Eat the Rich
In the wake of Enron and Global Crossing, following high-profile suits against Merrill Lynch and some of Wall Street’s firms, a little- known secret to investing escapes the average US investor.
Truth is, some of the most profitable investments available to the big players are forbidden to most US investors by law. Ironically, these same investments are available to even the most novice foreign investor. In today’s essay, John Mauldin shows us how all investors are not created equal, and then shows you how to find the funds the wealthy use.
If you went to court, and found out there were two sets of laws, one for you and a much friendlier set for your opponent, you wouldn’t be very happy. We assume we all have the same set of rules. Yet in the investment world, there are in fact two sets of laws: one for the wealthy and one for everyone else.
How would you like access to numerous fixed income funds which averaged 13% a year for the last five years with 90% positive months? What about stock funds which can go both long and short, and have made money every year for the last five years? What about bond arbitrage funds which have averaged 20% per year for many years? Or very stable funds which deliver 7-10% a year?
The laws now in place prevent American citizens from accessing the best opportunities and best managers unless they are worth at least $1,000,000, and in many cases the investor must by law be worth far more in order to simply qualify to access elite money managers.
Ironically, non-US citizens can access many of these same American managers with no net worth requirements. How can a country so obsessed with equal opportunity under the law come to the place where a citizen of Botswana has more access to the best American investment managers than does a resident of Boston?
The prime culprit which wants to keep you on the farm is the Investment Company Institute (ICI). The ICI is the primary mutual fund industry organization. They lobby vigorously to oppose any change to the rules which they think would mean less money for their members, and more opportunities for you besides mutual funds
To understand how we arrived at this situation, we have to start at the beginning… almost 70 years ago. In the aftermath of the stock market crash and a stagnant economy, Congress began to pass a series of laws designed to protect investors from rampant fraud and corruption. The 1933 Securities Act and the later 1940 Investment Company Act, while modified over time, have served as the backbone of our investment laws. In the main, they have done well.
But like many laws, they also had unintended consequences. In my mind the most ironic of consequences is the creation of a multi-tier class of investors based upon wealth. The simple fact is that the wealthier you are, the better and more varied your investment opportunities.
Wealthy Americans are allowed to invest in private offerings and scores of different types of hedge funds. The rich are pouring billions of dollars into these funds. Why? Because they offer the opportunity for excellent risk-adjusted returns with little or no correlation to the stock and bond markets, and because many have a strong track record of delivering stable profits.
I believe that a large majority of investors would at least like the opportunity to look at these funds, and decide for themselves if they are appropriate for their portfolios. However, there are several reasons they can’t.
#1, private offerings must remain private. You cannot read about them in general circulation publications. If you do, then the fund cannot legally take your money. Therefore they work very hard to stay out of the public press. Finding out about these funds usually requires consultants, attending expensive conferences and a lot of networking.
#2, these funds are usually limited to 99 investors. That means if they want to manage $250,000,000, they must get an average of $2,500,000 from each investor. If you are worth $1,000,000, you are what is known as an Accredited Investor. That means if you can find these funds or they can find you, you can investigate them. But for all practical purposes, many of them have minimums which are too high even for multi-millionaires, unless you know how to find alternative ways into these funds.
Yet these same managers have offshore funds available to non-US citizens with minimums as low as $50,000 (and sometimes lower.)
#3, even if a hedge fund manager wanted to open a mutual fund version of his fund to the general public, the mutual fund rules generally prohibit the very things that makes his management style so attractive to high net worth investors.
#4, small investors cannot legally invest in a fund which charges an incentive fee. Typically, hedge funds charge 20% of the profits they generate, which is called an incentive fee. Incentive fees represent the major portion of the income to a good manager. Most funds have a practical limit to the amount of money they can manage. If the fund gets too big, the profits start to fall, and the income of the manager drops. The incentive fee helps assure that funds do not grow too big.
Why do you think wealthy investors pay higher fees for the privilege of investing in hedge funds? The answer is the potential for risk-adjusted returns, pure and simple.
