On top of that, they have to constantly battle family disputes and the set of very unique challenges that comes along when one has too much money. It can consume their private lives with fatal consequences.
It is important to note that very few UHNWIs have become rich through financial market investing (maybe hedge fund owners). Almost all of them acquired their wealth by having established ownership in operating businesses or through their inheritance. From my personal network, I have rarely met or heard of UHNWI clients amassing new fortunes with stock or fund investing. On the contrary, like anybody else, they have been losing money. It seems that even with preferential treatment by the elite, private banking professionals investment success is not guaranteed.
This begs the question—wouldn’t it be easier to focus on the primary money-makers and businesses, and keep a simple, conservative cash and investment strategy?
INSTITUTIONAL INVESTORS: THE ELEPHANTS
The largest investors in town regarding assets under management (AUM) are institutional investors. They include pension, endowment, and insurance funds. The biggest pension fund in the world is the Government Pension Investment Fund (GPIF) of Japan that has about $1.1 trillion assets under management and employs more than thirty third-party asset managers. Only a few years ago, the GPIF decided to diversify parts of its holdings into international bonds and global equities, away from its ultra-conservative policy of only investing in domestic government bonds and other fixed income securities.
These types of investors are big and slow-moving. They have many institutional constraints and underlie strict regulation and supervision. They are managed by investment committees and have strict fiduciary duties towards their investors. They have a few structural disadvantages over individual investors or hedge funds, but can move markets and are a force to be reckoned with. They are the elephants at any party. But due to their size and, at times, inefficient management structures, money gets lost through attrition, such as overpriced third-party consultancies, investment management, incompetence in the face of market crisis, and self-aggrandizing operators at the top.
ASSET MANAGERS: A BUSINESS MADE IN HEAVEN
Because institutional investor’s assets under management (AUM) are so large, they delegate some, if not most, of their investment management responsibilities to third-party asset managers. Famous asset managers include PIMCO, Wellington, Janus Capital, and BlackRock. They are the second-largest group of institutional players on Wall Street that readers will either compete with or join as customers.
Asset managers manage a broad range of separate funds that include mutual funds, exchange-traded funds, index funds and even hedge funds—anything that can generate a fee and increase their own assets under management. They are mostly well-run businesses, and their business is size. Whether actively or passively managed, they are paid based on how much money they manage, rather than on how well they manage it. This especially counts for index funds.
Friends with Benefits
The vast majority of fund managers disappoint in generating performance for clients; index fund managers don’t even try. Their funds look alike and follow the same standard formulas of modern portfolio management. Active managers still believe that they can outsmart each other. On top of this, they always struggle with clients withdrawing funds abruptly and unexpectedly, forcing them to liquidate lucrative positions, a phenomenon that is known as “forced seller.”
From my experiences, these industry challenges don’t cause most fund managers sleepless nights, fretting over average performance, or beating the competition by 0.5%. After all, their salaries are de facto guaranteed and paid for in advance. There might be some variances in their bonus payments depending on general market performance, but they won’t have to line up at a soup kitchen anytime soon.
They enjoy some additional perks and benefits. Most of their clients are not aware or at least suppress it as well as they can. By pooling money into large funds, and in effect having complete power over those funds, fund managers, and their companies enjoy all sorts of benefits that are covered-up, flashy prospectus and long disclaimers. There has been a lot of lip service given when it comes to the topic of fiduciary duties. However, there is this massive gray zone that a lot of people will not touch with a six-foot pole. As we have seen from previous chapters, both brokers and fund management work in close cooperation together. Over several decades, they have created mutually beneficial relationships. I have been a part of this whole industry and have seen some of the inner workings and mechanisms of Wall Street’s darker underbelly. I saw how brokers sold their research to institutional and professional investors when I worked on the side of the research broker. Additionally, I saw how brokers garnered hedge fund clients when I set up my own hedge fund operations, and I became a customer of their research and trading services. I surely didn’t pay for all of those excellent dinners and nights out with brokers. I would be lying if I told you that I didn’t enjoy it, or didn't have a good time. But, that is a topic for another book.
CENTRAL BANKS: THE FAILING MAGICIANS
The biggest manipulators in today’s market are most certainly central banks.
Central banks around the world are crucial for the entire financial system. They provide liquidity and control monetary policy through the control of interest rates and other complex financial tools. The central bank's interest rate policy has become the ultimate cost of opportunity because they represent the default return rate for sovereign debt obligations. The Federal Reserve of the U.S. is the world’s most influential of central banks because it controls the USD, the reserve currency of the world. All commodities are traded in USD, and most of the world’s debt is traded in USD.
