Investors disillusioned, but not defrauded

A friend who is a securities lawyer writes:

I wanted to respond to your post and Jim Manzi's about the burgeoning "hedge funds are nothing more than a giant odds-playing scam" meme. Regardless of your views on the EMH, that meme is completely ignorant of the way the legal and market regimes governing hedge funds actually work. Maybe their investment ideas don't work as well as they'd like, but (a) investors generally know what the funds' investment strategies are, and (b) they think they work. Maybe delusions, but few scams.

Comments

So, your friend works for a firm with hedge fund clients. And I would expect a Milberg LLP securities lawyer (or a certain former-NY AG) to say the exact opposite. Of course, the reality is closer to your friends view in almost all cases (and undoubtedly for all of his/her firm's clients), but the blanket statement simply isn't true.

And "investors generally know what the funds' investment strategies are" is rather imprecise; it's more like "investors [should be expected to] know what the funds' investment strategies generally are".

Posted by zaleriana | March 21, 2008 2:15 PM

Y'all need to check this brilliant piece for the full story:

http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&skipauth=true&pli=1

where the only missing piece is an understanding of "mark to market" accounting and how it exaggerates swings. You can get that here:

http://s.wsj.net/public/resources/documents/WSJ_oaktreememo0803.pdf

and this one:

http://online.wsj.com/article/SB120468197325912303.html?mod=relevancy

this last one may require subscription to WSJ. It's from 5 March, 2008, entitled "Is fair-value accounting always fair?", by David Reilly.

Then ponder what you think the yahoos on the Hill understand of all this. And be afraid, very afraid.

Posted by Carl the Sailorman | March 21, 2008 3:28 PM

Here's the way to make money:

Take gains from success, but give risks to others. In real estate one can do the Trump method... form some kind of limited liability firm for a project. Using as little of your own money as possible, borrow millions from banks with that firm to . If the project is a success, profit and write a book. If the project fails, have the firm declare bankruptcy, let the bankers recoup pennies on the dollar and move to the next project.

For JP Morgan... realize Bear's assets are worth more than the stock price, get the Fed to take responsibility for its liabilities... profit.

Posted by Nelson | March 21, 2008 4:37 PM

I used to invest in a few hedge funds. I realized the same thing that you're posting about a few years ago.

That said, I don't think they're a scam. Most of the people who work at them don't really understand how they're playing with risk. They are deluded (which is easy when you make so much money from having an incorrect model of the world), not scammers.

Still, the sooner that more LPs understand what's going on, the sooner they'll stop investing. So, it's a good thing to explain to people...

Posted by Former LP | March 21, 2008 5:11 PM

You're first impression is correct. Most hedge fund investors have no idea about the strategies hedge funds employ. Quite a few hedge fund managers manage several funds that take bets opposite each other. Fund A bets on an industry/stock/market going up, Fund B bets on the same going down. Usually, one wins and one loses. The losing fund gets wrapped up at the end of a certain period -- sorry, investors, but we are closing this fund because of poor performance, but thank you very much for your fees. The other fund remains and, miraculously, has an amazing performance. In fact, since that's the only remaining fund, when new investors ask about the manager's performance, guess which data is provided? (Because, after all, there are no government disclosure requirements for hedge funds...) The best way to make money on a hedge fund is to manage one. In most other cases, you'd do better with a cheap index fund.

Posted by Epstein's Mother | March 23, 2008 4:51 PM

Quite a few hedge fund managers manage several funds that take bets opposite each other. ... In fact, since that's the only remaining fund, when new investors ask about the manager's performance, guess which data is provided?

Do you have specific examples of this? There aren't all that many institutional buyers, compared to the retail market, and a manager's reputation is all he has, so I'm skeptical that this is common.

(Because, after all, there are no government disclosure requirements for hedge funds...)

There are no form requirements, but there are certainly disclosure requirements. You may be familiar with this one:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Posted by AT | March 23, 2008 9:15 PM