IFA's Quote of the Week - 13 (Ben Kenobi)



"Who's the bigger fool?
The fool, or the fool who follows him?"

Ben Kenobi, aka Obe Wan Kenobi,
Star Wars Episode IV: A New Hope







Could there be more appropriate quote to summarize a current hedge fund disaster on this April Fool's Day?

It appears that hedge funds investors may suffer from “Long-Term” memory loss. This is the only plausible explanation as to why investors could have lived through the hideous Long-Term Capital Management (LTCM) debacle that lost its investors $4 billion in 1998 and still trust one of its founders with their hard-earned dollars in more hedge funds.

Falling into the “fool me once, shame on you, fool me twice, shame on me” category are those who invested in JWM Partners LLC, knowing that the man at the helm, John Meriwether helped set into motion a global financial crisis when LTCM imploded ten years ago. This second time around provides a sickening sense of déjà vu for the hedge fund world as Meriwether’s latest and largest hedge fund, Relative Value Opportunity Fund, has plunged 28% this year and another broader market fund is down 6%, with “subpar performances last year” for both, according to The Wall Street Journal.   

In a March 27, 2008 Wall Street Journal article titled “A Decade Later, John Meriwether Must Scramble Again”, Jenny Strasburg states “Some investors in the funds are seeking to get their money out. Mr. Meriwether and his colleagues at JWM Partners LLC -- which he launched in 1999 with LTCM alumni -- are trying to reassure investors in the two funds that they have slashed risk and will use their experience to survive this market crisis, preserving about $1.4 billion in assets.” They “will use their experience to survive”? While this statement may have intended to stem the tide of cash running for the door, any investor who has studied the devastation caused at and by LTCM should grab their cash and bolt.  

Back in 1998, the disaster that boiled under the surface at LTCM was left unchecked as the hedge fund enjoyed a steady up-tick in value from its 1994 inception until February 1998. But, when the market, inevitably turned against the hedge fund, massive leverage of 50-1 was revealed (the fund actually borrowed as much as $50 for every $1 invested!) When the blood-letting was done, the fund had hemorrhaged $4 billion in losses, initiating a Wall-Street led bailout and congressional hearings on the dangers of hedge funds.

Meriwether’s latest hedge fund is frighteningly similar to LTCM. According to Strasburg’s article, “Mr. Meriwether's recent troubles partly stem from borrowing. His bond fund had $14.90 in borrowed money for every $1 in equity."

The fund’s performance is also reminiscent of what transpired at LTCM. Take a look at the chart below. Just as with LTCM, the fund showed profits for every year since inception. That is, until its excessive use of leverage caught up with the fund when the market turned and it fell off a ledge. In fact, this is IFA's new term for hedge funds: ledge funds. It is a portmanteau word: (a word that is formed by combining both sounds and meanings from two or more words.)

Leverage Hedge Fund = Ledge Fund

Ten years after the devastation of LTCM, ledge fund managers seem to have remained brazen when it comes to excessive risk and speculation, perhaps expecting the investors are becoming increasingly desensitized to the enormous losses that come with ledge funds. And, why not? When most ledge fund managers get 2% management fees and 20% in performance fees, all of that leverage can fatten up a ledge fund manager’s bank account before the proverbial “you know what” hits the fan and investors limp away, having successfully transferred their wealth to the ledge fund managers.





IFA, along with a consortium of top fee-only financial advisors, has formed an alliance to declare April 1 Index Funds Day to expose the biggest hoax played on investors every day. The active money management "you can beat the market" myth has fooled investors into thinking that money managers can beat the market by forecasting the next news story that will move market prices. The fact is, news is random and cannot be predicted. Likewise, stock price movement is volatile, so picking stocks is largely a matter of luck, and success cannot be sustained over time.

April 1st is the ideal time to draw attention to the differences between active investment management and indexing – to illustrate why it is a fool's game to think you can outperform a market average or index given the unpredictability of news and randomness of stock market prices.

We chose April Fools Day to showcase the foolishness of stock picking over index funds. Decades of research by top academics and Nobel Laureates continue to show that index funds, which are based on efficient market theory, will preserve and enhance an individual's portfolio over the 30 to 50-year average investment lifetime. This is in direct contrast with stock picking which may deliver good returns in the short run but seldom, if ever, over time.

Consider this – research has shown that only 3% of active managers beat an appropriate index over a period of 10 years or more. In fact, Dalbar Research's 2005 Investor Behavior report showed that the average equity investor earned 3.90% annually for the 20-year time period of 1986 through 2005, while the S&P 500 Index delivered 11.93% a year over the same time period. On an inflation adjusted return, the average equity fund investor earned $19,625 on a $100,000 investment made in 1986, while the inflation adjusted return of the S&P 500 would have been $400,938 or 20 times greater The math is there and it is not pretty for active investors.

Efficient market theory coupled with a careful matching of risk capacity and risk exposure, are the keys to successful investing, not speculation. Active investors need to be aware that the expected long-term return on speculation is zero, minus their costs, which include commissions, management fees, margin costs, stock randomness and more.

History has shown that a diversified, tax-managed small-value-tilted portfolio of index funds will have better results than actively managed investments, which are higher risk and deliver lower returns over a portfolio's lifetime. Why is this important? Because close to 90% of individual investors actively manage stocks they pick themselves or they buy mutual funds where stocks are picked for them.

Free market principles are the cornerstone of capitalism. Low-cost globally diversified, risk-appropriate Index Portfolios that are bought and held over time are the best way to capture the returns of global capitalism.