Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street Part 2

I found it ironic that Patricia Dunn of HP defended her actions during her 60 Minutes 60 Minutes interview by claiming everyone was doing it while you lead your memo by debunking that excuse. I especially liked: interview by claiming everyone was doing it while you lead your memo by debunking that excuse. I especially liked: And culture, more than rule books, determines how an organization behaves. And culture, more than rule books, determines how an organization behaves.

Warren agreed that I should share the memo with others, and I sent it to several people, including Richard Beales, at the time a reporter at the Financial Times, Financial Times, who was looking for news. The paper posted the entire letter on its Web site. who was looking for news. The paper posted the entire letter on its Web site.

Jamie Dimon, CEO of JPMorgan Chase, wrote me that he agreed with Warren. When people justify their actions with the excuse that everyone else is doing the same thing, it is a red flag.

Warren walks his talk. When he took his stance in the 1980s that stock options should be expensed, it was an unpopular viewpoint. The SEC and U.S. politicians pressured to continue the practice. On Christmas Day 1994, the New York Times' New York Times' Floyd Norris handed out a "Consumer Deception Award" to Arthur Levitt, then chairman of the Securities and Exchange Commission. Levitt praised the Financial Accounting Standards Board for "great courage" when- Floyd Norris handed out a "Consumer Deception Award" to Arthur Levitt, then chairman of the Securities and Exchange Commission. Levitt praised the Financial Accounting Standards Board for "great courage" when-after succ.u.mbing to political pressure-FASB backed down from requiring that executive stock options be expensed.17 Even though the FASB, politicians, corporate executives and the SEC supported the opposite view,Warren Buffett never wavered. Even though the FASB, politicians, corporate executives and the SEC supported the opposite view,Warren Buffett never wavered.

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Neither Warren Buffett nor Charlie Munger takes stock options, restricted stock, or huge cash payouts as part of their compensation packages. Berks.h.i.+re Hathaway is run more like a partners.h.i.+p than a typical U.S. corporation. The annual report includes "An Owner's Manual" outlining the partners.h.i.+p commitment. Warren Buffett's and Charlie Munger's net worth is due to their Berks.h.i.+re Hathaway stock holdings, and the other board directors are heavy investors in the company, too. Their own gains and losses are in direct proportion to that of other shareholders.

Buffett and Munger draw a salary of only around $100,000. Their wealth grows as they create value for others. Successful value investing is not a get-rich-quick scheme, it is a way to get rich and stay rich.

Benjamin Graham wrote that a speculator "wants to make his profit in a hurry."18 The global capital markets suffered because people with access to The global capital markets suffered because people with access to other people's money other people's money wanted to get rich in a hurry, and "investing" seemed to be the last thing on their minds. Backdating executives put their own compensation ahead of investors' interests. But stock option backdaters are not alone in seeking extraordinarily compensation. Investment bankers that ended up subtracting value from the global capital markets earned millions of dollars for a single year of bad work. Many hedge fund managers create much less value than the prairie princes (Buffett and Munger), yet they rack up compensation in the hundreds of millions of dollars. wanted to get rich in a hurry, and "investing" seemed to be the last thing on their minds. Backdating executives put their own compensation ahead of investors' interests. But stock option backdaters are not alone in seeking extraordinarily compensation. Investment bankers that ended up subtracting value from the global capital markets earned millions of dollars for a single year of bad work. Many hedge fund managers create much less value than the prairie princes (Buffett and Munger), yet they rack up compensation in the hundreds of millions of dollars.

Chapter 4.

The Insatiable Curiosity to Know Nothing Worth Knowing (Oscar Wilde Was Right) I particularly liked the "Dean Man's Curve" commentary [ Jan and Dean wrote the song, "Dead Man's Curve," and I took Warren's message to be an intentional reference.]

-Warren Buffett to Janet Tavakoli, September 27, 2006

Warren Buffett has nothing against hedge funds, provided the price is right for the risk. After our lunch in Omaha,Warren showed me the letter he sent when he made his rejected bid for Long-Term Capital Management (LTCM). Along with Goldman Sachs and AIG, Berks.h.i.+re Hathaway made a $250 million bailout bid for LTCM and would have provided an additional $3.63 billion of funding.1 Instead, the Fed engineered a bailout with a consortium of 14 banks and investment banks; only Bear Stearns famously refused to partic.i.p.ate. LTCM had once shorted shares of Berks.h.i.+re Hathaway-a money-losing bet. Instead, the Fed engineered a bailout with a consortium of 14 banks and investment banks; only Bear Stearns famously refused to partic.i.p.ate. LTCM had once shorted shares of Berks.h.i.+re Hathaway-a money-losing bet.2 That is what happens when eggheads crack. That is what happens when eggheads crack.

