The great diversification bait and switch: We’ve been looking recently at the false promises of a zombie hedge fund industry

The great diversification bait and switch

Dan McCrum

| Oct 09 15:10 | 10 comments | Share

We’ve been looking recently at the false promises of a zombie hedge fund industry. Now let’s widen the lens a little to take in asset management more broadly, and the self-interested warping of a concept at the heart of investing. Start with this terrific piece from Bloomberg, about how investors have been gulled by the supposedly respectable brokers of Wall Street selling investment products known as managed futures.There’s a ton of killer stats in there, including examples like the Morgan Stanley Smith Barney Spectrum Technical LP fund. Over a decade it made $490.3m in trading gains and interest income from money markets:

Investors who kept their money in Spectrum Technical for that decade, however, reaped none of those returns — not one penny. Every bit of those profits — and more — was consumed by $498.7m in commissions, expenses and fees paid to fund managers and Morgan Stanley.

At one level this is a familiar story about excessive fees. For decades the overall regulatory push has been to cut out commissions, fees, and recurring charges built into investment products.

But don’t mistake the fees for a bug. They are all too often a feature of business models. For instance, alternative asset management firms such as KKR and Blackstone have lent their brands to loan funds offering humdrum products at high prices.

For 63 managed futures funds assessed by Bloomberg, it turns out that all the profits came from parking investors’ capital in safe T-Bills. Only around 15 per of the capital was actually used to make bets buying and selling futures contracts, without success.

The 63 funds that reported to the SEC collected interest totaling $2.34 billion in the decade from 2003 to 2012.

Without those gains, the combined 10-year earnings of $1.3 billion after fees in the 63 funds would have been converted to a loss of more than $900 million. As interest rates have fallen to historic lows since 2008, managed-futures funds have suffered their largest declines ever.

Focus on the thinking that goes into the construction of such products. In many ways it is like the Payment Protection Insurance (PPI) scandal in the UK, where millions of customers were sold essentially worthless insurance they could not use even if they did need it, ultimately requiring banks to pay many billions in restitution. John Lanchester nailed the totality of the failure:

PPI was about banks breaking trust by exploiting their customers, not accidentally, but as a matter of deliberate and sustained policy. They sold policies which they knew did not serve the ends they were supposed to serve and in doing so treated their customers purely as an extractive resource. That is why, uncharismatic as it sounds and dreary in many of its specifics as it is, PPI is the worst scandal in the history of British banking: the one that shows just how badly wrong the industry had gone, and just how fundamentally it violated what should have been its basic values

Caveat emptor indeed.

Treating customers as an exploitative resource is the game here, and at a deeper level than just a particularly egregious set of fees. It points to the way that investment managers have used complexity to profit, cloaked in the respectability of a concept at the heart of investing: diversification.

Consider this line from Bloomberg.

Because the managed-futures market is opaque and poorly understood, otherwise sophisticated investors often don’t realize how pervasive the profit-eating fees are. The firms marketing the funds are at times also left in the dark. The industry refers to the computers programmed with trading algorithms as black boxes.

Come with us oh sophisticated investors, you don’t belong with rubes on the street holding simple stocks and bonds.

That sentiment is summed up perfectly by Gerald Corcoran, CEO of Chicago-based R.J. O’Brien & Associates LLC, the largest independent futures broker in the U.S., and a director of the Futures Industry Association.

“You’re going to lose money in managed futures over the course of a period of time. There’s no question,” Corcoran says. “I mean, I’ve just experienced it myself.”

“I actually would not even encourage most retail investors to be in managed futures,” Corcoran continues. “It’s on the riskier end of the investment spectrum.” He says managed futures serve wealthy investors. “They’re an important part of a diversification of a sophisticated portfolio.”

Ah, the magic word. What has happened is that returns from supposed cleverness have been treated the same, for the purpose of earning fees, as returns from asset classes.

Capital allocation models work on the basis that there is an inherent return, over and above that available from a risk-free investment in government debt, to be found from owning an asset such as a stock or a bond.

So diversification comes from owning a collection of such assets that over time will deliver cash flows or appreciate in value. Mix stocks with bonds and property, maybe some art. (Fans of commodities, precious metals, commemorative plates, feel free to debate their inclusion in the comments).

There is no inherent return from risk-taking, however. We could sell-short stocks all day long without expecting a return from it.

The problem from a business point of view, is that it is relatively cheap and easy to invest in stocks and bonds. All you need is patience and occasional rebalancing. Performance can be easily tracked against benchmarks that show paying a lot for active management makes no sense.

Hence the rise of alternatives. It’s fair enough that an investor might want to hand some money to a friend, or an expert gambler, to take some speculative risk for them. That you are sophisticated enough to appreciate the opportunity is a compelling sales pitch.

Returns from such expertise at a relatively small scale, however, have a tendency to disappear at a large scale, or to be explained by simple underlying factors that do not require the guiding hand of expensive cleverness.

After all, money-making opportunities should not persist for long if there is a lot of money looking to exploit them.

So yes, outrageous fees paid by retail investors are part of the scandal, but it is part of a much larger and more subtle fleecing of so-called sophisticated investors.