#5, every few years someone proposes some minor changes to the laws governing private offerings. And every few years these proposals die.
For instance, many investors would like to see the 99 limit expanded dramatically. That would allow private funds to lower their minimums, and make these offerings more accessible. But the ICI aggressively opposes such a move. Their fear is that even more money would flow from mutual funds into private offerings. Their message to Congress is that small investors simply cannot be exposed to the risk of these funds. They trot out a few scare stories, along with liberal donations, and nothing gets done.
But the risk argument is a canard. Investors are allowed to invest in futures, where studies show 90% of all investors lose money. You can invest in options, where the vast majority of options expire worthless. You can buy Enron and Global Crossing. You can invest in the IPOs of internet companies. You are allowed to invest in mutual funds which can lose 80% or more of their net worth in a short time, and experience wild swings in value. In my opinion, in apples to apples comparisons with the best hedge funds which invest in the same markets, the best mutual funds offer less potential return with more risk. Let’s not even discuss comparisons with the worst mutual funds.
What should be done?
Congress should change the rules. The incentive fee rule should be thrown out. It is an anachronism that assumes that Nanny Government must protect you from yourself, but which actually means you cannot get to the best managers. You cannot expect good managers to take less money than the market will pay them.
The 99 investor limit must go. Why are 99 millionaires smart enough to examine a private offering but when 101 of them get together, they suddenly become collectively brain dead and need government assistance? This makes no sense, unless you are a mutual fund trying to protect your turf.
A new class of mutual fund needs to be created, one which allows for managers to pursue whatever legal strategy they wish in the pursuit of profits. Doesn’t it make sense to buy long-term bonds, to hedge out the directional interest rate risk, add a little leverage and give investors a AAA bond fund on steroids? Hedging works, and small investors should have access to those who know how to do it profitably.
This would have the added advantage of allowing mutual fund companies a whole new market. Furthermore, while some hedge fund strategies require a great deal of skill and market knowledge, others are fairly straightforward. For those simpler strategies, access to the broad public market would make fees come down for everyone.
Regulation for these funds should be limited to ascertaining that accounting reports are accurate, that independent custodians assure the money is where it is supposed to be and that the strategy the managers say they are pursuing is actually what they do.
It is my belief that over the next few years, most of these suggestions will become law. Logic says they should. And this time, political correctness is on the side of the small guy. The next time you see your congressman, let him know you want to be set free. Tell your broker or advisor you want to see the private offerings to which he has access.
John Mauldin, for The Daily Reckoning
May 29, 2002
P.S. By the way, the vast majority of hedge funds already use independent custodians and auditors, and many actually allow investors to see their portfolios on a far more timely and transparent manner than mutual funds. The wealthy are not stupid. They want to see controls.
John Mauldin is an investment advisor in Texas and an authority on hedge funds. His latest book, "Absolute Returns," on hedge funds and alternative investments, will be out this fall. He also writes The Accredited Investor E-letter, which teaches qualified investors how to find and invest in private offerings
DDGU – dollar down, gold up. Get used to it.
But here at the Daily Reckoning, dear reader, we know that we can’t predict the future. The dollar could go up, for all we know.
Still, we have a modest little insight into the way the world works. The dollar has been going up, more or less, against gold for the last 20 years. Even now that gold and gold shares are outperforming every other investment sector – most people still can’t believe it. The professionals – the people who really know the gold business – have huge short positions against gold. They’re betting that this rally fizzles out like every other one in the last 2 decades.
We suggest you get used to DDGU not because we know what is going to happen…but because after 20 years, the other side of the trade, DUGD, is overbought! There can’t be many people waiting to be convinced that gold is a bad investment, while dollar-based stocks and bonds are good ones. There are millions, on the other hand, who might come to believe the opposite.
In other words, we believe the trend of rising dollars and falling gold prices is not eternal, but cyclical. The results you get in the future, therefore, are not likely to be the ones you got in the past; it all depends on your point of departure. Begin hiking on a mountain peak and you are almost certain to end at a lower altitude.