My former Merrill Lynch boss, the late Edson Mitch.e.l.l, was the banker who oversaw Long-Term Capital Management's initial fundraising. 3 3 One of my Salomon training cla.s.smates, Swiss-born Hans Hufschmid, a partner and co-head of LTCM's London office, had borrowed $14.6 million to increase his stake in the fund. One of my Salomon training cla.s.smates, Swiss-born Hans Hufschmid, a partner and co-head of LTCM's London office, had borrowed $14.6 million to increase his stake in the fund.4 In 1993, Salomon denied rumors that Hans's compensation was as high as $28 million. Perhaps it was only $20 million. Hufschmid decamped for LTCM, because he thought it was a In 1993, Salomon denied rumors that Hans's compensation was as high as $28 million. Perhaps it was only $20 million. Hufschmid decamped for LTCM, because he thought it was a better better opportunity. opportunity.5 John Meriwether was a managing partner (formerly head of Salomon Brother's arbitrage group) and a University of Chicago MBA. LTCM's staff included Myron Scholes and Robert Merton, co-winners of the 1998 n.o.bel Prize in Economics, pioneers of equity option model pricing. David Mullins, a former Federal Reserve Bank vice-chairman, was also a partner. LTCM opened for business at the end of February 1994. In the late 1990s, LTCM was the largest hedge fund in the world, until it lost around $2 billion on its highly leveraged investments. John Meriwether was a managing partner (formerly head of Salomon Brother's arbitrage group) and a University of Chicago MBA. LTCM's staff included Myron Scholes and Robert Merton, co-winners of the 1998 n.o.bel Prize in Economics, pioneers of equity option model pricing. David Mullins, a former Federal Reserve Bank vice-chairman, was also a partner. LTCM opened for business at the end of February 1994. In the late 1990s, LTCM was the largest hedge fund in the world, until it lost around $2 billion on its highly leveraged investments.

According to When Genius Failed, When Genius Failed, Roger Lowenstein's book on the Long-Term Capital Management failure, if you invested $1 at the end of February 1994 when LTCM opened for business, it would have been worth $4.11 in April 1998 and only 33 by the time of the September 1998 bailout. But that was before fees. Roger Lowenstein's book on the Long-Term Capital Management failure, if you invested $1 at the end of February 1994 when LTCM opened for business, it would have been worth $4.11 in April 1998 and only 33 by the time of the September 1998 bailout. But that was before fees. After fees After fees that dollar would have been worth only $2.85 at its heyday value at the end of April 1998 and it would have been worth only 23 at the time of the bailout. that dollar would have been worth only $2.85 at its heyday value at the end of April 1998 and it would have been worth only 23 at the time of the bailout.6 Meanwhile, a dollar invested in Berks.h.i.+re Hathaway at the end of February 1994 would have been worth $4.44 in April 1998, and while much of the market suffered, it still would have been worth $3.95 at the time of the LTCM bailout. Berks.h.i.+re Hathaway handily beat LTCM's peak performance, as shown in Table 4.1 Table 4.1.

Berks.h.i.+re Hathaway beat Long-Term Management Capital's best after-fee performance by a very wide margin, and maintained strong value while LTCM stock plummeted.

Table 4.1 Value of a One-Dollar Investment Value of a One-Dollar Investment Source: Roger Lowenstein, Roger Lowenstein, When Genius Failed When Genius Failed (New York: HarperCollins, 2002), Pp. 224,225.,Tavakoli Structured Finance, and Yahoo! Finance. (New York: HarperCollins, 2002), Pp. 224,225.,Tavakoli Structured Finance, and Yahoo! Finance.

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Soon after LTCM's bailout, John Meriwether started Greenwich-based JWM Partners LLC. Its $1 billion fixed income hedge fund reportedly lost 24 percent in first quarter 2008.7 Berks.h.i.+re Hathaway continues to exhibit the characteristics most of us look for in a life partner: maximum upside for its size with minimum volatility.

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Warren's mentor, Benjamin Graham, said that speculators should do so with their eyes wide open. When you speculate, you will probably end up losing money. If you want to try it anyway, limit the amount you risk, and separate speculative enterprises from your investment program. Hedge funds, no matter how safe they are made to sound, engage in speculation.

Some hedge funds call themselves "arbitrage" funds, or "quant" funds that perform well in either up or down markets. In reality they are merely hedge funds, and they have risk. If a trade is an arbitrage, arbitrage, you can go long (buy) and short (sell) the identical security in the same time frame and lock in a risk-free return after paying trading commissions. A genuine arbitrage is a money pump. It guarantees a positive payoff with no possibility of a negative payoff and with no net investment. If a hedged trade makes money, then after the fact, it may be tempting to call it an "arbitrage." To make money, however, historical relations.h.i.+ps between your long and short position must remain aligned or must work in your favor. It is much better practice to call a hedge by its real name so that everyone understands you are making a bet, even if it is an educated bet. Many hedge funds that drain investors' money faster than a blood spurting artery drains your body, proudly-and inaccurately-call themselves you can go long (buy) and short (sell) the identical security in the same time frame and lock in a risk-free return after paying trading commissions. A genuine arbitrage is a money pump. It guarantees a positive payoff with no possibility of a negative payoff and with no net investment. If a hedged trade makes money, then after the fact, it may be tempting to call it an "arbitrage." To make money, however, historical relations.h.i.+ps between your long and short position must remain aligned or must work in your favor. It is much better practice to call a hedge by its real name so that everyone understands you are making a bet, even if it is an educated bet. Many hedge funds that drain investors' money faster than a blood spurting artery drains your body, proudly-and inaccurately-call themselves arbitrage funds. arbitrage funds.

