EAT THE RICH
by John Mauldin
If you went to court, and found out there were two sets
of laws, one for you and a much friendlier set for your
opponent, you wouldn't be very happy. We assume we all
have the same set of rules. Yet in the investment world,
there are in fact two sets of laws: one for the wealthy
and one for everyone else.
How would you like access to numerous fixed income funds
which averaged 13% a year for the last five years with
90% positive months? What about stock funds which can go
both long and short, and have made money every year for
the last five years? What about bond arbitrage funds
which have averaged 20% per year for many years? Or very
stable funds which deliver 7-10% a year?
The laws now in place prevent American citizens from
accessing the best opportunities and best managers
unless they are worth at least $1,000,000, and in many
cases the investor must by law be worth far more in
order to simply qualify to access elite money managers.
Ironically, non-US citizens can access many of these
same American managers with no net worth requirements.
How can a country so obsessed with equal opportunity
under the law come to the place where a citizen of
Botswana has more access to the best American investment
managers than does a resident of Boston?
The prime culprit which wants to keep you on the farm is
the Investment Company Institute (ICI). The ICI is the
primary mutual fund industry organization. They lobby
vigorously to oppose any change to the rules which they
think would mean less money for their members, and more
opportunities for you besides mutual funds
To understand how we arrived at this situation, we have
to start at the beginning... almost 70 years ago. In the
aftermath of the stock market crash and a stagnant
economy, Congress began to pass a series of laws
designed to protect investors from rampant fraud and
corruption. The 1933 Securities Act and the later 1940
Investment Company Act, while modified over time, have
served as the backbone of our investment laws. In the
main, they have done well.
But like many laws, they also had unintended
consequences. In my mind the most ironic of consequences
is the creation of a multi-tier class of investors based
upon wealth. The simple fact is that the wealthier you
are, the better and more varied your investment
opportunities.
Wealthy Americans are allowed to invest in private
offerings and scores of different types of hedge funds.
The rich are pouring billions of dollars into these
funds. Why? Because they offer the opportunity for
excellent risk-adjusted returns with little or no
correlation to the stock and bond markets, and because
many have a strong track record of delivering stable
profits.
I believe that a large majority of investors would at
least like the opportunity to look at these funds, and
decide for themselves if they are appropriate for their
portfolios. However, there are several reasons they
can't.
#1, private offerings must remain private. You cannot
read about them in general circulation publications. If
you do, then the fund cannot legally take your money.
Therefore they work very hard to stay out of the public
press. Finding out about these funds usually requires
consultants, attending expensive conferences and a lot
of networking.
#2, these funds are usually limited to 99 investors.
That means if they want to manage $250,000,000, they
must get an average of $2,500,000 from each investor. If
you are worth $1,000,000, you are what is known as an
Accredited Investor. That means if you can find these
funds or they can find you, you can investigate them.
But for all practical purposes, many of them have
minimums which are too high even for multi-millionaires,
unless you know how to find alternative ways into these
funds.
Yet these same managers have offshore funds available to
non-US citizens with minimums as low as $50,000 (and
sometimes lower.)
#3, even if a hedge fund manager wanted to open a mutual
fund version of his fund to the general public, the
mutual fund rules generally prohibit the very things
that makes his management style so attractive to high
net worth investors.
#4, small investors cannot legally invest in a fund
which charges an incentive fee. Typically, hedge funds
charge 20% of the profits they generate, which is called
an incentive fee. Incentive fees represent the major
portion of the income to a good manager. Most funds have
a practical limit to the amount of money they can
manage. If the fund gets too big, the profits start to
fall, and the income of the manager drops. The incentive
fee helps assure that funds do not grow too big.
Why do you think wealthy investors pay higher fees for
the privilege of investing in hedge funds? The answer is
the potential for risk-adjusted returns, pure and
simple.
#5, every few years someone proposes some minor changes
to the laws governing private offerings. And every few
years these proposals die.
For instance, many investors would like to see the 99
limit expanded dramatically. That would allow private
funds to lower their minimums, and make these offerings
more accessible. But the ICI aggressively opposes such a
move. Their fear is that even more money would flow from
mutual funds into private offerings. Their message to
Congress is that small investors simply cannot be
exposed to the risk of these funds. They trot out a few
scare stories, along with liberal donations, and nothing
gets done.
But the risk argument is a canard. Investors are allowed
to invest in futures, where studies show 90% of all
investors lose money. You can invest in options, where
the vast majority of options expire worthless. You can
buy Enron and Global Crossing. You can invest in the
IPOs of internet companies. You are allowed to invest in
mutual funds which can lose 80% or more of their net
worth in a short time, and experience wild swings in
value. In my opinion, in apples to apples comparisons
with the best hedge funds which invest in the same
markets, the best mutual funds offer less potential
return with more risk. Let's not even discuss
comparisons with the worst mutual funds.
What should be done?
Congress should change the rules. The incentive fee rule
should be thrown out. It is an anachronism that assumes
that Nanny Government must protect you from yourself,
but which actually means you cannot get to the best
managers. You cannot expect good managers to take less
money than the market will pay them.
The 99 investor limit must go. Why are 99 millionaires
smart enough to examine a private offering but when 101
of them get together, they suddenly become collectively
brain dead and need government assistance? This makes no
sense, unless you are a mutual fund trying to protect
your turf.
A new class of mutual fund needs to be created, one
which allows for managers to pursue whatever legal
strategy they wish in the pursuit of profits. Doesn't it
make sense to buy long-term bonds, to hedge out the
directional interest rate risk, add a little leverage
and give investors a AAA bond fund on steroids? Hedging
works, and small investors should have access to those
who know how to do it profitably.
This would have the added advantage of allowing mutual
fund companies a whole new market. Furthermore, while
some hedge fund strategies require a great deal of skill
and market knowledge, others are fairly straightforward.
For those simpler strategies, access to the broad public
market would make fees come down for everyone.
Regulation for these funds should be limited to
ascertaining that accounting reports are accurate, that
independent custodians assure the money is where it is
supposed to be and that the strategy the managers say
they are pursuing is actually what they do.
It is my belief that over the next few years, most of
these suggestions will become law. Logic says they
should. And this time, political correctness is on the
side of the small guy. The next time you see your
congressman, let him know you want to be set free. Tell
your broker or advisor you want to see the private
offerings to which he has access.
Regards,
John Mauldin,
for The Daily Reckoning
P.S. By the way, the vast majority of hedge funds
already use independent custodians and auditors, and
many actually allow investors to see their portfolios on
a far more timely and transparent manner than mutual
funds. The wealthy are not stupid. They want to see
controls.
Editor's Note: John Mauldin is an investment advisor in
Texas and an authority on hedge funds. His latest book,
"Absolute Returns," on hedge funds and alternative
investments, will be out this fall. He also writes The
Accredited Investor E-letter, which teaches qualified
investors how to find and invest in private offerings.
To find out how you can get this powerhouse letter
absolutely free for one year - no strings attached -
click here:
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