The Myth of the ‘Sophisticated Investor’
February 2, 2009, 9:50 am
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Peter J. Henning, a professor at Wayne State Law School, occasionally writes as a guest blogger for The Deal Professor. Mr. Henning specializes in issues related to white-collar crime and is a former editor of the White Collar Crime Law Prof Blog.
Until last year, we had often heard how “sophisticated investors” make more money than ordinary folks because they managed large pools of money that yielded enormous returns. Their particular insights into market forces seemed to insulate them from the vagaries of the market. Those returns justified charging outsized fees for the select few allowed to invest in them, which was often deemed a privilege.
If nothing else, the incredible Ponzi scheme executed by Bernard L. Madoff shows that even these so-called sophisticated investors can be duped, with losses of hundreds of millions of dollars because of their faith in a trusted investor. The latest investors revealed to have been caught in Mr. Madoff’s web include a number of former Merrill Lynch executives who lost money through a fund managed by their former colleague John Steffens, known as Launny.
Large banks with their special units catering to the very wealthy seem to be among those most easily snared by Mr. Madoff. Banco Santander, one of the few international banks actually making money these days, has tried to buy off clients who invested through its offices in Mr. Madoff’s operation with the offer of preferred shares in exchange for dropping all claims against the bank. Of course, all without any admission that the bank failed to protect its clients by making a reasonable effort at due diligence.
JPMorgan Chase pulled its investment in a fund that gave money to Mr. Madoff, but appears to have left some of its clients on the hook. I guess you always want to keep a little bit of your clients’ money in the game, as long as yours is safe.
Of course, it’s not just those who invested in Mr. Madoff’s house of cards who have been shown to be less than sophisticated. Some of our corporate chieftains have exposed their companies to enormous risks that may cripple them for years, if not lead to their demise, through questionable acquisitions.
Professor Davidoff has asked “What Is Dow Thinking?” as Dow Chemical plays what may be an enormous game of chicken regarding the offer to buy Rohm & Haas. It is not like this deal is one of those transactions made before the market melted down, and Dow is potentially staring into the abyss if it has to close the transaction on its current terms.
Bank of America chief executive Kenneth Lewis’s decision to buy Merrill Lynch almost on a whim in September 2008 may be the next example of a “Deal from Hell” as the company struggles with the toxic waste it acquired. John Thain, meanwhile, is starting to look a bit like a charlatan for engineering bonuses for his workers right before the deal closed, drawing President Obama’s rhetorical wrath even if there is nothing that can be done to reclaim the money.
Sophisticated investors who ran hedge funds were touted for their ability to beat the market with secretive strategies that could not be revealed to the general public at the risk of ruining those wonderful returns. These “black box” investment programs created the allure of the unknown, making those who reaped the benefits somehow special in their own right – in other words, they too assumed the mantle of “sophisticated investor.”
The impetus to maintain the aura of secrecy around hedge funds seems to be breaking down as we now learn that they are hardly any better than many plain vanilla mutual funds. And unlike a mutual fund or an exchange-traded fund, you can’t always get your money back, even if you have to continue to pay the annual fees on the amount invested.
That a person has a high net worth is hardly an indication of investment savvy, and calling your investment vehicle a “fund of funds” seems to mean only another layer of fees in many instances. Perhaps the term “sophisticated investor” should be understood to mean “I get mine first and the hell with the rest of you.”
Senators Carl Levin and Charles Grassley introduced on Jan. 29 the “Hedge Fund Transparency Act,” and voting against that would be akin to attacking Mom and apple pie. We have come to learn that hedge funds are hardly immune to the market’s travails, and the immunity the managers of these vehicles enjoyed is likely to end with greater regulatory control and disclosure of trading strategies.
Mr. Madoff showed that the black-box investment strategy is a chimera. His scam worked for as long as it did because he kept his investment program away from outside scrutiny, using a little-known accounting firm and not using an independent custodian to hold the securities. If the proposed legislation sheds a bit more light on the hedge fund world, then it may be worthwhile.
Greater regulation is no panacea, but breaking down the idea that great wealth and a rising economy somehow makes one a “sophisticated investor” would be a positive development. Public disclosure can have a great leveling effect by showing that investment managers are not necessarily all that sophisticated. And rather than making investments more complex, perhaps a return to an earlier time that valued protecting clients and managing their investments for the long term might be worth considering.
The next time you read that a financial advisor or hedge fund manager is a “sophisticated investor,” make sure to take it with a grain of salt.
–Peter J. Henning
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