A quant.i.tative hedge fund, or a "quant" fund, uses models to perform statistical a.n.a.lyses of historical data.They leverage up market bets when they think something is out of whack with history. They hope observed "anomalies" will revert back to historical levels. The future will not necessarily resemble the past. The future will not necessarily resemble the past. They know this, but they seem to be so in love with their own math that they brush away any doubts. They know this, but they seem to be so in love with their own math that they brush away any doubts.

Costas Kaplanis, another alumnus of the Liar's Poker Liar's Poker training cla.s.s, headed arbitrage trading for Salomon Brothers in London and became the head of Global Arbitrage Trading for Citigroup, after it acquired Salomon. Costas complained to me how an "arbitrage" ruined one of his summer trips with his wife, Evi. He was trying to enjoy an training cla.s.s, headed arbitrage trading for Salomon Brothers in London and became the head of Global Arbitrage Trading for Citigroup, after it acquired Salomon. Costas complained to me how an "arbitrage" ruined one of his summer trips with his wife, Evi. He was trying to enjoy an al fresco al fresco dinner, but he anguished over an interest rate spread trade he had put on. Positions of $1 billion were not unusual if the volatility was "controlled." The problem with volatility is that it doesn't care whether or not you think it is controlled, and the trade had moved against him. He couldn't eat, he couldn't sleep, and he couldn't think. dinner, but he anguished over an interest rate spread trade he had put on. Positions of $1 billion were not unusual if the volatility was "controlled." The problem with volatility is that it doesn't care whether or not you think it is controlled, and the trade had moved against him. He couldn't eat, he couldn't sleep, and he couldn't think.

If you lose sleep worrying about losing money, it is not an arbitrage.

At its Third World Conference of the Bachelier Finance Society in Chicago in 2004, Phelim Boyle, a visiting professor at the London School of Economics, presented work on stochastic volatility models and made an a.n.a.logy: "Pricing is like falling in love, but a hedge is like getting married." It sounded catchy and got a laugh. Never one to leave a bad a.n.a.logy unchallenged, I countered:"A hedge is just a date. If I am going to marry for money, I'll marry an arbitrage, arbitrage, but I'll dump a but I'll dump a hedge hedge in a heartbeat." in a heartbeat."

A genuine arbitrage is a very rare occurrence and technology inefficiencies can be a cause. Lee Argush, the managing partner at Concord Equity Group Advisors, ran a fund that took advantage of a rare information arbitrage opportunity in the new-born Russian currency market exchanges. In the early 1990s, the ruble traded at 200 rubles to the dollar in Moscow, but in St. Petersburg, it traded at 250 rubles to the dollar.The Russian phone system was poor. Even a bandwidth sharing arrangement using excess Soviet military communication lines resulted in numerous communication breaks. (Imagine if there was a real need during the Cold War!) Argush installed Sprint and traded the currency arbitrage.

Since a true arbitrage is so hard to find, I focus on value investing for my personal portfolio in the Benjamin Graham and Warren Buffett tradition.

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While Warren Buffett continues to look for value opportunities, all over the globe new money gushes into hedge funds and leveraged investments. We do not care if rich people want to speculate knowing they may lose their money. Unfortunately, many public pension funds and other "safe" investors allocate some of their money to hedge funds.

In 1990 there were a few hundred hedge funds with less than $50 billion in total a.s.sets under management. By the summer of 2008, there were around 8,000 hedge funds (depending on who was counting) with $1.87 trillion in a.s.sets under management.8 Since hedge funds can only be sold to wealthy investors, they are mostly unregulated based on the flimsy theory that rich investors are sophisticated investors. Since hedge funds can only be sold to wealthy investors, they are mostly unregulated based on the flimsy theory that rich investors are sophisticated investors.

Only accredited investors are allowed to invest in hedge funds, but they are pretty easy to find. Regulation D of the Securities Act of 1933 defines an accredited investor as anyone with a net worth-including the value of real estate-in excess of $1 million. If your net worth is not that high, but you have income greater than $200,000 for the past two years-make that $300,000 if you are married-and expected the same this year, you qualify as an accredited investor.

A mere million dollars makes you a high-net-worth individual, but that may not be enough to get you access to the elite hedge funds. Some require a minimum investment of $5 million. Others court the "carriage trade" (old money) and the "caviar crowd" (new money), seeking out ultra-high-net-worth investors worth more than $30 million. In the estimated $1.87 trillion global hedge fund business, fewer than 10 percent of the funds control more than 85 percent of the money.

Banks, savings and loans, and most investment companies qualify as accredited investors. Most trusts with more than $5 million in a.s.sets and partners.h.i.+ps also qualify. Many retirement plans, including Employee Benefit Plans, Keogh Plans, and IRAs meet the test. Now there is a happy thought. Now there is a happy thought. A pension fund manager can gamble away your retirement money for you, and sometimes they do, especially if their fees are based on "performance." Money has flooded into hedge funds. High management fees, combined with little regulation of hedge fund managers, is like throwing gasoline on a lit fire. A pension fund manager can gamble away your retirement money for you, and sometimes they do, especially if their fees are based on "performance." Money has flooded into hedge funds. High management fees, combined with little regulation of hedge fund managers, is like throwing gasoline on a lit fire.

