Inequality – in particular the growth of the super-rich – is a topic that should be better understood than it is.
Earlier in the year I reviewed the interesting book Plutocrats – The Rise of the New Global Super Rich by Chrystia Freeland.
If you prefer your knowledge in 15 minute video form rather than 300+ book pages, she offers a reasonably comprehensive summary of her book in this Ted talk from June 2013.
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I’m quick to criticize traditional media when they dumb down, or sex up, or just miss completely on finance topics.
The Wall Street Journal is better than most, but still I find myself shaking my fist at the paper from time to time.
Earlier this week, in anticipation of the relaxation of rules for Hedge Fund advertising – and most importantly, the WSJ’s pole position to attract that advertising – they ran an explanatory article on ‘What is a Hedge Fund?’
Actually, it’s quite good, and accompanied by an audio clip as well. Since the article is behind a pay wall for many, I’ve quoted it here:
Ask 10 investors to define “hedge fund” and you’re likely to get 10 different answers.
The catchall term is used to describe an industry with an estimated $2.4 trillion in assets and an array of portfolios that feature dramatically different investment strategies, tolerance for risk and goals for returns.
“It’s a misguided term that tells you nothing” about the manager’s investment approach, says Jason Gerlach, president of the California Hedge Fund Association and managing director at hedge-fund firm Sunrise Capital Partners LLC in San Diego.
Instead, the term generally refers to the structure of the investment: “It generally means a private investment partnership” instead of, say, a mutual fund, Mr. Gerlach says.
Though long viewed by many as secretive instruments offered only to the extremely wealthy via privileged connections or exclusive websites, hedge funds are about to come out of the closet: An 80-year-old ban on hedge-fund advertising is falling away, and some of these private investment pools are gearing up to launch ad campaigns—likely as early as this month.
Mysterious for a Reason?
Some believe the advertisements will help demystify the strategies used by hedge-fund managers. “Hedge funds are often raked over the coals because they’re mysterious, but they’re mysterious because regulators don’t let them talk,” says Mitch Ackles, president of the Hedge Fund Association and chief executive of Hedge Fund PR LLC, a strategy and marketing company.
Hedge-fund manager John Paulson reaped huge gains betting against subprime mortgages in 2007 and 2008.
The term “hedge fund” was reportedly first used by Alfred Winslow Jones, a sociologist and financial journalist who created an investment partnership in 1952. Mr. Jones used leverage—that is, borrowing—to increase his investment exposure, and sold short what he believed to be overvalued securities in an attempt to “hedge” the market and profit regardless of whether it rose or fell.
Today, hedge funds still generally employ a hedging technique—counterbalancing one investment against another—but even that is not always the case, says Josh Charney, a fund analyst at investment-research firm Morningstar Inc. “That was the first purpose of a hedge fund, to hedge and offer some safety, but over time it has strayed from that original definition,” he says.
But hedge funds still typically have more-flexible investment strategies than mutual funds. They may have higher leverage, for instance, or invest heavily in illiquid holdings such as art, antiques or thinly traded securities.
For these more aggressive tactics, the funds typically charge steeper fees than do mutual funds, generally an asset-management fee of 1% to 2% and a performance fee of 20% of the fund’s profit annually.
In an effort to protect investors with limited means, hedge funds are closed by federal securities law to all but “accredited” investors—which includes individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million excluding their primary residence. In addition, the funds generally require minimum investments of at least $250,000 and limit how frequently investors may withdraw cash.
Hedge Fund Research Inc.’s HFRI Fund Weighted Composite Index, a broad proxy for the hedge-fund universe, gained 3.8% this year through August (net of fees), while the S&P 500 index gained 16.2% with dividends and the Barclays Government/Credit Bond Index shed 3.2% over the same period, according to HFR. For the five years through August, the HFRI Fund Weighted Composite Index gained an annualized 3.4% while the S&P 500 index gained 7.3% with dividends.
Range of Volatility
Investors generally look to the funds to reduce volatility. But prospective investors should understand that just as some hedge-fund strategies may enhance returns, they may also amplify losses, and some strategies are more volatile than others.
“Investors have to judge each fund individually because fund managers may be doing vastly different things,” says Mr. Ackles.
“Relative value” arbitrage strategies account for about 27% of industry assets, according to HFR. Managers of relative-value funds will simultaneously buy markets or investments expected to appreciate, while selling related securities expected to depreciate, seeking to profit from their relative value. That allows the funds to generate returns with little correlation to markets. Such strategies can be executed with convertible bonds, preferred securities, options, warrants and other instruments.
