Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street

by Janet M. Tavakoli

  Nobel Prize-winner Daniel Kahneman and Amos Tversky, a Stanford psychology professor, studied the financial psychology of judgment and decision making. They found that people feel more strongly about the pain that comes with loss than they do about the pleasure that comes with an equal gain. In fact, most people feel about twice as strongly about the pain of loss according to their study. If you really hate to lose, you may feel even more strongly about it than that. Surprisingly, people will take much more risk to avoid a loss than they will to earn a gain, even when the economic results are the same.

  If you don’t believe it, try the following game. Imagine that I have given you $100,000, and I have also given you two choices. I will either guarantee you an additional $50,000 or I will allow you to flip a coin. If it’s heads you get another $100,000; if it’s tails you get nothing additional. If you choose to take my guarantee, you are certain to walk away with $150,000. If you choose to flip the coin, you get either $100,000 or $200,000. Which option do you choose? Most people choose to take my guarantee and walk away with the certain $150,000.

  Now suppose instead I have given you $200,000, and I have given you the following two choices. I will either take away—guarantee you lose—$50,000, or you can flip a coin and try for a different outcome. If the coin comes up heads, you lose $100,000; if it’s tails you lose nothing. Now which option do you choose? Most people will choose to flip the coin to try to avoid the certain loss of $50,000 even if it means they might lose $100,000.

  In both situations, you wind up with $150,000 if you choose my guarantee. In both cases if you choose the coin flip, you have a 50-50 chance of ending up with either $200,000 or $100,000. Most people choose the sure $150,000 when they stand to gain. It is a very different story when they stand to lose. Most people will choose to flip the coin because they will take more risk to avoid losing money, even if that means they will potentially be worse off than if they just took their loss. The feeling seems to be that they should at least try to avoid the loss.They shouldn’t stand by, do nothing and just let it happen to them.

  I prefer Warren’s conditional probabilities to any of these choices. The odds of a favorable outcome appear much higher to me.

  Now imagine you were running a hedge fund earning 2 percent on all of the funds you have under management and earning 20 percent of the upside. Better yet, if you can get away with it, take 5 percent as a fee on the assets under management, and take 44 percent of any potential upside. If your bet loses, your investors will withdraw all of their lovely money and you will get no fees at all. How much will you hate losing now? Enough to risk doubling your investors’ losses?

  If you were the hedge fund manager, would you hate losing enough to make it appear you were making money when you were not?

  In New York State Court, the trustee for the Lipper Convertibles Investment Partnership filed suit to get money back from a trust fund of Henry Kravis’s children, Sylvester Stallone, John Cusack, and the former New York City Mayor Ed Koch.They had all invested in the partnership, and each of them withdrew their investment and thought they made money. Other investors in the partnership lost money in an alleged fraud. It seems the trustee wanted all investors, even former investors, to share in the pain, claiming the gains were “unjust enrichment.”23

  The estate manager for the Bayou Group LLC was even more aggressive. Bayou had only about $100 million remaining of more than $300 million in original investments. Now Bayou’s past investors are being told they should have known that fraud had occurred, and they had no right to withdraw their money, even if they had withdrawn the money as much as three years before the fund collapsed.The estate manager is seeking not just their gains but even their original investments, so that presumably the pain will be shared on a pro rata basis. The coin is standing on end.

  Bayou’s principals, Samuel Israel III and Daniel Marino, pleaded guilty to fraud charges after the fund suddenly closed in 2005. Lawsuits alleged Bayou operated a Ponzi scheme using money from new investors to pay old investors. When Israel received his 20-year prison sentence and was ordered to disgorge $300 million, he said: “I lied to you and I cheated you and I cannot put into words how sorry I am.”24 So, if he had not been caught, would he have put even the admission of his guilt into words? We may never know, but it seems he really hates to lose. Israel wanted a reduced sentence claiming infirmities, but the judge ruled: “He suffered from these ailments while he did the crime. He can deal with them while he does the time.”25