The easiest way for a hedge fund investor to make a small fortune is to start with a large one. If you are an accredited investor and you are bound and determined to ignore caveat emptor, caveat emptor, no one will stop you. Besides, it can be thrilling. But the thrill you experience when you detect a glint of mica-fool's gold-feels as real as if you had actually struck gold. In the world of hedge funds, there is much mica and little gold. no one will stop you. Besides, it can be thrilling. But the thrill you experience when you detect a glint of mica-fool's gold-feels as real as if you had actually struck gold. In the world of hedge funds, there is much mica and little gold.

Theoretically, a hedge fund allows investors to invest in ways that would be difficult on their own. It can ama.s.s the funds to make a run at the equity of an undervalued company and take the inevitable regulatory heat. It can study thousands of technical charts to look for a market anomaly and perhaps find an "arbitrage" opportunity. It can take large loan positions in interesting ventures. Theory rarely works out in practice.

When I met Warren in 2005, six of the top 25 highest paid fund managers achieved only single-digit returns, and these are the "successful" hedge fund managers.Yet Edward Lampert of ESL, one of the "sickly six," earned $425 million in 2005. The top two earners, James Simons of Renaissance Technologies Corp and T. Boone Pickens of BP Capital Management, respectively, earned $1.5 billion and $1.4 billion. Renaissance's chief fund charges a 5 percent annual management fee, and the managers take 44 percent of the upside, if any exists. In 2007, Jim Simons, Steven Cohen, and Kenneth Griffin each earned over $1 billion.9 Warren Buffett and Charlie Munger each earn a salary of about $100,000 per year, yet their long-term track record has topped these hedge fund managers. Warren Buffett and Charlie Munger each earn a salary of about $100,000 per year, yet their long-term track record has topped these hedge fund managers.10 Many hedge fund managers got into the business because of the incredible success of the legendary Paul Tudor Jones. Tudor Investment Corporation's $5.7 billion Raptor Global Fund, managed by James Pallotta, had 19.2 percent annual returns since 1993, but when it stumbled a little on U.S. equity investments dropping 8.5 percent by the beginning of December 2007, investors pulled out $1 billion. It is unrealistic to expect that any investment, particularly a hedge fund, will always have a positive return relative to the market. Paul Tudor Jones has had a very successful investment run since 1980 with never a down year until 2007.11 Yet even he does not represent that his funds are safer than the market. Every new hedge fund manager wants to be the next Paul Tudor Jones, George Soros, Jim Rogers, or Ken Griffin. Like Warren, there are true stars who outperform the hedge fund averages, but Warren may sleep better at night. Yet even he does not represent that his funds are safer than the market. Every new hedge fund manager wants to be the next Paul Tudor Jones, George Soros, Jim Rogers, or Ken Griffin. Like Warren, there are true stars who outperform the hedge fund averages, but Warren may sleep better at night.

There is nothing wrong with making a big bet, but one cannot be lulled into thinking that investing in hedge funds is safer than the market. The strategies are so variable that some funds pose much more risk than others. The best can give high performance with few stumbles. Investors may find, however, that at best they have paid high fees to invest with a pale imitation of greatness or a clueless rookie. At worst, they may invest with a crook. Hedge funds have the potential not only to have a zero return-no increase in your capital-for a year, they have the potential to completely wipe out your capital. When you are trying to compound returns, it is fatal to multiply your capital by zero.

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I run a hedge fund. My strategy? It's a proprietary secret. Domicile? It is located onsh.o.r.e in the United States, but the investments are global. There is no lock-up or waiting period for withdrawing an investment from my fund. At the moment it is not leveraged, but sorry, you are not ent.i.tled to even that much information.

You won't find my fund's returns reported as part of a hedge fund index. Hedge funds do not have to report their returns. You won't find my fund covered in the financial press, either. What I refer to are not financial products that I market to outside investors. I refer to my personal investment portfolio. Given the low barriers to entry, almost any portfolio of $1 million or more in discretionary investments can call itself a hedge fund.

What does a good hedge fund make? It is supposed to make alpha, excess return-adjusted for risk-above and beyond a pa.s.sive investment in the overall market, or beta. Alpha is supposed to be your reward for accepting extra risk. Hedge fund investors should expect nothing less from a hedge fund than from any other well-managed company. Just like actual hedge fund, I have no obligation to disclose my portfolio's return, and I don't. But my returns after all expenses and taxes are enviable by any hedge fund standard, and actual hedge funds have not given me much compet.i.tion. Very few hedge funds achieve great returns, and if they do, they are not doing it consistently.

Part of the reason my personal returns are so healthy is that, unlike actual hedge funds, I do not withdraw fees ranging from 2 percent to 5 percent of the value of my portfolios each year, nor do I liquidate a.s.sets to pay myself 20 percent to 44 percent of the upside. My portfolios are tax efficient. I don't charge myself administrative fees of around 0.5 percent per annum, and I don't pay for research using "soft dollars" paid to investment banks by marking up trades at the expense of my investment portfolio. I don't lend myself money from my investment portfolio. I don't let brokers commingle my funds with theirs to potentially expose me to their credit risk, either. Unfortunately for their investors, traditional hedge funds usually do the opposite of what I do when it comes to fees and efficiency.