As Hurricane Katrina bore down on the U.S. in the summer of 2005, for example, some hedge-fund managers owned short-term contracts on oil and gas, a bet that prices would rise soon. But they also took bearish positions on longer-dated contracts, a bet that the prices would fall in coming months.
Relative-value arbitrage funds may employ lots of leverage, which can result in big gains or losses. Long-Term Capital Portfolio LP, which famously collapsed in 1998, was a relative-value fund.
This year through July, the HFRI Relative Value (Total) Index has gained about 3.6%, according to HFR.
Then there are event-driven hedge funds, which invest in securities that may be affected by corporate activity such as bankruptcies, mergers, reorganizations and hostile takeovers. Managers of these funds seek to predict the relative movement of the securities involved. A manager may invest, for example, in the stock of a company that is being acquired while also selling short the stock of the acquiring company. Event-driven strategies that focus on companies in financial trouble are often referred to as distressed investing.
Event-driven funds fared well in the first half, partly due to a dynamic merger-and-acquisition and corporate-actions environment, according to HFR. The HFRI Event-Driven (Total) Index gained 6.9% this year through July. Funds using these strategies account for about 26% of industry assets, according to HFR.
Next in size, with about 21% of industry assets, HFR says, are so-called macro strategy hedge funds, which, as their name suggests, invest with a broad outlook that tries to anticipate changes in economic trends and policy decisions.
Some of the funds that use a macro strategy invest in stocks, bonds, currencies and commodities, and may shift their exposure to asset classes and countries rapidly. Such funds often employ leverage and derivatives to enhance the impact of market moves, and their returns may be very volatile as a result.
Global macro investing is one of the best-known hedge-fund strategies, partly because it has been employed by well-known managers such as George Soros and Julian Robertson.
Many macro hedge funds were popular in the 1990s and posted big gains during the 2008 financial crisis. This year through July, the HFRI Macro (Total) Index has slipped 0.95%, according to HFR.
Ms. Maxey is a special writer for The Wall Street Journal in New York. Email her at daisy.maxey@wsj.com.
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Capital One Bank, my business bank since 2004,[1] called me yesterday.
“Great News!” chirped the person who introduced herself as my business account manager, but who I’ve never met, and who has had no previous conversation with me before, ever.
“Ok,” I replied flatly, immediately wary, because banks are not generally in the Great News business, in my experience.
“We’re in the process of switching all of our business customers over to new checking accounts by January 2014, and I thought I’d give you a call to tell you about the two great options you can choose from!”
“Ok.”
“You have previously been in the Completely Free Checking account, but we’re transitioning all of our customers away from that account, and you can choose from either a Cash Back Account, or an Interest Checking Account!”
“Ok. Tell me about the Cash Back Account.”
“Assuming you have a balance of at least $2,000, then for every transaction you make per month, whether a deposit or withdrawal or transfer, we’ll credit you with $0.10!”
“I don’t make many transactions per month, but it sounds nice, what’s the catch?”
“We limit the number of transactions in the Cash Bank Account to 100 per month. If you go over that many, we charge $19.95!”
“Ok. What about the other account?”
“With Interest Checking, if you keep an average balance of at least $10,000 we pay you interest, and you have an unlimited number of transactions. If you have less than a $10,000 balance in the account, we charge $19.95!”
“What kind of interest?”
“Right now we pay 0.2%!”
“Ok.”
“So which one would you like to choose?”
“Well, let me see if I’ve got my math straight here: With the first type of account you give me ‘cash back’ but that is capped at a total of $10 maximum, but above 100 transactions I’m paying $19.95 per month. So I earn an increasing amount up to $10 the more activity I have, but then suddenly I pay $20 just after I qualify for the $10 ‘Cash Back.’ And then with the second type of account, let’s say I keep my $10,000 balance in your account, you will pay me $20 per month on that size balance, but again you get the right to ding me basically that same $20 anytime I dip below $10,000.”
“That’s right! Which one would you like to choose?”
“Well, really, neither.”
Then, the cross sell
The conversation went on from there, and involved her trying to get me to take out a business credit card with Capital One (I don’t need another business credit card) because that could eliminate my fees if I had at least one transaction per month on the card.
Of course I actually do have a business credit card with Capital One, but with a different business entity, but that doesn’t count, because that would involve logic and human decision-making and taking into account a customer’s actual business relationship, which as I’ve written before has absolutely no place in modern banking.
What’s my problem here?
So why did this phone call remind me of why banks suck?