  I learned that Samuel Israel III has a tattoo on his right hip, was born July 29, 1959, his Social Security number is 438-68-0727. It said so on the Wanted by U.S. Marshals notice issued by the U.S. Department of Justice.26 In June 2008, after Israel failed to report to serve his 20-year sentence, his abandoned car was found on the Bear Mountain Bridge (despite its name, the bridge is not in the vicinity of Dead Man’s Curve). The car contained what appeared to be a rambling suicide note or the first draft of a new hedge fund document. Scrawled on his car’s hood dust were the words “suicide is painless” from the MASH theme song, which probably doesn’t sound funny to the investors whose cash was mashed by Israel.27

  Israel’s partner, Dan Marino, had earlier left a suicide note saying that he, Israel, and James Marquez, another partner, had “defrauded” investors. But Marino had not committed suicide, and many believed Israel did not either. Lee Hennessee, head of the Hennessee Group, said: “I believe he’s dead as far as I can throw him.”28 Greg Newton’s blog titled his review of “Scammy’s” disappearance: “Show Me the Corpse!”29 Twenty-three days after he faked his suicide, Samuel Israel turned himself in, faced an additional bail-jumping charge, and the $500,000 bail was forfeit.30

  Hedge fund managers seeking fast money sometimes find their exit of the business is quick and final. Kirk Wright, the Harvard-educated 37-year-old founder and CEO of International Management Associates, (IMA) committed suicide by hanging himself in his jail cell, after being found guilty in May 2008 of securities fraud, money laundering, and other charges. Since 2001, he had allegedly inflated balances in investors’ accounts and lied to investors about the performance of the $150 million fund, which collapsed in 2006. He spent lavishly and drained the fund’s cash accounts as it collapsed. When taken into custody, he was using an alias and was arrested poolside at the Hilton in Miami Beach, Florida.31

  If Wright had invested his clients’ money in T-bills and taken $3 million in management fees (2 percent of assets under management) per year, the clients would still have been misled, but they would have been better off since at least they would have their principal plus a little extra. It appears he neither played it safe nor legitimately bet the ranch; he simply bought the farm.

  In finance, the good do not die young and they do not go on the lam. Like Warren Buffett, the good are usually long-term investors and live to a contented ripe old age.

  Hedge fund managers may invest their own money in their funds thereby claiming their interests are aligned with their investors.Yet are they really aligned? Many managers and employees of smaller hedge funds are not as wealthy as the investors, but they would very much like to be. After all, they reason, if they are taking the risk of working for a hedge fund, they should get paid for it.

  How much should hedge fund employees get paid? Senior risk managers at investment banks get paid in the high six figures. A well-known bank hired a second-tier compliance officer for $800,000 per year. Structured credit researchers got paid anywhere from the high six figures to $2 million per year. A mediocre senior investment banker will earn around $2 million per year, and a good one can earn much more. But many beginning hedge fund managers can only aspire to this compensation.

  Many hedge funds are small, undercapitalized shops that have an “investors only” Web site. If a fund rents offices, purchases computers, phone systems, reporting systems, trading systems, hires staff and retains accountants, it may not break even on the 2 percent annual fee unless it has several hundred milli
on dollars under management. The trouble is, if a manager’s results are not good, investors will run for the exits.

  The strategy reminds me of a bridge saying I sent Warren about having a 50-50 chance your play will win while expecting it to work out 9 times out of 10.

  The temptation is to lever up just for the sake of making a lucky bet so that the 20 percent fee on the upside kicks in to keep the fund solvent and keep investors happy. But can you trust that leverage is employed for the right reasons when the fund is feeling a cash crunch? Is it any wonder they want a waiting period to return your money?

  Overcrowding makes most hedge fund strategies look very unattractive. Many hedge funds are merely shorting (selling) volatility to earn risk premiums, selling options in a low implied volatility environment and selling credit default protection in a skinny credit spread environment, or using investment banks’ financing to make a bet on the market. In other words, underperforming hedge funds often resort to leverage in a gamble to inflate returns.