Finding the right hedge fund is like truffle hunting-and you need a good pig. Investors may find that fund of funds managers are no help in sniffing out truffles; they are often mere fee hogs. A large Chicago-based fund of funds manager recently observed that out of the universe of hedge funds, only about 25 met his standard for investment. He looks for a critical ma.s.s of employees, comprehensible strategies, and well-developed back-office operations. But he is having his own infrastructure problems since his staff cannot keep up with the new structured credit products that the hedge funds embraced. This lack of expertise comes at a high price: on top of hedge fund fees, many funds of funds charge a 2.5 percent load, more than 3 percent in annual expenses, and ask for 25 percent of the upside. Instead of compound interest, you get compound fees.

I reinvest my fees. If I would not take out fees for my own use, why would I pay them to a manager who has a mediocre track record? Yet many investors allow mediocre managers to suck the life blood out of their portfolios.

Do you want to know the fastest way to become rich in hedge funds? Run one. Run one.

Financial journalists deify hedge fund managers, who boast of elite sports abilities and savant-like mental powers. A money manager may show off his ability to play multiple chess games simultaneously instead of showing off verifiable weighted average returns.This is especially useful when managers do not have a long, reliable, credibly audited track record to boast about.

Blackjack card counting is offered as evidence of a hedge fund manager's genius. I have played blackjack, I have counted cards, and I have won doing it. Unfortunately, playing blackjack will not make you a better money manager. The cards in the deck are known in advance. Even when casinos reduce the edge of a card counter by adding more decks, the cards are still known in advance. Real world finance is not as dependable. Not only does reality add more decks; it removes cards, and adds wild cards (fraudsters). Probability-based models fall apart. Besides, as Warren Buffett knows, the real action is in insurance companies, not casinos.

Warren Buffett plays bridge. What does this have to do with his ability to make lucrative investments? Nothing. It may help keep you sharp, but so would a lot of other mental (or even physical) activities. I also play bridge but I have never played with Buffett.Would I become a better investor if I played bridge with him? Not unless he gave me investment tips at the bridge table.

One reads about hedge fund squash champions, marathon runners, hang gliders, bikers, and triatheletes. That has nothing to do with whether a money manager will be successful. But I shouldn't sell sports short. After running a marathon, I had s.h.i.+n splints for three months. It gave me more time to read annual reports, and that that is useful when one is managing money. is useful when one is managing money.

It seems that hedge fund managers spring up out of nowhere. Many have addresses in New York, London, Chicago, Los Angeles, and other locations, but sometimes these managers are using the addresses of virtual offices in office buildings that provide a telephone number from which calls are forwarded to the "manager's" cell phone. It is very easy to create the illusion of a global corporate presence in the age of the Internet. It is even easy to create the illusion of a network of legitimate people.

Last summer I returned a cell phone call from a "hedge fund manager" who said a professor I know from the University of Chicago's Graduate School of Business was on his advisory board and the professor suggested he call me. The fellow's story sounded odd, so I declined to meet with him. I called the professor and asked him how well he knew the man. He admitted to being on the man's advisory board; but he was about to meet him for the very first time. When I asked the professor why he would lend his name to someone that appeared to operate from a cell phone, he said the man dropped other names other names and said he had raised $10 million. I told the professor: "I raised $50 million. See how easy it is to say that?" It is also easy to drop names and numbers! While the fellow may be legitimate, the professor had no way of knowing that. It is dangerous to lend one's name to a total stranger. and said he had raised $10 million. I told the professor: "I raised $50 million. See how easy it is to say that?" It is also easy to drop names and numbers! While the fellow may be legitimate, the professor had no way of knowing that. It is dangerous to lend one's name to a total stranger. Warren likes to look people in the eye. Warren likes to look people in the eye.

In June 2005, I was surprised to get an e-mail from Chris Sugrue, then chairman of Plus Funds. He invited me to some hedge fund events organized in concert with the development office at the University of Chicago:

The University and alumni in the hedge fund industry are working together to provide additional networking and educational events in the future. We've put together several hedge fund events over the past two years. . . . Starting July 1, 2005, future hedge fund events will only be open to those who are $2,500+ annual fund [of the University of Chicago] donors.

Sugrue had an undergraduate degree from the University of Chicago, but did not have an MBA, and somehow had gotten names of Graduate School of Business alumni to solicit. I wrote back to Sugrue asking for an explanation. I said that I found his e-mail solicitation "pretty shameless." My firm and nine others had already contributed funds to the Finance Roundtable so that students and alumni could attend for free. We gave hedge fund seminars usually discussing the risks; I had given one myself; they were open-and would remain open-to everyone.

