Daily Dose of Optimism

Some More Wisdom on "Hedge Funds" that Don't Hedge

Jeff Matthew's piece on Friday, Since When Did "Hedge Funds" Stop Hedging?, reminded me of this piece below by Carlo Cannell, from 1999. Cannell's article is more data-driven, whereas Matthews extrapolated wildly from a conversation he heard at Starbucks (as we bloggers are wont to do). My money says that Matthews is right about as early as Cannell was - which means we've got a great year ahead of us in 2007. Enjoy! - Ed

Bogus hedge funds -- those with no short positions -- will not survive the next market downturn
By J. Carlo Cannell (Red Herring - February 1999)

Phoenician sailors earned a thick slice of the profits from a successful voyage. Today a different risk-taker -- the modern-day hedge fund manager, or "hedgie" -- earns a similar benefit on land.

According to Hedge Fund Research, there are now more than 3,200 hedgies, two-thirds of whom operate in the United States. Estimates of their total capital under management vary from $150 billion to $250 billion.

Hedge funds have multiplied because in a bull market there are few better businesses. Assuming a standard 20 percent profit allocation, for example, a hedge fund general partner who started 1997 with $100 million and matched the S&P 500 would have received a paycheck of more than $6 million the next New Year's Eve -- healthy compensation for matching an index.

The rot in this picture is that most of these hedge funds have little or no short exposure. According to Edward Bowman of Hawthorne, the asset management division of PNC Bank, less than 10 percent of what are today called hedge funds have had any real hedge for the past several years.

This fall provided some vindication for the classic hedge. By early October the Russell 2000 was down more than 20 percent for the year; classic hedge funds were up more than 20 percent, but hedge funds as a whole were down more than 40 percent. During the last "trough" for hedge funds, in the early 1970s, there were fewer than 300 funds managing only a few billion dollars. Going forward, will we see an attrition to this level? Yes.

HEDGE HOGS

When things are good for hedgies, they're really good. Hedgies are the ultimate purchase managers, meeting, playing, and dining with scores of interesting entrepreneurs. Travel and computers are often their biggest expense items.

The hedgie mortality rate, however, is high. A shocking survey published in 1998 by Montgomery Asset Management indicates that the average U.S. investor expects the market to return 34 percent annually over the next ten years. The historical reality is somewhere closer to a 7 percent annual return. Fueled by these inflated expectations, some of the long-only managers masquerading as genuine hedgies will fall into a chasm of margin calls and redemptions like oblivious motorists plummeting off a cliff.

THE LONG AND SHORT OF IT

The Harvard-educated sociologist Alfred Winslow Jones is the father of the true hedge fund. In 1949 he structured a portfolio consisting of common stocks that held both long and short positions at all times -- even in a rising market. Mr. Jones's theory was that one can analyze a particular business even though the stock markets can't be reliably forecast. Buying good, well-respected but neglected companies long while shorting wildly overvalued companies should yield above-average results, he reasoned. By 1966 his fund had nearly doubled the results of the Dreyfus Fund, one of the better-reporting funds of the day. "Hedging," Mr. Jones often said, "is a speculative tool used to conservative ends."

KEEPING THE FAITH

A couple of years ago, as I broiled under the sizzle of short squeezes, a colleague told me that "a hedge fund doesn't have to hedge." What does it mean, then, to manage a hedge fund? Why do I deserve these high fees without undertaking the difficult process of researching short candidates -- a specialized and painstaking task that is usually more than twice as time-consuming as researching long candidates?

It hasn't been easy to be faithful. The longest-running bull market in history has toughened and twisted those true hedge fund managers who have survived it. I know one traditional hedgie who regularly vomited from anxiety during trading. Another has become so skeptical of financial statements that he retains private detectives to verify all information.

Windsurfers on the San Francisco Bay are an apt metaphor for today's proliferating hedgies. Both love to perform acrobatic feats in steady, high summer winds. Those winds, like the last 25 years in the equity market, can seem remarkably predictable. But eventually fluke winds do arrive, and the equipment's lack of keel and buoyancy makes the cold water and strong tides treacherous. The windsurfer's sailboard, like the fake hedge fund, is not an all-season craft.

Thoughts like these make cranks like me feel a little better.

J. Carlo Cannell is the president of Cannell Capital Management, an alternative asset adviser.

US Coinage Hoard/Spend Index: Value of Metal in US Coins

Times were, when kids asked their parents why nickels were called "nickels," they got an answer about how the coin was once made out of the metal nickel, even though they are now made primarily from copper.