Current Issues
All the main central banks around the world have been struggling to stimulate the movement of money in our economic system. In the simplest of terms, their goal has been to boost the flow of money within our financial system that banks lend to institutional clients and retail customers alike. They, then, use the money to invest or consume, stimulating our economy as measured by GDP. It is called velocity of money, and central banks have been feverishly trying to kick start its revival. Obviously, without much success. Banks, corporations, and consumers suffered from the hangover of the last financial crisis. The vast majority has simply become more cautious with the usage of money out of concern for the future. That pre-eminent attitude among the major market players is poison for central banks and their mission to do their jobs. Let’s see what other desperate measures they’ll pull out of their rabbit hats to get us to spend and invest our money.
GLOSSARY
Assets Under Management (AUM): Is the total market value of assets that an investment company or financial institution manages on behalf of investors.60
Black Swan Event: An event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. Nassim Taleb who popularized the term regards almost all major scientific discoveries, historical events, and artistic accomplishments as "black swans"—undirected and unpredicted. He gives the rise of the Internet, the personal computer, World War I, dissolution of the Soviet Union, and the September 2001 attacks as examples of black swan events.
Cash Engine: An engine that produces cash non-stop as long as it runs. Anybody can earn money, and if you end up spending less than you make, you have a positive cash flow. You are yourself your primary cash engine—take good care of it.
Credit Default Swaps (CDS): CDS are complicated financial contracts. They work like insurance contracts paying out premiums to the holder but demanding payment in full when a certain event occurs to the seller.
Chinese Walls: An insurmountable barrier, especially to the passage of information. Wall Street firms use these barriers to block information flowing from one department to another, usually in the form of access key restrictions or separate office locations.
Flash Crash: The quick drop and
recovery in securities prices usually caused by computer glitches, flawed programming or order manipulation.
Financial Leverage: Refers to the use of debt to acquire additional assets. A lot of traders borrow money to magnify small speculation gains.
First in First out Principle: A strategy to be the first of any investment fad, bubble or market hype and sell before anybody else can, reaping the first and easiest gains, while latecomers provide the necessary liquidity to exit smoothly.
Force Majeure: Unforeseeable circumstances that prevent someone from fulfilling a contract.
Free Cash Flow: Equals net income + depreciation charges minus any capital investments and money needed to maintain operations at current levels.
Fund of Funds (FOF): Funds that invest in other funds managed by other companies or different fund managers. It not only spreads the risk of each diversified fund but also among different fund strategies or asset classes. Of course, all this risk diversification comes at a price in the form of another layer of management fees for the managers of the Fund of Funds.
Gambler’s Ruin: Refers to a phenomenon where “a gambler who raises his bet to a fixed fraction of bankroll when he wins, but does not reduce it when he loses, will eventually go broke, even if he has a positive expected value on each bet.”
GARP Investing: The GARP strategy is a combination of both value and growth investing. It looks for companies that are somewhat undervalued and have solid sustainable growth potential. Garp stands for Growth At a Reasonable Price.
Hostile Tender Offer: Is the acquisition of one company (called the target company) by another (called the acquirer) by directly asking the shareholders directly rather than negotiating with the target’s management. To be successful, the acquirer needs to convince a large percentage of shareholders to get the acquisition approved.
House flipping: Is a form of speculation on real estate properties and their market prices. By purchasing property, which is expected to rise in value due to demand and supply changes or property improvements, buyers can make a quick profit but only if the speculation pays off. As soon as they’ve realized a certain profit, they move on, selling their property in order to deploy their cash in the next speculation.
Intraday: Intraday refers to price movements of a given security over the course of one day of trading.
Investor’s Itch: An investor’s psychological weakness to have the urge to be active, because they think they might lose out or miss some exciting action.
Liquidation Value: Liquidation value is the likely price of an asset received through an open market sale. Liquidation value is typically lower than fair market value. The money you would get through liquidating your entire asset column at short notice is an investor’s base valuation model.
Long Con (also known as the “long game”): This a scam that unfolds over an extended period of time and involve a team of swindlers, as well as props, sets, costumes, and prepared lines. The purpose is simple: “to rob the victim of huge sums of money.”
Market Capitalization: Is the market value of a listed company derived from multiplying its total number of shares outstanding with the current market price.
Optionality of Cash: Is a permanent option that holder’s of cash possess, to either keep cash or to invests it in any asset class, within any industry at any time of the holder’s liking and personal preference. Institutional investors including most hedge funds and private equity funds don’t have that option.
Overpayment Risk: The most important risk definition for retail investors. It is the risk of paying too much for an investment target than the real value you receive in return. Overpayment usually leads to deferred losses.
