Wall Street is abuzz over an open letter from a first-year hedge fund analyst in support of the “Occupy Wall Street” movement. In the letter, the analyst says:
The finance industry is a complete scam, designed to funnel money from the 99% investing public into the hands of the top 0.1%. Sure, some of you will make good money, but statistically, the rest of us will lose, and who is feeding off us? Hedge funds. You have better odds going to a casino and playing slots, the worst-paying game in the house, but still better than the stock market.
You lack information and exposure. You have no idea what is going on in the market besides what you see on the news - while hedge funds have analysts working around the clock and a bunch of service providers who give minute-by-minute analysis of their portfolio opportunities and weaknesses in all markets with exposures to nearly everything.
The worst part by far is that the government "encourages" you to put your money into your 401k through 'tax exemptions', which basically puts your money with the lowest tier of the financial industry - pension funds and retail asset managers. These guys have s**t strategies like long-only or domestic equity (which means they only invest in American stocks), and have nowhere near the capability and reach of hedge funds. These guys are even more likely to lose your money than you are, and even worse is they will take a 2.35% cut while doing so. And you get penalized when you try to take your money out early. How f***ed up is that?
Wow, reading this makes you want to cry. But don’t. This wet-behind-the-ears first-year analyst is clueless if he thinks hedge funds are the path to riches. Has he forgotten what happened to the Nobel Prize winners with unlimited financial resources at Long-Term Capital Management? As I wrote in Future Babble: The Best Experts Know What They Don’t Know, most expert! predict ions are no more accurate than a dart-throwing chimpanzee. Vanguard founder John Bogle is famous for having made the following statement about short-term market timing:
Let me tell you all you need to know about the investment business: Nobody knows nuthin'.
Investing in Hedge Funds is the Real Financial Scam
"Knowing nuthin'" is why hedge funds are under pressure to justify their exorbitant “2-and 20” fee structure by engaging in illegal insider trading. As I wrote in Hedge Funds and Insider Trading: A Bad Deal Just Got Worse, academic studies have shown that hedge funds underperform index funds after fees are taken into account. The most recent example of a hedge-fund screw up is John Paulson, the star of the book entitled The Greatest Trade Ever that chronicles his huge and successful bearish bet in 2007 on subprime home mortgages. In his third-quarter letter to limited partners, Paulson apologizes for his poor performance in much the same way that bond king Bill Gross had to apologize for his fund’s massive underperformance.
Through September, Paulson’s flagship Advantage Fund LP was down 32.57% (page 5) compared to the relatively minor 9.65% decline (dividends reinvested) of the S&P 500 ETF (NYSE: SPY). According to Paulson:
Year to date 2011 performance is the worst in the firm’s 17-year history. We are disappointed and apologize for these results. At the beginning of the year, we positioned our portfolios with net equity exposure appropriate for growth in the U.S. and an orderly resolution of Europe’s sovereign credit issues. However, as the year progressed, our assumptions proved overly optimistic and our net equity exposure was too great.
To improve our ability to assess macro conditions going forward, we are pleased to announce that as of November 1st we have added Dr. Martin Feldstein to our Economic Advisory Board, joining Dr! . Alan G reenspan.
In other words, Paulson’s huge team of analysts and billions of dollars in assets under management did not help him one iota. One of his biggest mistakes was an investment in Chinese timber company Sino-Forest, which turned out to be a fraud. Paulson made the following incredible statement concerning his losses:
As a passive investor in public companies, Paulson has access to the same information that everyone else in the securities markets does. Like other public market investors, we must rely on audits and underwriter due diligence for comfort that financial statements and disclosures are accurate and reflect the true state of affairs at companies with publicly traded securities.
Same information? Why would anyone pay Paulson his high hedge-fund fees for access to the same information available to all? And how does Paulson’s statement square with the kid analyst’s assertion quoted above that hedge funds have much better access to investment information?
The kid analyst is correct that the financial services industry is a “scam,” but he is wrong as to the nature of the scam. The scam isn’t that hedge funds have an insurmountable investment advantage; rather, the scam is paying them high fees as if they actually do have an advantage!
Economists are Useless
Paulson’s “solution” to the fund’s horrible performance this year is to hire Martin Feldstein, who was portrayed in Charles Ferguson’s documentary Inside Job – a much better movie about the financial crisis than Margin Call -- as a bought-and-paid-for shill paid millions of dollars by the financial services industry. Ferguson’s on-film interview with Feldstein includes the following exchange:
Ferguson: You’ve written a very large number of articles, about a very wide array of subjects. You never s! aw fit t o investigate the risks of unregulated credit default swaps?
Feldstein: I never did.
Ferguson: Same question with regard to executive compensation; uh, the regulation of corporate governance; the effect of political contributions -
Feldstein: What, uh, what, uh, w-, I don’t know that I would have anything to add to those discussions.
Not impressive. Equally unimpressive is the economist he will be joining on Paulson’s advisory board: former Fed Chairman Alan Greenspan who presided over the housing bubble. As I wrote in It’s Time to Regulate the Investment Banking Psychopaths, Greenspan stated the following:
Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity are in a state of shocked disbelief. I made a mistake in presuming that . . . they were best capable of protecting their own shareholders and their equity in the firms.
You’re right about that, Alan. Better late than never (but not much better).
Don't Follow John Paulson's Stock Picks
The bottom line is that I see no reason to think that Paulson’s relative performance will be any better in the future than it was in 2011. The best way to make money in the stock market is the old-fashioned way – through patient value investing. As I wrote in How to Beat the Stock Market Without Really Trying, taking advantage of other people’s short-term behavioral biases through “time arbitrage” is the key to long-term investment success. You don’t need billions of dollars or an economics advisory board to outperform the S&P 500. All you need is the temperament to buy cheap stocks and wait. And wait. And wait.
For those of you curious to know what investments Paulson likes right now, his third-quarter letter mentions the following stocks positively:
J ohn Paulson’s Favorite Stocks
Company | Industry |
Capital One Financial (NYSE: COF) | Credit Cards |
JP Morgan (NYSE: JPM) | Money-Center Bank |
Wells Fargo (NYSE: WFC) | Money-Center Bank |
Hartford Financial Services (NYSE: HIG) | Insurance |
AngloGold Ashanti (NYSE: AU) | Gold mining |
NovaGold Resources (AMEX: NG) | Gold mining |
Lundin Mining (Other OTC: LUNMF.PK) | Industrial metals mining |
Keep in mind that Paulson has liked these financial and mining stocks all the way down. Please don’t fall for the scam.
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