You will soon know how old you are when you tell your kids about buying anything with pennies, nickels, quarters, or dimes, and they ask you what the hell a penny, nickel, quarter or dime is, as that type of money won't exist anymore. Then, you will remember that metallic currencies were phased out around 2015 when the price of the metals used to make those coins was prohibitively expensive, and you will kick yourself for being old.

I have written for about the value of the zinc in pennies, and said that the metal in a penny would be worth more than a penny when zinc hit about $3,200 per metric ton. (Turns out that figure wasn't exactly correct - new calculations say, depending on the price of copper, that this would be around $3,900 per metric ton.)

I now realize that we are probably just a few years away from a scenario where the US decides that all money is either paper or electronic. Why would I say this, after calculating for myself the prices of just a few coins?

Take a look at the US Coinage "Hoard/Spend Index" below (a DDO exclusive!). Coins to hoard have a metal value greater than the currency value. Coins to spend have a metal value less than the currency value.

Conclusion? Dimes and quarters still have a few years left as coins. However, pennies and nickels have either outlived their usefulness, or are close to it. - Ed

Note: I am not factoring in the cost of producing the coins, and only have pricing for high grade metals. Metal prices:

Daily Reckoning on Buffett's Charity

I thought this was a nice encapsulation of Buffett's folly:

People occasionally appreciate the truth in the same way they appreciate a good joke. It breaks the monotony. But it is to falsehood that they look to organize their lives. Myths stick to them like burrs to a sweater.

For example: Warren Buffett is giving away his fortune because he doesn’t want to corrupt his own children with too much wealth. “I have given them enough so they can do anything,” he says, “but not enough so they can do nothing.” The Sage of the Plains also strongly supports death duties, because he believes it is better for babes to start out life like worker bees - each one an exact duplicate of the other.

But they don’t even start out equal. Not in America. Not anywhere. Warren Buffett was born into the most privileged ranks of American society - the son of a U.S. congressman. Not everyone is so lucky. Of course, not every scion of a political family makes good. And few make as good as Buffett.

But the man from Omaha can’t exactly claim that he started life on an equal footing with the average man, most of whom never get close enough to a congressman to shoot him, let alone have dinner with him every night.

For some prior thoughts of mine on Buffet's social theorizing, I'd refer you to an earlier post:

Questionable PC Pablum Item #1: Buffett Would Not Have Survived 2,000 Years Ago. Well, there were money changers and tax men in the Bible, and no doubt Mr. Buffett's talents would have been useful there. Perhaps he means 30,000 years ago, but I'm sure he'd be there happily perched in the top of a tree, thinking what fools people are to try and fight tigers and bears when trees were safer, plus they had all this great fruit. This self-effacement is probably a defense against the reciprocal - that Buffet might have some inherited advantages, and keeps him palatable for wide consumption. [...]

Questionable PC Pablum Item #2: Life Outcomes are Luck; Governments are Good at Adjusting for that. Buffett espouses a way of thinking that says in order to understand a society's fairness, you have to imagine life outcomes as the result of a "cosmic lottery" where we all draw tickets that determine what advantages we receive. As a theoretical tool, it isn't bad when you try to explain why the legal system has to be fair, but applied more broadly, it discounts the effect of intelligent observation and lots of action in pursuit of positive outcomes.  For a man who is happy to call people "fools" all day long based on folksy common sense, it seems strange that he would result to the equivalent of "efficient markets theory" to explain social outcomes.

How to Handle a Layoff

Getting laid off is never easy. The least you can do it handle it with aplomb, as does Johnny O'Connor, war hero of the silver screen, in this scene. - Ed

 

Some Friendly Advice for Jeff Skilling

To Jeff Skilling: When you appeal your guilty verdict in the Enron trial, try hiring Unfrozen Caveman Lawyer instead of Daniel Petrocelli. - Ed

 

Larry Ellison's Rising Sun, DDO Boat Porn, and Charlie Munger

I read an article this weekend about Larry Ellison's new yacht, the Rising Sun. Never mind what the article said - check out this boat:

The Rising Sun is the longest yacht in the world - 452 feet, versus Paul Allen's measley 414 foot Octopus yacht. Some key stats:

• Four diesel engines with an output of 50,000 hp
• Cruising speed of 28 knots
• 82 rooms on five stories with a total living area >8,000 square meters

Why a 452 foot yacht, you ask?

