The Investor's Consigliere

Paul Krugman and the Future of Value Investing

It's link-to-the-New-York-Times day today.  First up, this fascinating and informative article about dog/human yoga classes.  You can learn how dogs say "Get me out of here" with their faces.

OK, back to the show.  In today's op-ed Paul Krugman picks up from John Hempton and argues for a return to boring finance.  If Krugman and Hempton get their way, I'd think that would be good for value investing.  Broadly speaking, value investors are the low-financiers of Wall Street:

• They tend to invest only in common stocks and avoid more complicated instruments. 
• The less going on on the right side of the balance sheets of the companies they invest in, the better. 
• The less going on on the right side of their own balance sheets, usually limited partnerships, the better.
• Value investors earn their money by identifying securities trading at a discount to intrinsic value, and by benefitting from the compounding that occurs within the businesses in which they invest.  

Value investors face competition for institutional investment dollars from more complicated strategies, the hedge funds and other vehicles that formed the shadow banking system.  This competition relied on complexity and leverage throughout the entire supply chain to generate their returns.  And if Krugman and Hempton get their way, much of that competition is going away, and investing will go "back to business". 

Deutsche Bank Alternative Investment Survey and the Coming Disappearance of Smaller Hedge Funds

According to this article about Deutsche Bank's annual Alternative Investment Survey, over 50% of hedge fund investors will only invest in funds with $1 billion or more in assets under management:

“It means that smaller hedge funds will disappear,” observes Andrew Ang, professor of finance and economics at Columbia University’s business school. Bigger funds are in a better position to have good risk management and can borrow more cheaply, he points out, and are more likely to have a track record.

“There is a magic number where economies of scale really kick in,” Mr. Ang adds. “It’s at about $2 billion to $3 billion. With funds smaller than that, it’s much harder to get significant rewards.”

I disagree with Professor Ang, and with any hedge fund investor that limits itself to $1 billion+ funds.  Taking Professor Ang's points in turn:

1)  Why are big funds in a better position to have good risk management?  What does he mean by good risk management?  If he means larger funds are more able to hire dedicated risk managers, I think that's more likely to provide only the appearance of risk management rather than the reality, as Ken Akoundi explains in detail.  The ultimate guarantor of good risk management is when the investment process is joined at the hip with the risk management process, which is usually truest when one very competent person is doing both. 

2)  Bigger funds can borrow more cheaply than smaller funds.  With "advantages" like this, it seems to me, you don't need disadvantages. 

3)  Bigger funds are more likely to have a track record.  Yes, but fund size is a very lazy heuristic to use to screen for track records.  If you the hedge fund investor wish to confine yourself to funds with longer track records--a legitimate aim--the way to do that is to screen for funds with longer track records, not to use fund size as a proxy for track record. 

4)  Larger hedge funds benefit more from economies of scale.  Yes, but the benefits of these economies of scale accrue to the hedge fund itself, not to the hedge fund investors.  If anything, hedge fund investors face diseconomies of scale as the size of their funds grows:

      a)  As a fund grows its universe of opportunities shrinks.

      b)  If a fund grows by adding new investors, those investors are less likely to share the investing philosophy and expectations of the original partners.

      c)  Because of a) and b), larger funds are more likely to experience unfavorable style drift.

The Name of this Blog

If you are a very wealthy American family, what is the probability that you have lost money and/or sleep in the past year or so from one or more of the following:

1)  A blown-up hedge fund or PE fund owned by one of the large investment banks and marketed to you through its private bank.

2)  Bernard Madoff and his feeder funds.

3)  Stanford Financial.

4)  The UBS offshore tax scandal.

My guess is that if you're in one of the wealthiest households in the country (the top tenth of one percent, i.e. the top 100,000 households), odds are good that you've been touched by at least one of these events.

I started this blog in March of 2008, and one of my biggest decisions was what to call it.  I decided on the term "Consigliere" for several reasons:

1)  It's catchy and Google-friendly.

2)  In Italian the term simply means "one who gives advice," and that's what I intended this blog to do.  I pictured myself as an advisor to a family of means that wished to grow and preserve its wealth by choosing competent outside money managers.  I'm not Italian but using a foreign term had an old-world appeal for me.  "The Hofjude" would have been more accurate--I've got a few of those in my family tree--but I wanted to be ecumenical.  "The Investor's Advisor" would have been boring.

3)  Most of my readers are from the English-speaking countries.  When they think of the term consigliere they don't think "one who gives advice."  Neither do I.  When we think of the term, we of course think of The Godfather, the book and the movies (even the third one).  This is what I really wanted to convey:  The Godfather needed a consigliere because his world was a very dangerous one, and he needed one person whom he could trust completely.  As the last year demonstrates, the investment world of a wealthy family is similarly dangerous.  And it's not just the obvious dangers--taxes, inflation, markets, etc.  Even more dangerous are the enemies who posed as friends, like the list above. 

I was a little embarrassed at the time to use such a pop-culture reference in the name of my blog--I want to be taken seriously after all.  But in hindsight I'm very glad I did.