  It is as if they are the young boy in D. H. Lawrence’s story “The Rocking-Horse Winner,” who gets visions of the winners of Ascot’s horse races while madly riding his rocking horse. At first he wins enough money to pay off the family debts, but that is not enough, the household goes mad with greed and he must keep riding to produce winners until he dies of exhaustion. “Although they lived in style, they felt always an anxiety in the house. There was never enough money.” After the boy’s initial bet wins, the house seems to say: “There must be more money, there must be more money.” When the boy wins even bigger, the voices become louder and more urgent: “There must be more money! There must be more money!” The boy asks his emotionally bankrupt yet greedy mother about luck and she responds: “I don’t know. Nobody ever knows why one person is lucky and another unlucky.” The boy manically rides the rocking horse “Now! Now take me to where there is luck! Now take me!”The voices in the house rise to a frantic pitch: “There must be more money! Oh-h-h; there must be more money. Oh, now, now-w! Now-w-w—there must be more money!—more than ever! More than ever!” The boy eventually dies of nervous exhaustion and his uncle mourns: “eighty-odd thousand to the good . . . But, poor devil, poor devil, he’s best gone out of a life where he rides his rocking-horse to find a winner.”32

  Warren avoids leverage. While it is true that Berkshire Hathaway’s returns would have been much higher on average, both Buffett and Munger feel that it is their responsibility to shelter shareholders from leverage’s swift and painful downside. Benjamin Graham counseled: “It should be remembered that a decline of 50 percent fully offsets a preceding advance of 100 percent.”33

  Some hedge funds are betting on leverage and luck as if they are rocking horses. Instead of relying on rocking horses, they look to their prime brokers, their investment banking and bank creditors. The hedge funds not only gain access to leveraged financing—there must be more money!—the investment banks also provide trading strategies.

  Richard Heckinger ran into many hedge fund managers during his multiyear stay as managing director at Deutsche Boerse. He believes that many of them have no financial savvy:

  I am amazed at how many of them don’t understand the nuts and bolts of what they’re trading. I’ve met . . . several dozen over the last several years who are not too clear even on the concept of an “exchange” . . . most deal with their prime brokers and order up their strategies much like calling Domino’s and ordering a pizza.34

  The barriers to entry into the hedge fund world are low, and there seems to be a philosophy in the global hedge world that “anyone can do it.” It seems all it takes to go from zero to hero is swagger and loudly trumpeted self-reported claims.

  In the late 1990s, there were only a few hundred hedge funds. By the summer of 2008, the number was estimated at around 8,000 globally, and hedge fund management had become a $1.87 trillion industry. Most of the money is concentrated in large funds. Funds that manage more than $5 billion have 60 percent of the market share; funds that manage $1 billion to $5 billion have another 26.7 percent of the market share. Put another way, less than 3 percent of hedge funds control 60 percent of the money, and somewhere between 6 percent to 9 percent of the funds control around 87 percent of the money.That means more than 90 percent of hedge funds are chasing the remaining 13 percent of market share.35

  Hedge fund managers often claim they can beat the S&P 500, mutual funds, and just about any other investment available to individual investors. Some hedge funds state that their goal is to achieve positive returns in both bull and bear markets. Others claim to speculate with the (usually elusive) goal of highly volatile but ultimately high returns. Quantitative funds or “quant” funds like LTCM claim their models help them outperform the market.

  Survivorship bias distorts returns reported by hedge fund indexes since the low returns of failed hedge funds drop out of the equation. If anemic returns and total wipeouts disappear forever, then reported returns have a greater chance of creating an illusion of better performance than other investments.

  Creation bias is an even bigger problem. In military terms, it is the strategy of rapid dominance through shock and awe. Only “successful” funds that show a track record of outperforming the market are sold to investors, while failed attempts to create a successful track record are never reported. The initial outperformance has a halo effect on later years since the long-term record will continue to carry its swelling effect, even if subsequent returns are mediocre. As more money flows in, the funds often cannot replicate outperformance, devolving into under-performers. Multiyear returns are rarely dollar weighted, so returns are overstated, because large slugs of new money are earning lower returns. As the funds grow, it is harder to make excess market returns, since it is harder to find those incrementally attractive new ideas and assets.