The alarming part was Sugrue's Plus Funds' a.s.sociation with Refco, where Sugrue had once been an executive. Plus Funds' investor money had been commingled with Refco's in an unregulated account. When Refco filed for Chapter 11 bankruptcy protection on October 17, 2005, Sugrue demanded that the money be moved to segregated accounts, and the money was moved to accounts at Lehman Brothers Holding Inc. Refco creditors naturally wanted the money back. One wonders why the money was not in segregated accounts in the first place. Refco had lent money to Sugrue for various purposes including $50 million, of which $19.4 million went to an ent.i.ty controlled solely by Sugrue.12 Court doc.u.ments state that "Upon information and belief, Sugrue has fled the United States and currently resides in Angola."13 Angola is a lousy venue for hedge fund conferences. Greg Newton pointed out in his blog, Angola is a lousy venue for hedge fund conferences. Greg Newton pointed out in his blog, Naked Shorts, Naked Shorts, that the bad news is Angola does not have an extradition treaty with the United States. The good news is that "[f]oreign nationals, especially independent entrepreneurs, are subject to arbitrary detention and/or deportation by immigration and police authorities." that the bad news is Angola does not have an extradition treaty with the United States. The good news is that "[f]oreign nationals, especially independent entrepreneurs, are subject to arbitrary detention and/or deportation by immigration and police authorities."14 Warren's Omaha isn't a grand enough address to feed some hedge fund managers' ravenous egos. How's Angola for a sw.a.n.ky address? Warren's Omaha isn't a grand enough address to feed some hedge fund managers' ravenous egos. How's Angola for a sw.a.n.ky address?

Robert Cialdini, Ph.D., wrote about confidence men in his book, Influence. Influence. Grifters know that glitz, honorific t.i.tles, and seeming sponsors.h.i.+p of well-known inst.i.tutions have a powerful influential effect on us, and they do so without any conscious effort on our part. Investment banks tend to lend money just because another investment bank has lent money due to Grifters know that glitz, honorific t.i.tles, and seeming sponsors.h.i.+p of well-known inst.i.tutions have a powerful influential effect on us, and they do so without any conscious effort on our part. Investment banks tend to lend money just because another investment bank has lent money due to pluralistic ignorance. pluralistic ignorance. The second bank to lend will a.s.sume the first bank checked out the borrower, and it will skimp on its due diligence. We look around to see what the other guy is doing, and if everyone else is doing it, we go ahead. As Warren Buffett admonished in his letter to his All-Stars, don't do something just because "everybody else is doing it." The second bank to lend will a.s.sume the first bank checked out the borrower, and it will skimp on its due diligence. We look around to see what the other guy is doing, and if everyone else is doing it, we go ahead. As Warren Buffett admonished in his letter to his All-Stars, don't do something just because "everybody else is doing it."15 Fortunately, Dr. Cialdini points out that all we have to do avoid being fooled is to make a conscious decision to look for counterfeit social evidence. People can rent virtual offices, expensive homes, flashy cars, and eye-popping jewelry. They can infiltrate the alumni list of a prestigious business school. Question everything. By the way, Robert Cialdini got his Ph.D. in psychology. Did you even question me? But if Cialdini's Ph.D had been in art history, you would be right to be upset with me for citing him as an expert in psychology.

Irrational hype should make an investor skeptical as should any claim of intellectual superiority or mystical abilities. Some men seem driven to self aggrandizement. When Father W. Meissner's psychobiography of St. Ignatius was published in the 1990s, shock waves reverberated through the Catholic Jesuit community. Ignatius was born to a n.o.ble Spanish family and aspired to become the paragon of hidalgos; he was a soldier, courtier, and seducer. After a canon ball shattered his leg, Ignatius devoted his energies to founding the Society of Jesus. Meissner claimed he displayed the symptoms of a phallic narcissist: exhibitionism, self aggrandizement, arrogance, unwillingness to accept defeat, and a need for power and prestige. Phallic narcissists can have "counterphobic compet.i.tiveness and a willingness to take risks or court danger in the service of self-display." This "ruthless drive" may give them the "appearance of strength of character and resourcefulness."16 In other words, the biography of the saint read like the profile of many a hedge fund manager.

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Alfred Borden, a magician played by Christian Bale in The Prestige, The Prestige, counsels a small boy on the art of illusion: "Never show anyone anything. No one is impressed by the secret. It is what you use it for that impresses." Borden offers this advice right after showing the lad a cheesy coin trick. counsels a small boy on the art of illusion: "Never show anyone anything. No one is impressed by the secret. It is what you use it for that impresses." Borden offers this advice right after showing the lad a cheesy coin trick.

Just as a private investment portfolio can maintain secrecy, hedge fund strategies can remain a proprietary secret. Hedge funds that have a "patented" investment strategy or that feel they have a "proprietary" model that only they, "the smartest guys in the room," have discovered, are probably bad bets. The usual excuse for secrecy is that they do not want someone else to copy their trades or manipulate the market and damage their profits. That was Long-Term Capital Management's excuse, until it blew up and had to disclose its positions to its creditors. Sometimes there is no strategy other than to employ as much leverage as possible with the hope to get lucky.

What if the secret strategy means your hedge fund manager invests in a diversified stock index fund portfolio and pays fees of only about 0.1 percent per year while charging you much more? How would you know? Suppose your hedge fund manager thinks the stock market is going to tank. When a hedge fund manager has more than $1 billion in funds under management, he can invest in virtually risk-free T-bills and do well for himself with a 2 percent management fee. In a down market, he can claim victory with even a small positive performance. How long would it take investors to figure it out they are paying hedge fund fees for T-bill performance and pull out? Remember, the strategy must stay secret.

Warren does his best to create transparency. His shareholder letters try to explain everything, even anomalies created by accounting and conventional reporting. He even explains his derivatives positions and educates investors on potential volatility of earnings. His investors can find him at the annual meeting, and he and Charlie Munger entertain detailed questions for hours on end.

