June 30, 2005

Market Summary – 2nd Quarter, 2005

This legendary song lyric, penned by Joni Mitchell (do you remember the name of the song?) lamented a change in the culture that took place in postwar America. Materialism had become the accepted mainstream and there was no turning back. Our culture had lost something.

These days, we’re lamenting the apparent loss of something else – reason! What passes as paradise on Wall Street these days is an arcane and often mysterious vehicle known as hedge funds. They’ve popped up like dandelions across the investment landscape.

The rapid growth in popularity of hedge funds seems to be highly correlated to the rugged bear market of the early 2000s. Hedge funds claim to be able to profit from any market environment. This concept dates back to the origin of hedge funds in the late 1940s. Their bets are often contrary to what happens in a standard fund or managed account. Today, with more than 8,000 hedge funds on the market, strategies and favored investment vehicles can vary widely (see more discussion below under Question #1).

As an introduction, this represents much of what we know about hedge funds. But frankly, we’ve got a lot more questions about the value of these funds than facts to support the current rush of money flooding into this marketplace (to the tune of more than $1 trillion today).

Question #1 – What is their strategy for making money?
This is one of the biggest mysteries of hedge funds and why they can’t all be lumped together as an investment style. Some hedge fund promoters suggest that they deserve their own asset category – like stocks, bonds, cash and commodities. But we agree with a veteran money manager recently quoted in Barron’s as saying, “No asset class or investment technique has the birthright of a particular rate of return.” For all their bluster, hedge funds haven’t shown us a consistent track record.

How do they try to make money? Market timing is a big strategy for many. These market geniuses remind us a bit of day traders during that craze in the 1990s – people who figured they could outsmart the market on a day-to-day basis to pick up a quick profit here or there. We’re not fans of market timing, and the most celebrated investors of our times (Warren Buffet, Peter Lynch, et al.) are in the same camp.

If market timing isn’t the preferred approach of a hedge fund manager, he might, instead, focus on arbitrage opportunities, known in the industry as a “non-directional” approach. These managers try to take advantage of temporary anomalies in the pricing of a security to gain a small profit. Unfortunately, this strategy doesn’t always work.

As a recent example, a number of hedge funds shorted General Motors stock (borrowing stock to sell at one price, hoping to buy it back to replace the borrowed shares later at a lower price). At the same time, they were buying GM bonds, betting that if the stock goes down, bonds will increase in value. Unfortunately, a buying binge of GM stock by a major shareholder sent the stock price skyrocketing. Hedge funds who played this two-way bet lost both sides of it in a big way.

Regardless of the preferred technique, we can put this description on hedge funds – they rely on a “black box” approach. They crunch numbers, use mathematical models and quantitative measures to try to gain an edge on the market. We believe a more accurate description would be that they are trying to outsmart some 200 years of investment history in America.

That’s not to say there aren’t bright people with tremendous educations and wonderful, creative ideas who may uncover nifty ways to exploit the markets. But that’s nothing new. The investment world has never had problems attracting the best and the brightest. The problem has been that too often they outsmart even themselves. Look no further than the collapse of Long Term Capital Management in the 1990s, a hedge fund created by Nobel laureates and PhDs, that came perilously close to collapsing our entire financial system when it failed in dramatic fashion.

What’s missing from hedge funds is something we like to see in an investment – INVESTING! Hedge fund strategies appear to be focused on speculation. Investment reason – identifying companies that offer attractive buying opportunities, waiting out challenging periods for long-term rewards, using powers of observation (and patience) to build a solid return – is out the window in favor of a whole new way of trying to make money in the markets. Count us among the skeptics who question whether quantitative measuring sticks and “magic” black boxes can replace qualitative stock analysis.

Question #2 – What track record do they have to sell?
According to Professor D. Quinn Mills of the Harvard Business School, “people who managed funds during the Internet and telecom bubble, and then saw those funds go under, now emerge as managers in hedge funds.” Professor Mills suggests that these managers wouldn’t be able to attract investment dollars using their own reputations, so instead, they turn to banks and brokerage houses as a middleman. The broker brings in the money, convinces the investor that they have carefully and prudently selected a hedge fund manager, then hands the money to some of the very people who burned investors before on Internet stocks. And today, hedge funds are reaching smaller investors, either through their public pension plans or even through direct investments.

The prime appeal of hedge funds seems to be that they are a ticket OUT of the traditional market. If traditional investing were dead, this would make a lot of sense. The limited record of hedge funds shows something different. While they claim to offer an edge in a down stock market, they almost always lag in a good market, and often in a big way. Since the stock market, historically, goes up in 7 or 8 out of every 10 years, hedge funds are at a clear disadvantage.
One more note about comparing the hedge fund index to the S&P 500. The S&P may not be perfect; however, it’s been around for four decades and provides a fair reflection of the broad stock market. On the other hand, hedge funds have a limited history, and it is difficult to know just how well the hedge fund index measures the performance of that market. It should be noted that when a hedge fund fails or closes its performance may not be accurately reflected in the index.