Money Managers--Worst vs. Best

This article by Allan Sloan of Fortune contains a very interesting chart, based on data from Cambridge Associates.  The chart shows, for eight asset classes, the differences between the top 5th percentile of asset managers, the top 25th percentile, the median, etc for the past ten years.  Here is the chart by itself:

Manager performance by percentiles

(note: David Swensen presents similar data in his book.)

With the customary caveat that it's very difficult to compile accurate return information on alternative money managers, I draw the following implications:

1)  The chart reinforces the observation I've heard before from Michael Moritz of Sequoia among others, that venture capital is a sucker's game unless you can invest in one of the few top firms--the top 24 out of 483 in Cambridge's data.  If you could only manage to invest in a top 25th percentile VC fund, you would have been better off paying way lower fees and taking less risk in any of the four classes of publicly traded securities.

The top firms are the firms that everyone's heard of, whose partners are in the magazines and on Charlie Rose.  They are the rich and get richer, because VC is not just about money, it's also about validation and access to a network.  If you're a startup company, you'd much rather tell the world that you got $10mm from Kleiner Perkins than the same $10mm from your rich uncle.  You'd also much rather have access to Kleiner Perkin's network of other investees and executives.  Startups know this and therefore seek funding from the top VC firms.  VC firms know this and therefore are able to extract very favorable terms on their investments.  I hope to expand on all this in a future post.  For now, check out these  articles about top New York venture capitalist Alan Patricof.  The myth that you can start a Fortune 500 company in your garage may be true, but it's much more difficult to start a VC firm there.

This dynamic is true to a lesser extent in PE.

2)  The eye-popping returns earned in the past ten years by the best PE and real estate funds are almost certainly largely the result of leveraged bets that worked out well.  I doubt the next ten years will be as favorable.

3)  In any asset class, the ability to identify and invest in a top performing money manager rather than an average or poorly-performing one is a valuable skill.  Encouraging news for me I guess.  

4)  If all this data is updated through 12/31/08, it will look a lot different.

 

Sedotta e Abbandonata by Fortune Magazine

Seriously:  Please don't read this Fortune profile of hedge fund manager Thomas Steyer of Farallon.  It's not just the fawning tone: it's the factual misstatements, misdefinitions, and dumbing-down too. 

I used to love Fortune.  I read it as if every word were holy writ.  No more.  From now on I will force myself to skip any money manager profile it runs, unless it's Buffett speaking or writing directly.

Question:   If I want to learn about money managers, what publications should I read?

Investment Advisors

One of my guilty pleasures is the WSJ's Wealth Report blog, written by Robert Frank.  Last weekend he posted on a new survey from Prince & Assoc. that indicates that wealthy investors are angry with their investment advisors. 

As a "boutique" investment advisor I guess I should be encouraged that so many hate the brand-name wealth managers.  On the other hand, I suspect that most wealthy investors will take their money away from hated brand-name X, only to put it with hated brand-name Y--and vice versa.  It's a tough business that way for people like me. 

AIG: Quis Custodiet Ipsos Custodes?

I hate to rant, but it's amazing that an insurance company, an entity charged with protecting others from the consequences of catastrophe, put itself in a position in which a mere downgrade could put it out of business:

The big insurance company, the American International Group, was seeking a $40 billion bridge loan Sunday night from the Federal Reserve, as it faces a potential downgrade from credit ratings agencies that could spell its doom, a person briefed on the matter said.

Ratings agencies threatened to downgrade the insurance giant’s credit rating by Monday morning, allowing counterparties to withdraw capital from their contracts with the company. One person close to the firm said that if such an event occurred, A.I.G. may survive for only 48 hours to 72 hours.

Coming soon:  Why I bought AIG stock and lost a lot of money--and why I sold it in time to avoid losing a lot more money.

Lakshmi Mittal and Money Manager Selection

In my opinion, money manager selection is a specific skill in and of itself, one that's best left to the professionals--that is, me.

The "strong form" of my self-serving theory states that even brilliant businessmen, or even brilliant money managers themselves, are not necessarily brilliant money manager selectors. 

Here is one example: Lakshmi Mittal, a modern Carnegie of the steel industry, lost a lot of money
investing with hedge fund group RAB Capital.

One example does not make a theory, so I'll keep my eye out for others, as well as counterexamples.

Funds of Funds Perversity

From a WSJ article about funds of funds withdrawing money from hedge funds:

"As the hedge fund investor base broadens, hedge fund portfolio management...slips out of the hands of the portfolio managers and into the hands of the investors," wrote Andrew Redleaf, who runs Whitebox Advisors, a Minneapolis hedge fund with about $5 billion under management, in an August client letter. "It is no insult to the investors to say that this worsens performance."

In other words, funds of funds feel justified paying 2 and 20 to hedge funds for their portfolio management brilliance, but their redemption demands effectively take away the hedge funds' ability to do their jobs, thus rendering much of the the 2 and 20 wasted.  Not to worry though, because the funds of funds charge THEIR investors 1 and 10 for their own brilliance, which I guess makes up for it.

Where does that leave the investor in the fund of funds?

Your money manager should think long-term,

but maybe not this long.