It’s not precisely the dehumanization, the elimination of judgment, that I complained about before.
And I swear it’s not because they want to change me from completely free to charging fees.
Well, it’s partly that, but in a really specific way.
I don’t mind paying some fees, and I do believe banks should charge for their services, one way or another.
No, what really gives me diaper rash in this situation is Capital One’s introduction of an essentially hidden, complicated, and disingenuous pricing scheme.
“Cash Back Checking?”
It’s called “Cash Back Checking” but your number-of-transactions algorithm means I either get a fraction of $10, or I pay $19.95? And the way you charge me month-to-month could toggle back and forth, just like phone plans with a limited number of minutes that suddenly fall over the cliff and get expensive when I go over the limit?
All that means is that I can’t predict what I’m paying for the service on a monthly basis. Meanwhile Capital One has all the information for determining fees. In case I want to inquire, I’m facing long waits in voicemail and call-center hell.
“Interest Checking”
Also, your “Interest Checking” is a joke as well. $20 on a $10K balance, but with the right to charge $20 when the average balance drops? Obviously consistently larger business balances will go to higher interest-bearing accounts, and much more so, when rates actually rise to something meaningful.
It’s the toggling back and forth between “interest” and “fees,” when the interest is hardly significant in the first place, that shows the point here is not a straightforward fee structure, but rather the smoke-and-mirrors of a bait and switch.
So it’s not really the fees that scratches the rash, it’s the opacity.
Opacity is always a banker’s friend. Opacity is also a reason to end a friendship.
Please also see related post: Why You Hate Your Bank
and Maybe there’s hope, The kitty called me back
[1] Actually I signed up with North Fork Bank, a business-oriented bank built up on Long Island, then making an aggressive push into Manhattan at the time I started my business. Their Free Business Checking was of course why I went with them in 2004. But in an era of constant bank mergers, it makes no sense to expect a bank to maintain the same deal over the years, or to expect any personnel to stay in place. North Fork fatefully bought Alt-A giant Greenpoint Mortgage in 2005 (seemed like a good idea at the time!), then got bought by Capital One in 2006. Capital One announced the elimination of Alt-A lending in August 2007 and took a massive hit on that investment. Ah, shareholder-wealth destruction via bank merger…good times!
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The Millionaire Mind by Thomas J. Stanley did not win the acclaim of its predecessor The Millionaire Next Door, but I consider it an equally valuable resource for personal financial education.
As with The Millionaire Next Door, which I reviewed earlier, Stanley conducts a type of ethnographic study of multi-millionaires, surveying them on attitudes, life experience, purchasing behavior, and habits of mind.1
A number of these insights stuck with me throughout the years, a good indication to me that Stanley’s got quite a bit to offer.
Small Business Owners
Many millionaires own their own businesses, and they typically either started it or continued a family-owned enterprise. Further, their businesses often lack the prestige of professions celebrated in the popular press.
Stanley takes pains, for example, to highlight the story of Mr. Richard, a junk-yard operator worth over $10 million, with an annual salary above $700,000. Avoiding the prestige professions is not only an accident, Stanley argues, but a strategy to avoid competing with other very smart people. Stanley returns frequently to this theme of wealth accumulation through entrepreneurship, which, of course, I believe in myself.
Not the best students
Interestingly, Stanley claims that his cohort of millionaires tends to be made up of people who received Bs and Cs in high school and college – but who found a vocation, after their school years ended, at which they excelled.
The traditional A students, he points out, tend to seek out competitive, prestigious professions such as law and medicine that require a flawless educational transcript. Many lawyers and doctors earn generous salaries but frequently do not join the ranks of multi-millionaires. There can be a huge difference at the high end of wealth creation between a good salary and ownership of a profitable business.
Cheap Cheap Cheap
Stanley’s favorite theme – sounded throughout The Millionaire Next Door as well as The Millionaire Mind, is that wealthy people are frugal.
This makes sense, as of course the less you pay for everything – from your car to your morning coffee – the more you have left over in net worth. On the other hand, much of the Advertising Infotainment Industrial Complex is dedicated to convincing us that the more you have, the more you need to show what you have, through a fancy watch2 or a second home, or by hiring Rod Stewart for your 60th Birthday.
Other insights
Stanley describes other characteristics of multi-millionaires. They tend to be long-term married (and only once), they tend to have iconoclastic ideas (somewhat), they show courage and respond well to setbacks, they seize business opportunities that others did not see, and they tend to reduce their borrowing once they’ve achieved some financial success.
All sounds like reasonable advice to me.
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