature of the products. And it’s a complex investment. In fact, the complexity of the foreign intermediaries involved in international aspects of the transactions – and the lack of regulatory compliance by Portus – has made it difficult for investigators to understand this product after months of forensic accounting…

“When considering the extent of the distribution of these products, it is important to keep in mind that this was not a case of early investment successes fueling explosive demand. And the promoter was a relatively unknown individual, with no proven track record and no market reputation. So what could have accounted for the firm’s tremendous sales record? Perhaps there is only one particular feature to speak of – high up front fees and trailer fees for referrals. The potential earnings for agents were high…

“There may well be some issues to address in relation to the manufacturers of some of these investment products. But the responsibilities of the intermediaries involved are clear. They are professionals with a duty to understand the products involved and the risks entailed.”

In short, the OSC Chairman is suggesting that the sale of Portus shares appears to have been driven mainly by advisors who were hungry for big commissions and who either did not understand the risk involved or, worse, didn’t care. Either way, it’s a damning indictment.

Exercise caution
This doesn’t mean no one should ever invest in hedge funds. But if you are determined to do so, make sure the fund is subject to regulation by the OSC or SEC. Then see if the fund has a verifiable track record and ask for a copy of the latest annual report. Review it carefully to see what strategies the manager uses. Make sure you understand and are comfortable with them. Then, once you’ve made a decision, stick with it.