The offsh.o.r.e location of many hedge funds makes it easier to keep investors from second guessing managers. Moreover, managers do not even have to tell you when they change strategies, as long as the doc.u.ments you signed allow them to do it.There is usually a waiting period for withdrawing your investment from a fund, so in the meantime, you just have to take a manager's word for how well they are doing.

A hedge fund manager usually has an anecdote, an after-the-fact after-the-fact anecdote, about how he made a small fortune on a prescient bet on, say, the renminbi. He will leave out the part about the large euro trade in which he lost a large fortune. The manager is rarely able to tell you about his anecdote, about how he made a small fortune on a prescient bet on, say, the renminbi. He will leave out the part about the large euro trade in which he lost a large fortune. The manager is rarely able to tell you about his current current trades; he will claim he doesn't want other managers to know his strategy. trades; he will claim he doesn't want other managers to know his strategy.

Hedge funds do not create new a.s.set cla.s.ses or new investments, and investing in them does not necessarily make you more diversified. You cannot be more diversified than the market portfolio, and hedge funds trade in the global markets. If you go long and short market a.s.sets, as traditional hedge funds used to do, the mix does not become more diversified. The stock market offers a simple way to look at this. Together, pa.s.sive and active investors own 100 percent of the global stock market. The average return of all pa.s.sive and active investors together is exactly equal to the average return of the global market. The average return of pa.s.sive investors, the indexers, is also equal to the average return of the global stock market.

This means that active investing is a zero-sum game. Given that pa.s.sive investors' return is the average, active investors must also have the same average return as the global market, before fees, before expenses, and before taxes. If some hedge funds wildly outperform the market, as some claim to do, other hedge funds must spectacularly underperform. Fees, expenses, and taxes just make the spectacular underperformance even worse. Tavakoli's Law states that if some hedge funds soar, some must crash and burn. Tavakoli's Law states that if some hedge funds soar, some must crash and burn.

Hedge funds protest that active investors also include some small individual active investors, and they say they are making money off of those people. But there is no evidence that is true. I do not buy the argument that, on average, individual active investors underperform hedge funds. It is probable that individual active investors outperform outperform hedge funds after one adjusts for creation bias, survivors.h.i.+p bias, fraud, other misleading methods of reporting returns, and high fees. hedge funds after one adjusts for creation bias, survivors.h.i.+p bias, fraud, other misleading methods of reporting returns, and high fees.

Taken as a whole, active managers in the market will underperform the market average by an amount equal to their cost of trading (their trading commissions plus their total fees). This is true for hedge funds, mutual funds, and an individual investors' stock portfolio. Unless you can consistently improve your a.s.sets by trading, the less one trades and the lower one's fees and commissions, the better off an active investor will be.

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Investors are only human, and human beings are not good at a.s.sessing probabilities (and therefore risk) without formal training. Even experts sometimes have trouble. Scientific American Scientific American's Martin Gardner auth.o.r.ed a section on mathematical games and a.s.serted that in probability theory it is "easy for experts to blunder."17 One study suggests that people with injuries to the frontal lobe might be better investors, even though this type of brain damage results in poorer overall decision-making ability. Studies showed individuals would take 50-50 bets in which they could win 1.5 times more than they would lose, but people with sound minds would not take the bet unless they had a 50-50 chance of winning twice twice as much as they might lose. A few business school professors suggested that the brain-damaged people would make better investors. For example, brain-damaged hedge fund managers might accept a 50-50 chance of winning $3 billion versus losing $2 billion, whereas a hedge fund manager of sound mind might not accept the bet unless he had a 50-50 chance of winning $4 billion versus losing $2 billion. as much as they might lose. A few business school professors suggested that the brain-damaged people would make better investors. For example, brain-damaged hedge fund managers might accept a 50-50 chance of winning $3 billion versus losing $2 billion, whereas a hedge fund manager of sound mind might not accept the bet unless he had a 50-50 chance of winning $4 billion versus losing $2 billion.

The problem with that reasoning, as hedge fund after hedge fund has discovered, is that the market has uncertain outcomes and the probabilities are unknown in advance. In such circ.u.mstances, making riskier bets does not show superior decision-making ability, it just means the fund manager is happy to accept a lower margin of safety.