This is in "key contrast to the Reagan years," writes Paul Krugman in the New York Times, " – the attitude of foreign investors. During the Reagan recovery, overseas investors, who had previously been down on America, flocked in. This time we start from a very different position. Foreigners have been wildly enthusiastic about America for years – an attitude we have come to count on, because we need $1.2 billion in capital inflows every day to cover our foreign-trade deficit. What happens as they lose their enthusiasm?" "One of the largely unreported stories of the last few months…" he continues, "is the precipitous decline of foreign confidence in American leadership and institutions…Foreign purchases of US stocks, foreign acquisitions of US companies, are way off."
"One thing is clear," he concludes. "Those confident declarations, several months ago, that our troubles were over look pretty foolish now."
Over to you, Eric…
Mr. Fry writing from New York…
– Consumers may be confident, but most investors are cowering in a dark corner somewhere. Despite the news of rising consumer confidence, the stock market took another header yesterday. The Dow slipped back below 10,000 by losing 122 points to 9,981. The Nasdaq shed about half a percent to 1,652.
– Gold responded to the stock market sell-off with a sparkling new gain. The yellow metal jumped $3.40 to $324.10, a new 27-month high. Apparently, gold investors do not lack for confidence. They are confident that the world is becoming an increasingly dangerous place for capital, especially capital denominated in dollars.
– The Conference Board’s consumer confidence index rose to 109.8 in May from a revised 108.5 in April. The "present situation" component also rose nicely – from 106.8 to 110.3. "Consumers’ upbeat mood about current business and labor conditions underscores the economy’s continuing recovery," beams a very confident Lynn Franco, director of the board’s consumer research group. Unfortunately, the effervescent mood of consumers hasn’t been much help to the stock market. The more confidence rises, the more stocks fall. "Confidence has been an unreliable predictor of the markets," observes Apogee Research.
– To summarize Apogee’s findings, sometimes consumer confidence and the stock market track together and sometimes they don’t. "It’s nice to see consumers in a good mood, but their moods are usually more reflective of what they’ve read – an upbeat article in The New York Times, for example…than of any actual insight into the economy or the markets," observes Apogee. "So even though, as the Times reported, a confident Colorado woman is splurging on a pedicure with friends, we aren’t ready to endorse Abby Joseph Cohen’s year-end price target for the S&P 500."
– Nor is the economy itself getting much of a pick-me-up from the increasingly confident consumer. There are some bright spots, to be sure. Existing homes jumped a blistering 7 percent in April, according to the National Association of Realtors. And yes, consumers continue to spend just a little bit more each month than they actually earn. The Commerce Department reported yesterday that personal spending rose 0.5 percent in April, even though personal incomes increased only 0.3 percent.
– And yet, despite consumers’ resilient spending – not to mention their much-ballyhooed confidence – there’s plenty of grist for the double-dip recession mill: "Three [hotel] companies, together accounting for some 775,000 rooms worldwide, are simultaneously running free-night giveaways," the Wall Street Journal reports. Starwood Hotels & Resorts, Marriott and Hyatt are each offering free-night specials in an effort to woo clients back to their less-than-full hotels. It seems that business travelers aren’t jetting about the country to ink e-commerce deals as often as they used to. The travails of these three large hotel chains are hardly unique.
– I recently received in the mail a "Free Nights" offer from the Fairmont Hotel group. And two days after that, my mailbox contained no less than four separate offers for some kind of discounted luxury travel – one offered a "Romantic Getaway" to Hawaii; another dangled "The Ultimate, All-Inclusive Cruise" of the Mediterranean; the third promised "VIP Treatment" at selected luxury hotels in Manhattan; and the last one offered a free companion airplane ticket for a five-night luxury hotel stay in Bermuda. Altruism is probably not the motivation behind this barrage of luxury travel bargains.