Here's Charlie Munger, from an excellent lecture on 24 cognitive biases:

Envy and jealousy made, what, two out of the ten commandments? Those of you who have raised siblings you know about envy, or tried to run a law firm or investment bank or even a faculty? I've heard Warren say a half a dozen times, "It's not greed that drives the world, but envy."

Here again, you go through the psychology survey courses, and you go to the index: envy / jealousy, 1,000-page book, it's blank. There's some blind spots in academia, but envy is an enormously powerful thing, and it operates to a considerable extent on a subconscious level. Anybody who doesn't understand [envy] is taking on defects he shouldn't have.

For some boat porn of Paul Allen's Octopus, see this slideshow. - Ed

Evolution vs. Religion

If people who believe in evolution have a lower birthrate than people who don't, can we then say that people who believe in evolution are less evolutionarily fit?

Just a thought. - Ed

Famous Emails: Jim Rogers vs. HBS MBA Student (Update 1)

I'm reprinting the email chain below between Jim Rogers and a feisty Harvard Business School student for your entertainment. Please note that this email exchange is over two years old, although the issues discussed are still relevant today.

I don't think that Rogers' current straits as pertains to the RIRMF should at all affect how we interpret this exchange (ie, thinking that because of Refco, Rogers' judgment is somehow suspect) - after all, it isn't that his thesis on commodity prices was poor (it was, in fact, excellent and extremely well timed), it was just that his choice of trading counterparties was unfortunate. It's not like many other informed people didn't make similar errors (see: Thomas Lee, McKinsey, etc.).

In re-reading this exchange today, I saw a tiny flash of recognition in Jim's thin skinned response. Slightly edited text is below.  - Ed

----- Original Message -----
From: Dmitry Alimov
To:   HBS Classmates
Sent: Friday, September 12, 2003 11:28 PM

Jim Rogers, a famous international investor and writer attended HBS this Wednesday. In his speech, he badmouthed Russia (in his usual style) and quoted several "facts" that were completely bogus. As you would expect, I could not let him get away with lying about our country and publicly disputed his factual claims. He basically told me I was a moron and left. In response, I sent an email to him with facts and references disputing his claims (sending a copy to my HBS classmates). What ensued is quite amazing - read attached emails. Start with the first email and read from the end (my original email), then read his response and finally my rebuttal in the second email. This will be worth your time I promise. This has already been circulated all over HBS, several other universities and in the investment community in New York. Since this is already in public domain, feel free to forward on.

Dima
__________________________________________________

Dear Mr. Rogers:

I am the “lad” who disputed your factual claims with regard to Russia today. First of all, I would like to thank you for speaking to us at the Harvard Business School.  I think I speak for my fellow HBS students when I say that we enjoyed your original views and interesting stories today. However, I must address the unfortunate reality that your facts about Russia are plain wrong. You made three principal inaccurate claims today - I will deal with all of them in sequence.

Claim #1.  People are leaving Russia

Wrong.  In fact, according to Financial Times, your favorite newspaper, Russia turns out to be the second largest recipient of immigrants after the US (see attached FT article). Oops. While it is true that Russia’s population is declining but the reasons for that have nothing to do with people leaving the country, it is things like low birth rate (only 1.2 per woman), which is an issue that confronts many European states.

Claim #2. Russia’s production of oil is declining, oil companies do not reinvest in production

Wrong and wrong.  Russian oil production has increased for the fifth year in a row (see attached Reuters article), and Russian oil majors are reinvesting in production (many of them have US GAAP accounts audited by Big Four firms you could easily have access to if you chose to look).

Claim #3. Investors are leaving Russia

Wrong again. Equity indexes (US Dollar denominated) are trading around their all time highs (see attached Barrons article), Russian bond yields are at historical lows.  As an experienced investor, surely you will recognize these as pretty convincing signs of investor confidence.

Overall state of the economy

Finally, I would like to quote World Bank’s recent report on Russia:

“The Russian Federation has made remarkable progress in tackling crisis and moving towards sustainable development between 1999 and 2002. With a much more stable political environment, the government has been able to build on experience gained in the 1990s and implement a sound reform agenda, in addition to maintaining macro-economic stability. Since 1999, assisted by high commodity prices, the economy has recorded strong growth, business confidence has revived, and poverty has declined. Russia’s sovereign credit rating has improved, although it has yet to reach investment grade. The speed and extent of recovery has taken most observers by surprise. Between early 1999 and end 2001, GDP grew by 21 percent, inflation fell from 86 percent to 18 percent, the fiscal situation turned around from a deficit of 5 percent of GDP to a surplus of 3 percent of GDP, and barter and arrears largely disappeared.”

