What were you thinking, man

Hindsight is 20/20 vision, but sometimes so is foresight. Investment is simply a numbers game, and the mathematics of compound interest form the foundation of how well the investment performs. Often using the magic of compound interest, and the history of past performance, investment sales people offer the promise of fantastic wealth extrapolating from an often selective history.

Right from the outset the extrapolation is dangerous, but when one takes account of the twenty and twenty fee structures that hedge funds charge, the wealth becomes illusory.

Just playing a little bit the spreadsheet makes this obvious.

if you want to invest in equities, the lowest cost options are index linked funds. These are funds that aren’t managed, but have a portfolio made up of the shares that comprise a specific index, say S&P, or Dow Jones. Usually for an index linked fund the fee runs at 0.2% of the capital invested. A hedge fund would need to outperform the index linked fund after deducting its higher expenses.20121222 FNC667

Plugging the figures into the spreadsheet makes it apparent how difficult that is. If the index is growing at 7%, which over an extended periodis considered to be very good, the hedge fund would need to be earning 12% just to break even with the index linked fund, after expenses.

Playing a little bit more with the numbers, the reality hits home. Taking economic growth of 3% over an extended period, together with the 7% return used earlier, a $100 billion hedge fund, which is small to medium-sized fund in relation to the $2 trillion hedge fund market, after 40 years would be the market. And that’s just assuming that the fund makes returns that break even with an index linked fund. If, after fees, it outperforms the indexed linked funds, as they promise, then it gets to be the market quite a bit sooner.

Perhaps that explains why the hedge fund market is shrinking now, quite rapidly.

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Robbing the rich to give to the richer

Hedge funds have a fee structure called two and twenty. Two percent on the capital invested, and twenty percent on the profits they earn on the assets in which the capital is invested. That means that the returns have to be really good before investors get something themselves.

Many investors are getting a negative return, meaning that they’d be better off with the money stuffed in a mattress. The hedge fund managers are earning fortunes, but it seems that’s still not enough.

Two recent studies have found that the hedge funds are adjusting their figures subsequent to the initial announcement. What at first looks like good accounting is, on closer examination, just another way of gauging from investors.

Some of the prior adjustments are downwards, and that happens a lot in cases where the fund needs to be above its previous highest valuation before performance fees are earned. By reducing earlier figures, the performance target is lower.

The others, not constrained by the performance target, and that revise their figures upwards do so to look better for prospective investors.

The research found that investors who chose an adjustment of the earlier figures as an immediate trigger to sell out of the fund outperformed those who stayed invested by a considerable 3.3%.

And hedge fund managers wonder why their popularity is at an all time low?

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How to make money

How to make money

People in the finance industry are very good at making money – for themselves.

Take a look at the hedge funds, which have a fee structure called “two and twenty”. The two is 2% of the capital invested, and the twenty is 20% of the profits. When one does the maths, it works out that, as a client, it’s quite difficult to make money. If the return on investment is 5%, then the “twenty” gives the hedge fund 1 of the 5% and the “two” gives them another 2 of the five, which is 60% of the return. And it appears that’s a generous example. An insider, with access to the data, calculates that hedge fund managers have kept 84% of the returns, and their clients have got the other 16%. It’s a good deal for the managers.

Of course, it’s the clients who carry all the risk. It’s really not a very good deal for the clients.

Now the funny thing is that it’s not really all that complicated making money on the stock market. One of the best books on the subject “Security Analysis” has been around since 1934. Its most successful proponents is Warren Buffett. Another is Seth Klarman who, like Buffett, has made extraordinary returns for his investors. Klarman is also the author of the book “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” which is now also considered to be an investment classic.

Value investment is the term given to the strategy. Briefly summarized, it’s proponents argue that it makes sense to buy something worth a dollar, if you can find it at 40 cents. They argue that the markets often react emotionally, and then sometimes going against the market makes sense, especially if you know that there is something special about the business. That’s how one finds the dollar for 40 cents.

Let’s use the example of Olympus. Last year there was a lot of bad news about the company. It had been hiding losses, and the share price crashed from a peak of ¥2,773 on 08/1/2011 to a low of ¥424.00 on 11/11/2011.

Olympus makes cameras. The camera market has become quite challenging as phones have captured the point and shoot market. So the market is shrinking to the professionals and dedicated amateurs.

Olympus has just introduced a new model that is changing that market. The new model replaces it’s clunky SLR predecessors. The new camera matched to similarly svelte high quality lenses is going to give the dominant players, Nikon and Canon, something to worry about.

If Olympus was only about cameras, buying their shares would be a great value investment, even with the market as it is. Unfortunately, they make a lot of other products, and not knowing enough about those makes the investment less certain.

Certainly worth investigating though.

Legal note: This article does not constitute financial advice. If you follow any of the suggestions contained herein, losses are for your own account. Profits are to be shared on 1% and 20% basis.

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