Are Hedge Funds Safe?

Many people now regard hedge funds as an alternative to mutual funds.  Marketed as the “rich man’s mutual fund,” hedge funds are supposed to be safer than mutual funds but with higher returns.  Is it true?

In the past, most hedge funds hedged.  That is, hedge funds positioned themselves so that whether the markets went up or down, they would make small but consistent returns.  One strategy, for example, was to buy stocks, but also buy put options on those stocks in case the market dropped (put options go up in value if stocks drop).  The end result would be a slightly lower return than the general market in boom times, but also a small return in panic times – overall, a small return that is more reliable and steadier than the market.  But that is the past.

These days, virtually all hedge funds make money from extreme leverage – investing with borrowed money.  Using borrowed money and derivatives increases (not decreases) risk, which can lead to both spectacular gains and spectacular losses.

The average life span of a hedge fund is approximately 5 years.  By the five-year point, most hedge funds have either failed (lost most or all of their money), or closed down.

Hedge funds tend to fail most often within the first 30 months of their existence.  After 30 months they are less likely to fail, but more likely to shut down due to mediocre returns.  As a hedge fund investor, you are screwed either way.  If you invest in new hedge funds you risk losing everything; if you invest in an established fund you probably won’t get the returns you are looking for.  Some say that the way to avoid this minor inconvenience is to invest in a "fund of funds": a single fund composed of a number of hedge funds to reduce risk.

The expected annual return on a “fund of funds” is about 7-8% per year (a 9% return on the funds, minus 1-2% management fees), vastly lower than most investors imagine.  For comparison, a typical balanced mutual fund also returns between 7-8% per year.  Some longstanding balanced mutual funds - such as the Fidelity Balanced Fund, available since 1986 - have returned more than 9% annually.

In 2008, Protégé Partners bet Warren Buffett - the most famous investor of all - that hedge funds would outperform the S&P 500 over a 10-year period, as Buffet himself has done.  In the first year of the bet hedge funds vastly outperformed the S&P (dropping only 24% compared the market drop of 37%).  In the following two years the S&P outperformed the hedge funds.  Time will tell the final result.

If you are looking for safe and steady returns, my advice is to forget about hedge funds. Take the easier route: create a balanced portfolio or buy a balanced mutual fund consisting of about 30-40% quality bonds and 60-70% stocks – the time honored strategy for consistent returns with lowered volatility.

If your primary purpose is to show off that you are rich and have money to burn, invest in a hedge fund and tell all your friends.

If you are keen to risk everything to get rick quick, try poker.

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"We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed."

Burton Malkiel and Atanu Saha

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See also:
Hedge Funds: Risk and Return (the pdf presentation)

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Four Classic Hedges

"Hedge your bets," say the wise.

In the beginning, "hedge funds" actually hedged, meaning that they would make money in both rising or falling markets. Nowadays, the "hedge" in "hedge fund" has lost all meaning. Hedge funds simply invest in risky investments and/or use leverage (borrowed money). Most hedge funds these days do not hedge at all.

So what does it mean, exactly? What is hedging?

Hedging, in simple terms, is a method for taking precautions against financial risk. The goal of hedging is not to make money; rather, it is to prevent losing money.

As an example, if you are worried about a stock market crash, you can buy put options against the stock market, which gain in value if the market drops. Of course, if the stock market goes up, the value of your put options goes down – and the outcome is neutral. If you are a baker and are worried about the rising cost of grain, you can buy wheat futures that gain in value if the price of grain increases. If the price of grain declines, you will lose money on your wheat futures, but also pay less for the wheat you need – again, a neutral outcome.

The financially sophisticated investor has almost unlimited choices for hedging. But, this article is not about these sophisticated hedging choices. It is about simple hedging for the layman.

Hedge #1, Insurance
Say, for example, that you are a married father of two. If you were to pass away, your spouse would be left with the mortgage payments, the costs of raising two children, etc. Therefore, the wise person buys life insurance. If you pass away, your income to the family is gone forever; however, the life insurance pays off the mortgage, with hopefully enough money left over to see the children through college. Thus, life insurance is your “hedge” against possible financial ruin caused by your premature death. Virtually everyone should have life insurance, disability insurance, home insurance, and home content insurance (the building and its contents are usually insured separately). The goal of insurance is not to have so much as to guard against any possible occurrence – it is to buy just enough to prevent extreme financial hardship.

Hedge #2, Gas and Oil
If you drive, consider buying stocks of a large oil company, or an energy mutual fund. As the price of oil (and gasoline) goes up, you can be compensated by an increase in the value of your oil company stock, and also an increase in the amount of dividends it pays you. If the price of oil goes down, your oil stock may decline in value, but so will the price you pay at the pump – this is classic hedging.

Hedge #3, Real Estate (for current non-owners)
If you rent, consider buying a real estate investment trust (REIT), a form of stock market real estate investment. If real estate values increase (along with your rent), the income provided by the REIT will also increase. If real estate values decline, your rent will likely not decline (unless you change buildings), but it won’t go up, either – a 3/4 hedge.