Source: http://www.worldbank.org.ru

GDP growth of 21%?

Hardly a picture of total collapse, don’t you think?

Conclusion I believe the facts speak for themselves. I have no time or desire to try to convince you to invest in Russia. However, I do kindly ask you to abstain from spreading inaccurate information.

You are a public figure and many people including future leaders at Harvard Business School listen to you; it would be very unfortunate if they were misled by your inaccurate statements.

Finally, if nothing else, it is not good for your own public image. 

Kind regards,

Dmitry Alimov
CFA MBA Class of 2004
Harvard Business School

P.S. I took the liberty of sending a copy of this email to my fellow students so that we can set the record straight.

----- Original Message -----
From: Jim Rogers
To: Dmitry Alimov

Thank you for coming and for writing.

I rarely suffer fools gladly and even more rarely bother with chauvinistic know nothings, but since you sent this ludicrous canard:

The Daily Reckoning on Vacations, and Value vs. Price

As I sit at home, taking some much needed time off (and blogging up a storm), I came across this old excerpt from a Daily Reckoning column on the various attitudes towards vacations held by Europeans and Americans. Consider Ed to be one American happily at leisure, and hopefully you are (or will be soon) too. - Ed

Europeans take long vacations; Americans do not. The former feel superior because they believe they have a higher quality of life. The latter feel superior because they think work is a virtue in itself. They credit their growing economy and their wealth largely to their willingness to work long hours.

Americans under-price leisure, in our opinion. They have gotten caught in a trap. They spend more - believing that gadgets, gizmos, new autos and larger houses improve their standards of living. Where do they get the money? They have to work longer hours - or borrow it. Either way, they have to work longer hours to keep the cash flowing...and need more gadgets and gizmos to make the extra work seem worth it.

We sat out on the lawn last night and wondered whether it was worth it at all. The gadgets give a kind of instant pleasure. But instant pleasure is all people  have time for. When you have no time, you have to spend money; you cannot grow your own vegetables, or wash your own car, or clean your own house, or fly "stand by" on your vacation, or even sit around and wonder about it all - you're too busy spending money.

If a man earns $25 per hour, you may say that an hour of leisure costs him $25.  But taking out the costs of taxes, transportation and so forth, it probably only "costs" him about $15. Is an hour of leisure worth $15 to him? The poor man can't even ask the question - he has to work to pay the bills. He knows the price of the un-worked hour. What he doesn't know is its value.

Europeans, meanwhile, have decided to "consume" more leisure. They spend less and save more, too. It may not be the most dynamic economic model. But it seems  in much less danger of falling apart.

Another Reason to be Wary of Big Talkers...

February 8, 2004:

WSJ: A year ago, Bret Grebow, a 28-year-old who runs hedge fund HMC International, was taking cheap flights on JetBlue Airways and keeping a lid on his spending. But his fund's investment portfolio surged nearly 40 percent last year, and Grebow says he's confident that the market has regained its footing. So two months ago he bought a new $160,000 Lamborghini Gallardo. He says it was his first "treat" in months.

These days when Grebow and his girlfriend travel between his Highland Beach, Fla., home and his New York office, he charters a catered plane with a bar, paying as much as $10,000 for the three-hour flight. Last weekend he spent more than $12,000 to fly himself and some friends on a Learjet 55 to the Super Bowl.

December 22, 2005:

NY Post: A hedge fund whiz kid who bragged publicly that his fund's sky-high returns let him fly around in private jets and buy a new Lamborghini was in fact running a classic Ponzi scheme, the Securities and Exchange Commission charged yesterday.

Regulators froze the personal assets of Bret Grebow, a trader at HMC International LLC, a Montvale, N.J.-based hedge fund.

Grebow and the fund's portfolio manager, Robert Massimi, were accused of "ongoing fraud" that began in 2001 and ran for more than four years, according to the rare emergency action filing.

In February 2004, Grebow featured prominently in a Wall Street Journal article describing the return of "high living" on Wall Street. ...

According to the SEC, Grebow's deep pockets were lined not with profits from savvy trading, but with his fundholders' investments.

The SEC alleges that the pair stole $5.2 million of the fund's nearly $13 million in assets. Grebow pinched $2 million himself, and Massimi transferred another $1.5 million to an account in his wife's name.  Link