– Business travel is one very visible casualty of the corporate cost-cutting axe. Ad spending is another. "Despite the boost provided by the Winter Olympics," the New York Times reports, total advertising spending in the U.S. rose a paltry 0.4% in the first quarter…Ad spending on cable TV fell 16% in the quarter to $22.14 billion, while ad expenditures in national newspapers declined 9.3%."
– The advertising industry probably won’t get much help from America’s beleaguered brokerage firms. "Selling Wall Street to the public has become one of the toughest jobs in town," observes the Wall Street Journal. It’s got to be pretty tough for these Wall Street firms to market their sullied reputations to a newly skeptical public.
– In fact, Wall Street firms are reeling on several fronts. As their reputations ebb, so do their revenues. Investment banking business has utterly collapsed. The Wall Street brokerage houses have dismissed more than 40,000 bankers over the last 12 months, according to the International Herald Tribune.
– Furthermore, notes First Union Securities, "Merger and advisory activity, which generates the highest margin for brokers, is currently running at 1994 levels. Preliminary announced values in April of $32 billion are down 49% from last year."
– Maybe there’s some truth to the saying: "What goes around comes around."
*** I asked Porter Stansberry what was going on with his $1,000 recommendation:
"Nothing has changed since our last update," said he… "which we sent on Thursday. When we recommended the stock the price was between $7.04 and $10.00. It is still in that range and is paying a 7% dividend."
Sounds like it might be a good stock to own…too bad it hasn’t been a good stock for speculation…
"Yet…" adds Porter.
*** I rode back from Dulles to Baltimore with a man named Roscoe. He began a pleasant conversation even before I got in the van and didn’t end it until I got out.
*** "I grew up in DC on Rhode Island Avenue," began the white-haired black man. "It’s a terrible neighborhood now, but in the ’50s it wasn’t bad. It was even integrated. Of course, the schools were segregated. But the black schools weren’t so bad. And we had one heck of a football team. We loved to play the white kids…we would just tear them up. Boy, that was fun…"
*** Roscoe reminded your editor of an episode which he would sooner forget, for it was a moment of everlasting shame and regret…and the origins of his contrary thinking.
*** Integration came to the white schools of Southern Maryland in the early ’60s. In particular, it was given flesh at Southern High School, during your editor’s freshman year, in the form of 3 little black girls, of whom the leader was an especially determined and strong- willed 12-year-old named Ruby Smith.
*** People are not bad, dear reader, but they are weak…and when they get in a group they are given to appalling acts of imbecility. Thus, when the black girls walked down the hall on their first day, the white boys would stand back…acting as if the girls were leprous. And on that first day your editor, in the group of delinquents that were his usual chums, did as they did – pressing himself against the corridor walls as the girls passed by.
*** At that very moment, your editor – an altar boy at Christ Church at the time – was overcome with such self- loathing, shame and disgust with himself that he recalls the feeling vividly, even 4 decades later. He can still remember the cold, greenish tile of the hallway and the look of complete contempt on Ruby’s face.
*** After about 3 days, integration had been accomplished. The white boys and black girls became friends…and life went on. And your editor, quite possibly, learned something important. He vowed that henceforth he may be a fool and a lunkhead on occasion…but at least, he would do so on his own.
*** "I’ve got no complaints," Roscoe continued. "I mean, the schools were desegregated the year I left. But I don’t know if they got any better. Besides, I was lucky. I had good teachers…and when I went in the service I had good officers…
*** "I spent 34 months in Vietnam, 1966 to 1969…the worst time to be there. On my first tour I was a machine gunner in a helicopter. Got through without a scratch. So I volunteered for another tour. But this time I was on the ground. Once, in the highlands, we were surrounded and cut off for three days by the North Vietnamese. And they had European advisers with them. But they didn’t know how tough we could be. We broke out after 3 days and practically wiped out the whole group of them. I got shot and spent three months in the hospital.
*** "Oh, let me tell you…it was rough. I had nightmares for years afterwards. But I couldn’t tell anyone about them…because if they thought you had psychological problems they’d push you out…or you wouldn’t get promoted. Even telling you about this is going to give me nightmares again…but what the heck…life goes on…"