Hedge #4, Household Energy
Almost everyone pays for electricity and heating supplied by a utility company. Utility companies are not only some of the safest investments around, but they also pay regular dividends. The more money they make, the larger the dividends. Utilities can be bought through utility ETFs or utility mutual funds.

The first hedge (insurance) can save you from ruin and protect your family. The final three are long-term inflation killers. Together, and for a minimal outlay of cash, they protect you from both unforeseen circumstances and unexpected costs.
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"(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

Warren Buffett

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Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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Canada’s Banking Albatross

And How to Benefit from it.



Deathly afraid to enter the stock market, Canadian retail investors are keeping their money in low-yielding GICs and bond funds - if they are investing at all. Mortgage and refinance business has collapsed. The self-employed have entrenched. Business is slow.

With mortgages newly dead and rigor mortis setting in on investing, there is nothing to sustain the currently high stock prices of Canadian banks. As an investor, what can you do to protect yourself, and perhaps make some money in the process? The Frost Report states the case in black and white.

First off, sell your Canadian bank stocks, as well as your Canadian dividend mutual funds (which usually contain 50% bank stocks). In order for stocks to drop, banks don’t need to have a disastrous quarter; they just need to have a quarter that is less spectacular than the last one.

Secondly, sell your Canadian REITs (Real Estate Investment/Income Trusts). There is no point holding on to REITs to generate income when you know that income from real estate will soon drop, and the price of REITs along with it.

Thirdly, buy distant at-the-money put options on Canadian banks, so that you can make a profit on the coming stock price decline. If you don’t know what an at-the-money put option is or how it works, completely ignore this piece of advice, for now is not the time to be learning.

Alternatively, you can buy Inverse financial ETFs, such as the Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF 2X, (symbol HFD). Again, if you just read this description and have no idea what any of it means, don’t even consider buying HFD. For those who understand, read the full prospectus.

Lastly, Canadians should start paying down debts and building cash reserves. While everyone else is experiencing a crisis, you can be comfortable. Cash gives you a sense of control & security, and, when things start to pick up again (which they always do), you can take advantage of the bargains that will be everywhere.

The Bank of Canada shot the albatross with its low interest rates months ago, and for a while the results looked good. Now, however, the storm is approaching. As with any other impending disaster, preparation is crucial.
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Bank of Montreal reports Tuesday Aug 24th. Analysts expect third-quarter share profit of $1.21, up from $1.05.

Canadian Imperial Bank of Commerce reports Wednesday Aug 25th. Analysts expect third-quarter share profit of $1.53, up from $1.36.

Royal Bank of Canada reports Thursday Aug 26th. Analysts expect third-quarter share profit of $1.02, down from $1.21.
National Bank of Canada also reports Thursday Aug 26th. A third-quarter share profit of $1.52 is expected, down from $1.79.

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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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“Instead of the cross, the albatross / About my neck was hung”

The Rime of the Ancyent Marinere, Samuel Taylor Coleridge.
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Power of the VIX

In recent days, newscasters been talking a lot about the VIX – commonly known as the “fear index,” and as an important gauge of investor sentiment.

But, just how well does the VIX measure investor sentiment? More importantly, what relevance does it have to investors? We explore these things and more...

Part 1 - What is the VIX?

The CBOE Volatility Index, or VIX, is a measure of the short-term expected volatility of the S&P 500 stock index. In simple terms, the VIX measures the likelihood that stocks of America’s largest companies will go up and down in value in the near future. The higher the VIX, the more likely it is that stock prices will fluctuate.

Part 2 - Is the VIX a good measure of investor sentiment or fear?

Mostly yes.

Using volatility to measure fear is one of those idiotic things that result when mathematicians attempt to measure human psychology. They do this by creating a model that is relevant most of the time, and assume that it is relevant all of the time.

The VIX makes the grossly inaccurate assumption, common in investing circles, that “volatility” and “risk” are the same. If you ask an average person what they are afraid of, they will not tell you that they are afraid their stocks will go up and down. What they are afraid of is that their stocks will go down and never come back up; that is, they are afraid of a permanent loss of capital.

Having said all that, investors often forget their beliefs and flip out when stocks temporarily drop in value. For practical purposes then, it can be said that while the VIX doesn’t measure what investors are truly afraid of, it does a reasonable job of measuring what they actually react to.

Part 3 - Does the VIX anticipate the future?

While some claim that the VIX anticipates the future, what it actually measures is today’s expectations of the future: so really, it measures the present. Expectations of the future change daily, and so does the VIX.

Part 4 – Is the VIX useful to options and futures users?

If you trade options or futures, it is vital to know the level of the VIX. Options that are far out-of-the-money increase in value only when the underlying stock gets close to the strike price. If volatility is high, the likelihood that your strike price will be reached is also higher. Thus, volatility tends to increase the price of options and futures.

A perfect example of the importance of the VIX occurred last March with UYG (a U.S. financials exchange traded fund), where I made one of the biggest investing mistakes of my life. U.S. financials had just hit a new low and everyone was talking about the end of capitalism, so I knew that financials would soon be going up. To capitalize on this, I bought UYG call options with a strike price of $40, at a time when the price of UYG was $15. And I waited.