Even the hedge fund manager of "sound mind" can be wiped out on a series of bets that have a 50-50 chance of winning $4 billion versus losing $2 billion. John Maynard Keynes warned: "The market can stay irrational longer than you can stay solvent."18 Warren Buffett is even more risk averse than the hedge fund manager of "sound mind."Yet he is the best investor in the last century-perhaps in the history of mankind-disproving the theory of efficient markets, a pet theory of many business school professors. "You can occasionally find markets that are ridiculously inefficient," Warren points out, or "...you can find them anywhere except at the finance departments of some leading business schools." Warren Buffett is even more risk averse than the hedge fund manager of "sound mind."Yet he is the best investor in the last century-perhaps in the history of mankind-disproving the theory of efficient markets, a pet theory of many business school professors. "You can occasionally find markets that are ridiculously inefficient," Warren points out, or "...you can find them anywhere except at the finance departments of some leading business schools."19 In his book Innumeracy, Innumeracy, mathematician John Allen Paulos gives many examples showing human beings are not good at a.s.sessing probabilities without formal training.We like to explain random events after-the-fact as if we predicted the outcomes. Many hedge funds are successful simply because of lucky bets. If the bets randomly pay off and the fund has a great year, the lucky fund manager takes credit for being a genius.When Na.s.sim Nicholas Taleb, a risk theorist, discusses Buffett's success, he seems to d.a.m.n it with faint praise: "I am not saying that Warren Buffett is not skilled; only that a large population of random investors will mathematician John Allen Paulos gives many examples showing human beings are not good at a.s.sessing probabilities without formal training.We like to explain random events after-the-fact as if we predicted the outcomes. Many hedge funds are successful simply because of lucky bets. If the bets randomly pay off and the fund has a great year, the lucky fund manager takes credit for being a genius.When Na.s.sim Nicholas Taleb, a risk theorist, discusses Buffett's success, he seems to d.a.m.n it with faint praise: "I am not saying that Warren Buffett is not skilled; only that a large population of random investors will almost necessarily almost necessarily produce someone with his track records produce someone with his track records just by luck. just by luck."20 If Taleb needed an example of success due to random luck, he did not choose well; he could have chosen from any number of hedge funds instead. Taleb fails to mention If Taleb needed an example of success due to random luck, he did not choose well; he could have chosen from any number of hedge funds instead. Taleb fails to mention conditional conditional probabilities (in this context), and it is remiss to describe Warren's success without bringing that up. Certainty is not possible, and luck is always a part of the equation, but Warren works hard to uncover a margin of safety whenever possible. probabilities (in this context), and it is remiss to describe Warren's success without bringing that up. Certainty is not possible, and luck is always a part of the equation, but Warren works hard to uncover a margin of safety whenever possible.

What is the probability of a successful investment, given that one has a sound methodology for a.n.a.lyzing a business? It is much better than the probability of success without the sound methodology, and the probability of disaster is very low. In contrast, a one-sided leveraged bet presents an altogether different conditional probability.What is the probability of a disaster, given that one has merely leveraged a market bet? If one is lucky one will do well, but if one is unlucky-or simply flat out wrong from not doing one's homework-the probability of disaster is about 100 percent.

I sent Warren a client note in September 2006 in which I made a similar point after the Amaranth hedge fund imploded after losing its s.h.i.+rt on natural gas contracts.The hedge fund leveraged up a bet and the bet (on natural gas spreads) went against them. It was a cla.s.sic Dead Man's Curve trade: "The last thing I remember, Doc, the market started to swerve."21 Unlike Warren Buffett, Amaranth had no margin of safety. Warren wrote back: "You both think and write well." Unlike Warren Buffett, Amaranth had no margin of safety. Warren wrote back: "You both think and write well."22 Since meeting Warren, I've found myself comparing every trade against value investing. Since meeting Warren, I've found myself comparing every trade against value investing.

A man once asked the late Richard Feynman, a n.o.bel Prize- winning physicist, how he would design an anti-gravity machine.When Feynman replied he could not, the man pointed out that it would solve the world's problems. Feynman said it didn't matter, he didn't know how to do it. Many investors seem to hope that hedge fund managers have designed a strategy that uses leverage to create profits that will forever defy gravity. Yet Warren Buffett will be the first to admit that even he cannot design the financial equivalent of the anti-gravity machine.

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Most hedge fund managers happily load up on risk to stay in the game. Hedge fund wisdom is "heads I win, tails you lose, and I still still win-just not as big."There is one other possibility:The coin can stand on edge-the hedge fund manager gets bailed out, and you give back your winnings, but we will get to that later. For now, winning means that a hedge fund's returns are up, managers collect hefty fees while attracting new money, and investors get a reasonable return on their money. Losing means that hedge fund managers still make hefty fees and investors have a negative return or perhaps even lose all of their money.The hedge fund manager hates to lose, since he will not be able to attract new money and the money, upon which he gorges, will shrink, thus decreasing his payday. win-just not as big."There is one other possibility:The coin can stand on edge-the hedge fund manager gets bailed out, and you give back your winnings, but we will get to that later. For now, winning means that a hedge fund's returns are up, managers collect hefty fees while attracting new money, and investors get a reasonable return on their money. Losing means that hedge fund managers still make hefty fees and investors have a negative return or perhaps even lose all of their money.The hedge fund manager hates to lose, since he will not be able to attract new money and the money, upon which he gorges, will shrink, thus decreasing his payday.

n.o.bel 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 a.s.sets 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 Partners.h.i.+p 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 partners.h.i.+p, and each of them withdrew their investment and thought they made money. Other investors in the partners.h.i.+p lost money in an alleged fraud. It seems the trustee wanted all investors, even former former investors, to share in the pain, claiming the gains were "unjust enrichment." 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 princ.i.p.als, 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." 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 doc.u.ment. Scrawled on his car's hood dust were the words "suicide is painless" from the M 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 doc.u.ment. Scrawled on his car's hood dust were the words "suicide is painless" from the M[image]A[image]S[image]H theme song, which probably doesn't sound funny to the investors whose cash was mashed by Israel. 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 t.i.tled his review of "Scammy's" disappearance: "Show Me the Corpse!" Greg Newton's blog t.i.tled 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. 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 a.s.sociates, (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 a.s.sets 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 princ.i.p.al 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.

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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.