Professor Mills believes we’ll see a repeat of the dot-com bubble within the hedge fund marketplace, but in a much more subtle way. He says money will be made and lost “in arcane positions trading with or against the market, sometimes in so complex a fashion that not even fund managers will know what caused success or failure.” What will matter though, is that investors could get hurt in the process, and not know what hit them.

Question #3 – Who is really making money in hedge funds? (or “Follow the Money.”)
The purported quote from W. Mark Felt (Deep Throat of Watergate fame) of “follow the money” seems particularly appropriate for this discussion. In the highly unregulated world of hedge funds, the question of who is making money is critical.

As you no doubt have gathered from this piece so far, we question whether investors are getting much bang for their hedge fund buck. But there seems to be no question that the managers of hedge funds, especially large hedge funds, are raking it in. According to the Times of London, the 25 highest-paid hedge fund managers averaged compensation of more than $250 million in 2004 – and the average return for hedge funds in 2004 was 8.3%, that is 2.56% below the S&P 500! (according to Fortune magazine).

How is this possible? Investors who want to participate in hedge funds pay the price. First, just to enter the arena, plan on a 1% to 2% annual management fee (and by the way, they are locked in too – many hedge funds require the money stay invested for at least one to three years). If the fund does well, expect to share the wealth with the manager. Many funds are structured with an additional “performance” fee of 20% of all profits (usually above a certain level of return, like 8%). So a $1billion hedge fund with a 2% management fee and the performance bonus could rake in $64 million in a banner year where the fund achieves a 30% return. That’s more than a 6% net management fee!

We also question the low standard used to warrant a share of the profits. An 8% return, a number it appears many funds use, is not very high when you consider the stock market averages a return of around 11% per year (in fact, many hedge funds may use a lower standard before adding the performance fee). Why should a hedge fund manager earn extra rewards for a return that is sub-par compared to historic market averages?

The bonanza doesn’t stop there. Hedge funds also use lots of leverage – borrowing money to buy more of an investment or to buy stock for short selling purposes. Brokerage houses and investment banks can score huge fees by servicing the needs of hedge funds. Fortune magazine (June 13, 2005) reports that Goldman Sachs pulled in nearly $1.3 billion in 2004 from its business servicing hedge funds.

As that same issue of Fortune points out, “Wall Street has no social or economic agenda…other than to make more coin.”

Question #4 – Are hedge funds really reducing risk for investors? (Do they really hedge?)
Because they claim to be able to make money even in down markets (although the evidence to support this claim is questionable), hedge funds are sold as a way to offset portfolio risk.

But from all we can tell, most hedge funds are managed using rather risky strategies such as:
• Leverage – expanding their “bets” on specific, short-term market opportunities by borrowing money, which risks a bigger loss if their bet is wrong.
• Performance incentives – the very fee structure we discussed above means managers are incented to take chances with investors’ money. They don’t offer a money-back guarantee if they fail to perform. But they are willing to roll the dice in order to generate a big gain, which also could generate a big fee.
• Short-term mindset – moving money in and out of investments quickly seems to be a staple of hedge fund strategy. This fails to let time assist in overcoming short-term market swings that might work against their investments.

So forgive us if we’re a bit cynical about hedge funds being a “risk reduction” vehicle. These strategies don’t exactly fit our definition of “low risk.”

Question #5 – Whatever happened to “real investing?”
The sudden clamor for hedge funds makes us wonder just what ever happened to investing? Why are individuals suddenly convinced that good old-fashioned stock picking can’t be successful? And why are they so sold on the idea that in what seems to be a riskier market environment, it makes sense to be more speculative with your money?

After doing this for many years, we’ve determined that one very effective way to cope with market risk is to buy stocks at bargain prices. When done right, value investing eliminates much of the risk of paying too much for a stock. More important, making good stock choices and letting time work for you can result in significant gains – the whole point of investing.

To us, the stock market is a little piece of paradise for the average investor who commits for the long term. We need no more evidence than this statistic uncovered by Ben Stein, the TV game show host, movie star and financial columnist for the New York Times. He points out that if you are investing for at least a ten-year period, the chance of losing money is quite slim. Stein says that the S&P 500 Index hasn’t had a negative return over any 10-year period since 1931. Just look at the ten-year average annual returns for the S&P 500 at the end of each calendar year since 1979!

It is just another reminder that investing is a long-term
proposition, and if you stick to that idea, you are likely
to be rewarded.

For our money, and yours, we find paradise and a sense of reason can be found in the stock market. Let those others hang out in the parking lot waiting to pay an exorbitant fare for a ride in the Big Yellow Taxi (answer to trivia question in first paragraph) of hedge funds. Great companies and great investments are always out there. In fact, much as we lament the rapid rise of hedge funds, we also know that the securities they sell (or sell short) may suffer an unreasonable price loss, creating what we’re always looking for – a quality company that’s a bargain. So maybe we should say thanks. Let’s just hope not too many people take a hit if a hedge fund or two (as was the case with Long Term Capital Management) go down in flames.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.