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Smart Investing
Weapons of wealth destruction
20 July 2007
Robin Bowerman
The ability of hedge funds to dramatically destroy – rather than create - wealth has been highlighted here and around the world in recent weeks.
The dramatic losses and withdrawal suspensions at US fund manager Bear, Stearns & Co and local operator Basis Capital underline just how seemingly distant things – like concerns about the US subprime mortgage market – can suddenly wipe out investors’ assets. The Bear, Stearns funds reportedly have wiped out about $1.7 billion dollars. In a letter to investors the manager has confirmed that the Enhanced Leverage Fund had been effectively wiped out. Such is the destructive power of borrowing when things go sour.
Now hedge funds are hard animals to categorise at times – some are conservative products run by serious investment professionals looking to manage and offset risk while others are way out on the risk spectrum preferring to operate in a twilight world that involves mysterious computer programs and a good deal of faith.
The question that really arises from these fund losses is not that they happened but rather did the investors who handed over money – and the advisers who recommended the funds – fully understand the risks they were signing up for.
According to Hedge Fund Research in the US hedge funds account for about $1.4 trillion today compared to $240 billion back in 1998 when Long Term Capital Management – a high flying fund in its day – collapsed.
So it is a sector of the industry that has grown strongly – although not always smoothly – and along the way has generated millions of dollars in fees for the managers and promoters of the funds.
These are typically sophisticated and complex products – increasingly so where funds are buying credit derivatives or instruments like “collateralised debt obligations” where effectively mortgages from the sub-prime US housing market have been bundled up by the banks and lending providers and sold on. Good for getting risk off a banks’ balance sheets but not so good for the investors taking the risk.
Paternalism is generally frowned on in a competitive, capitalist market system but these type of events raise the question of whether these type of products ought be on offer to individual investors for relatively small amounts of money.
Large institutions have the resources and expertise to evaluate these type of products – and can afford the risk. But can individual investors really be expected to understand a chain of transactions stretching all the way back to a credit risk in the US housing market?
Given the general concerns about basic levels of financial literacy that seems quite a stretch. Even well-regarded research companies whose job it is to evaluate these type of products gave them positive ratings.
Last December the US regulator the Securities and Exchange Commission (SEC) proposed that a $2.5 million minimum net worth be set for investors in hedge funds – a step aimed at protecting individual investors.
But perhaps the most damning statistic of all comes from a research paper co-authored by Burton G.Malkiel (Princeton University Professor and author of A Random Walk down Wall Street) and Atanu Saha which provides a detailed analysis of hedge fund returns through the 1990s and early 2000s. It highlights the biases in many of the major hedge fund indices and fund performance databases.
If you adjust the annual returns of the Tremont hedge fund index for the biases and costs identified by the Malkiel-Saha study hedge fund index returns decline dramatically – from 11.1% to 2.3%. Returns that fall well short of the performance of a simple portfolio allocated 50 per cent to US shares and bonds.
So US hedge funds between 1994 and 2000 failed to deliver on the most basic of scorecards. Once again it reinforces the virtue of keeping things simple and only investing in things you can understand.
Whatever your views, you can discuss this article - or any of Robin's articles - on our message board Your 2 Cents.
Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia and the former managing editor of Shares and Personal Investor magazines. To receive this column by email each week go to http://www.vanguard.com.au/ and register with smart investing.
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