  Size has its disadvantages. Warren Buffett and Charlie Munger project they can achieve a tax-efficient average annual return of around 10 percent to 15 percent for the next five years—a very respectable return—but it isn’t likely they will match the tax-efficient 27 percent plus average annual return of the past 30 years. Their strategy and projections are disclosed for anyone to read in annual reports.

  In first quarter 2008, hedge funds reported their worst performance in nearly two decades according to Hedge Fund Research, Inc.36 Even those numbers may not represent reality because the lack of reporting controls tempt hedge fund managers to inflate their performance. Some academic studies “suggest hedge funds have been routinely dishonest, or at least economical with the truth.”37 Investment banks tightened credit terms for hedge funds. By the beginning of August 2008, year-to-date hedge fund performance was down 3.5 percent. Hans Hufschmid, a first-hand witness to LTCM’s financing crisis, observed it was “much worse” than in 1998 when LTCM collapsed, because “hedge funds live on credit and leverage and the ability to finance esoteric positions for a long time.”38 I would have added that some hedge funds seem to extend their lives because of the ability to set the prices on their own esoteric positions.

  Academics seem late to wake up to this. Warren Buffett and Charlie Munger have publicly criticized (mis)representations of hedge funds for decades. Forbes has published article after article about hedge fund problems. Some hedge funds simply make things up. Even “legitimate” reporting is often materially misleading. In 2004, Forbes said: “Fakery aside, hedge funds have returned less than stocks and bonds.”39 If you took away various ways of plumping up performance such as creation bias (and a variety of other shenanigans) a Reality Check study showed: “TASS [the largest hedge fund tracking service] net returns drop from 10.7 percent to 6.4 percent annually for the six years through 2002.That compares with a 6.9 percent annual return for the S&P 500 and 7.5 percent for Lehman Brothers’ intermediate bond index.”40 Yet, poor relative average performance did not deter investors. Money continued to pour into hedge funds.

  Most hedge funds rely on borrowed money. Goldman Sachs, Credit Suisse First
Boston, Merrill Lynch, Morgan Stanley and others lend money through hedge fund umbilical cords called prime brokers.Then they trade with the hedge funds and often supply research and other helpful information. Most of the time, the information sharing is legal.

  If a hedge fund uses borrowed money to buy securities, it backs the loan with the assets it “bought” plus collateral (margin). For example, if a prime broker lends $100 million to a hedge fund to buy securities that the prime broker’s investment bank is selling, it may ask a hedge fund to put up $10 million or 10 percent as additional collateral against the $100 million loan (so the assets plus margin are $110 million or 110 percent of the amount the hedge fund owes). That way, if the price of the securities falls a little (not more than 10 percent), the investment bank will have a cushion to make sure it gets back its money. If the price of the securities drops by 5 percent, or $5 million, the investment bank will ask the hedge fund to put up more money (approximately $5 million) to keep the percentage of margin roughly constant. When the investment bank calls for more collateral, it is known as a margin call. One would think that investment banks only accepted cash or a cash equivalent such as a T-bill as margin (collateral). But sometimes they accept something very illiquid (while asking for a bit more of the illiquid stuff). Investment banks try not to think about the possibility that the value of the securities will drop by say, 50 percent, or that the hedge fund will not be able come up with the margin when asked (perhaps because everyone is asking at the same time). That would probably mean the hedge fund is going bust. Prime brokers (affiliates of banks and investment banks) avoid thinking about this horrific scenario by comforting themselves with the thought of the high fees they charge the hedge funds.

  Investment bank prime brokers will even help spawn hedge funds. Typical of most investment banks, Bear Stearns Asset Management (BSAM) offered a “turnkey” program, essentially a 50-50 economic split after expenses. BSAM became the general partner. In exchange for that, the hedge fund manager would get office space, back office clearance, accounting, legal support, and marketing support, all of which is a top line expense. If BSAM accepted someone onto the platform they also invested seed capital of up to $25 million.41