Even as UYG climbed from $15 to $35, my call options hardly increased in value at all. The reason? Although the ETF was growing closer and closer to the strike price, the VIX was declining at the same time. My option prices hardly moved, and didn’t substantially increase in value until they hit the strike price. It is an important lesson to all those who would buy options during a time of market turmoil: be aware that during times of large market fluctuations, you will be paying a premium for your options. I would have been better off buying at-the-money options or UYG itself. It was a lost opportunity of regrettable magnitude.

Part 5 - Can the VIX be used to hedge my portfolio?

For those who run their own portfolios like a hedge fund, the VIX is tradable under the symbol “VIX,” and has a negative correlation to equities of about -.80. Reread that last line in case you missed it. VIX or VIX call options can therefore be bought in anticipation of disaster as an excellent hedging tool.

Conclusion

The VIX is vitally important if you buy options or futures, important if you want to hedge your portfolio, and useful if you want to put a number to how much gray hair you just got by watching CNBC. As a measure of investor psychology and market sentiment, however, the VIX has little predictive value: it mostly measures what just happened.
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Note to Journalists reading this blog: Please do me a favor and stop printing the headline, "VIX jumps as stocks fall." The VIX will always jump as stocks fall, since it is part of the calculation. It's like reporting, "Body falls as man jumps out window."
Thank you.

Gold, Finger

Nothing excites people like gold. It is malleable, shiny, never loses its luster, and looks great around a girl’s neck. It is the stuff of legend, where a new discovery can make a man rich overnight. Gold is now at record prices, and the airwaves are inundated with ads to buy gold, sell gold, and invest in gold. What do you get when you combine beauty, excitement, and instant riches? Why, a great opportunity to scam investors, of course.

The typical gold mining scam follows a theme with common elements. The first of these is a great story. Maybe the speculative property is an “overlooked” piece of land next to one owned by a large mining firm. Maybe the owner went bankrupt and had to sell it on the cheap, regardless of its true value. Maybe the story combines a bit of everything.

I attended a seminar of a TMX-venture listed company a couple of years ago that nicely illustrates the “story” portion of a gold venture. First, the meeting place itself. The conference room was supplied with boxes covered in gold foil (each of which, I was told, represented one metric tonne). On the tables were gold vases and gold foil chocolate bars on gold tablecloths. But aside from flair, this presentation had a great story.

As I soon learned in a video, an old prospector (we’ll call him “Yukon Bob”) had a gold mine. The mine was so successful that he made a living at it using only a pick, shovel, and some occasional dynamite. It was this dynamite that proved his undoing. Yukon Bob’s beloved mine collapsed upon him, killing him instantly. That was about a hundred years ago. The family kept the property, but did not mine it in memory of poor Yukon Bob. Our heroic CEO convinced the family to sell this accursed mine to him for a small sum, just to be rid of it. Great story.

After hearing the tale, I perhaps didn’t look as excited as I might. The CEO noticed this, and immediately sent over a honey trap. Sitting uncomfortably close for a room full of people, the lovely lady asked me what I do for a living. Upon saying, “banker,” I thought I could see drool form at the edges of her mouth.

The other part of their story, which is typical of gold-mining presentations, is the quality of management. Having nothing but a hunk of land and an office somewhere, the company will tell you how management is “well respected” in the industry, and has “100 years” of experience between them.

A truly really great opportunity (you will hear) is when the company has not yet gone public. They will hint that if you invest now, the eventual IPO will make you rich whether the company finds gold or not. Not mentioned is that in the meantime, the CEO and directors will pay themselves nice six-figure salaries using your money until, hopefully, the company goes public as planned. At the peak of the hype, the owners will sell most of their shares, leaving penny stocks that will eventually get bought out by still more promoters, at which point the company’s name will change. This is why venture companies often have press releases for names that read like a play-by-play of what is hot in the market; for example, “Super Wind Alternative Energy, formerly known as Capsule Biomedical, formerly known as BuyIntoIt.com, has changed its name to Gold Sierra Cortez Inc.”

Then there are companies that tell you the truth, but neglect to mention the downside risks. Take for instance, a company that made a great gold discovery in Peru. The core samples showed excellent potential. The mineralized area was close to the surface, in rock that was easy to mine. All great so far. What the promoters neglected to mention was that the property is commercially inaccessible except by helicopter, that local prospectors frequently get kidnapped and held for ransom, and, oh yes, the small matter of the thousands of land mines.

Of course, some companies actually do search for gold, and some even build mines and strike it rich: probabilities, however, are not on your side.

The “golden rules” (pun intended) of investing in venture mining companies are as follows: first, if you want to invest your money, choose companies that are either in the process of building a mine or where production has already started – this alone with weed out the 95% of discoveries that never pass the feasibility stage; this should be the start of your research, not the end. If you want to speculate, there are almost no rules save one: don’t commit a penny more than you don’t mind losing.

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“Oh, the only gold I know about is the kind you wear... you know, on the third finger of your left hand?” Miss Moneypenny to James Bond, Goldfinger, 1964