Prop Desks: are places where ‘prop trading’ takes place. Prop Trading stands for proprietary trading—industry jargon for “trading with your own money instead of your clients.”
Quant Hedge Funds: A sophisticated and complex hedge fund trading strategy using quantitative analysis and computer-based models in order to calculate the mathematical odds of each bet versus the invested capital necessary, while aiming to reduce the statistical form of risk.
Return on Capital (ROC) or return on invested capital (ROIC): Is a ratio used in finance, valuation, and accounting, as a measure of the profitability and value-creating potential of companies after taking into account the amount of initial capital invested.
Risk Arbitrage (M&A Arbitrage): Is an investment or trading strategy often associated with hedge funds. Two principal types of merger are possible: a cash merger and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash.
Going Short: Selling something in advance, in the hopes that you buy it back at a lower price in the future.
Tail risk: A rare form of portfolio risk that—“The possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution.”
Time value of money: Refers to money concept that the importance of cash in your hand is much more valuable than the same amount of cash in an uncertain future.
Ultra High Net Worth Individuals (UHNWI): A person with investable assets of at least US$30 million, excluding personal assets and property such as one's primary residence, collectibles, and consumer durables. UHNWIs comprise the richest people in the world and control a disproportionate amount of global wealth.
Yen Carry Trade: A currency trading strategy in which traders borrow a low-cost currency like the yen and buy high-growth currency, netting a profit. In recent years, for example, Japanese housewives began accumulating Australian dollar deposits, which yielded a significantly higher rate than they could get at home.”
White Knight: A person or company making an acceptable counter-offer for a company facing a hostile takeover bid.
Window Dressing: A simple form of price manipulation. Usually, refers to the market price manipulation on the last trading day of a calendar month in order to raise the prices of key holdings in a portfolio. The purpose is to make monthly performance figures more appealing to existing and new investors.
ACKNOWLEDGEMENTS
I would like to thank my launch team and all the people who reviewed and critiqued this book. Special thanks to my editorial team. My editor, Subodhana Wijeyeratne, has been a great help and guidance in formulating some general arguments on a complex topic. His wealth of historical knowledge has been extremely helpful in identifying some of the trends discussed here. I would also be remiss in not mentioning the tireless efforts of Valerie Smith as critical voice and eye of the team. Both are very talented writers, whom I highly recommend.
I would like to thank my numerous friends from the DC community, as well as my sources and contacts in the financial industry, who have always offered a helping hand and their personal views.
As always, I am grateful to my parents. Only due to their selflessness, have I had numerous and very much cherished opportunities.
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The 80/20 Investor: Investing in an Uncertain and Complex World
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NOTES
1 Amazon.com (2016). Retrieved f
rom: https://www.amazon.com/gp/bestsellers/books/10020675011/ref=pd_zg_hrsr_b_1_4_last
FOREWORD
2 La Roche, Julia (2016). Warren Buffett's right-hand man gave a dark warning about American finance. Retrieved from http://www.businessinsider.com/charlie-munger-warns-about-american-finance-2016-4
3 Damon, Matt (2016). Massachusetts Institute of Technology (MIT) Commencement address June 2016.
CHAPTER 1
4 Investopedia. Investing 101: What Is Investing?. Retrieved from http://www.investopedia.com/university/beginner/beginner1.asp
5 Graham, Benjamin (2006). The intelligent investor: the definitive book on value investing. New York, NY: HarperCollins Publishing, Inc., p. 79.
CHAPTER 3
6 Harari, Yuval Noah. Sapiens: A Brief History of Humankind (p. 27). HarperCollins. Kindle Edition.
7 Farrow, Paul (2012). Fidelity China Special Situations fund manager Anthony Bolton has been shanghaied in China. Retrieved from http://www.telegraph.co.uk/finance/personalfinance/investing/9217436/Fidelity-China-Special-Situations-fund-manager-Anthony-Bolton-has-been-shanghaied-in-China.html
8 Wikipedia. Black swan theory. Retrieved from https://en.wikipedia.org/wiki/Black_swan_theory
9 Jorion, Philippe (1999). The Story of Long-Term Capital Management. Retrieved from http://www.investmentreview.com/print-archives/winter-1999/the-story-of-long-term-capital-management-752/
CHAPTER 4
10 Keynes, John Maynard (1936). The General Theory of Employment, Interest and Money (Chapter 12)
11 Smith, Adam (1976). The Money Game (Kindle Location 53). Open Road Media. Kindle Edition.
12 Investopedia. Wall Street Definition. Retrieved from http://www.investopedia.com/terms/w/wallstreet.asp
13 Wikipedia. Gambling. Retrieved from https://en.wikipedia.org/wiki/Gambling
Modern Investing Page 16
