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Slaughtering the Sacred Cows of the trading industry

  1. There are a number of "Sacred Cows" in the trading and investment industry, that are - quite frankly - ridiculously indefensible. It is about time that these moronic behaviours are eradicated for good. Here's a few particularly egregious examples.

    1) Hedge fund 2 and 20 performance fees. This one is really easy - NO fund should have any management fees whatsoever. If you actually underperorm t-bills, then you have screwed over your investors and you should earn a big fat zero. Hedge fund managers are supposed to be risk-takers, yet they aren't willing to risk not getting a management fee if they actually have a down year? If Buffett in the 1950s could do 0 and 25, and if Mohnish Pabrai can do that now, then so can hedge fund managers. So, this should be abolished because it is a sign either of having no confidence in one's ability to trade profitably; or of being a greedy git. If you are the latter but not the former, then 0 and 25, or 0 and 30+, makes much more sense. Live and die by your performance, not by being a fee-creaming asshole like the mutual funds

    To see how this really fleeces investors, just look at the fees taken at different return levels. Then compound that over 5-10 years. For terrible single digit, or mediocre 10-15% returns, the hedgie makes a fortune whilst investors get the shaft.

    2) Annual fees with lack of clawbacks. This is one of the worst. You know the scam - use a high win rate strategy (usually short-gamma e.g. put selling, "relative value", convergence trades, stat "arb" etc) that works 4-5 years in a row then blows up. Make 30%, 30%, 30%, 30%, -100%. The hedgie gets 20% of profits and 2% of assets each year for the first 4 years, then leaves investors holding the bag. LTCM and Niederhoffer are great examples. The way to avoid this free trader's option, which promotes scamming and criminal behaviour and costs investors fortunes, is to have a clawback provision - 3 years, for example, with the hedgie only getting 1/3 of his bonus in year 1, 1/3 in year 2, and 1/3 in year 3, and a 3 year clawback on past bonuses if he has future losses. That way there is lower incentive to do yield-hog blowup high-win-rate strategies, since the hedgie has much more to lose - his bonus is deferred, and can be clawed back if he blows up.

    3) Abolish the high-water mark. Once a hedgie is down 30% or so, he faces ages before getting incentive payments again since he has to get back to the high-water mark. This encourages gambling and reckless trading - Niederhoffer in 1997 was the perfect example. Heads the hedgie wins and makes a killing; tails the fund blows up. But since it would suffer massively withdrawals and pay no bonuses anyway, that isn't such a big deal. The trader has upside if he is reckless, and little downside if he blows up investors' funds. Replace the high water mark with the clawback provision. That way, each year the manager starts afresh and is incentivised the same. He can then take risks based on the current market climate, NOT based on how he did the year before.

    4) Position limits. Exchanges already have the ability to enforce 100% cash purchases, or even to go to liquidation-only trading. As seen by the massacre of the Hunts during the 1980 silver bubble, these tools are more than powerful enough to stop any true market manipulation. Position limits therefore do not help one iota in stopping a manipulation, especially nowadays in a globalised market where many speculators own storage & delivery systems, thus classifying themselves as "trade"/hedgers and circumventing the limits. Position limits nowadays only serve to stop skilled speculators from supplying liquidity and achieving price discovery, which retards the correct supply & demand being portrayed and thus addressed by the market.

    5) Mutual funds, and asset management fees. It should be made illegal to charge any asset management fees in excess of the fair administrative costs of a fund. All fees that generate actual profit for a fund management company should be based on performance only. The mutual fund industry has for decades exploited ignorant and naive retail investors by charging massive fees, having huge turnover, and sucking performance-wise compared to the indices. It is a triple whammy that results in huge costs to investors over time. The economic rent scammed by the fund management industry is effectively a reverse form of welfare - taking from the poor and middle class, to make the rich richer. Now the real culprit here is people being too stupid to educate themselves and their offspring/students, and the government having such appalling financial/economic education. However, just because a vulnerable person is ignorant does not mean it is acceptable to scam them. I am sure I could con an old lady into investing her life-savings into the vehicle of my choice - that does not stop it being a crime. The assessing of totally outrageous, excessive, undeserved mutual fund management fees is no different - except the scale is far bigger, and thus the social and individual cost in terms of pensions f*cked, retirement savings demolished, is numbered in the billions if not trillions.

    6) Brokers pooling investor/customer accounts for cross-margining. This exposes customers to unnecessary credit risk - one trader blows up and everyone loses their money. It is unacceptable for brokers to take customer funds, and receive the profit, in return for exposing the customers to excessive credit risk. Customer funds should be placed at a kind of clearing-house, and brokers only allowed to use those funds for the trading of each customer. This would raise the cost of trading, but it would be safe trading.

    7) Imposition of margin limits for ALL investment transactions of any kind. Whilst we have a fractional-reserve system, with socialisation of bank losses, and private control of the money supply, it is completely unacceptable to allow banks to charge economic rent by gambling on high leverage with customer funds and thus (due to the Bernanke/Bear Stearns put) charging the tax payer annually the cost of that put, without paying the premium in real cash. Since abolishing bailouts, fractional reserve banking, or taking control of the money supply (using a GDP money growth rule a la Friedman) seem politically off-limits, the only moral and sensible economic course is to regulate all leveraged transactions and impose margin limits. I would suggest 10-20% margin should be used as a baseline - lower volatility products which bear little relation to face value (e.g. Eurodollars) can get different % rates, higher vol stuff like oil futures should be 10% at least. Anything off-exchange (with no clearing house) should be charged double-margin. This should also apply to housing - minimum 20% deposit to own a house. The reason is that housing risk is also socialised. Poor & middle class people gamble with 0% deposits, and the rich high-bracket taxpayers have to pick up the tab when the former lose, whine, then get a government bailout. That's totally immoral, therefore the reckless gambling with OPM must be limited in the first place.

    8) Equal regulation of financial journalists, newsletter writers and financial advisors. It is totally unjustified that to charge someone for financial advice, one has to jump through onerous regulatory hoops, none of which in any way protect the customer; yet journalists are able to freely dole out advice, usually totally unsound and destructive of wealth, and also charge (via newspaper/magazine costs). Fund managers are given free reign to promote investment ideas in the press. This is ridiculous - one class is allowed freedom of speech, the other denied it...for the same subject! Therefore, abolish all restrictions on giving financial advice, but make people legally liable for giving atrocious advice that destroys wealth. Most common liability can generally be avoided by disclaimers - let anyone use them then, and level the playing field - but the worst advice could not. This is a fair situation, which would allow more people to enter the advisory field, reducing costs for the public; and the lawsuit threat would be enough to enforce justice and keep advice relatively sound.

    9) Eliminate any regulatory controls on setting up an investment fund or collective investment scheme. As we have seen from multiple hedge-fund failures, regulation does not protect investors, and there is ZERO legal enforcement after the fact for reckless gambling and defrauding blowup artists like LTCM, Brain Hunter/Amaranth etc. Replace it with mandatory alignment of interests - make it compulsory for the fund manager to have 75%+ of his entire net worth in the fund. That way, the manager will trade the way investors would want him to - as if it was his own money. If investors get fucked, at least they have the consolation that the manager took an even bigger hit to his capital. Having alignment of interests relies on nothing more than basic human nature - self-interest - to make sure the manager is responsible and acts fairly to investors. Anyone who thinks this is reckless should consider that it is perfectly legal to give someone a 100% mortgage, or to take all their money and use it as a 5% deposit on a commercial office building - both of which are many, many times more risky than even a leveraged hedge fund, let alone a normal cash-only investment portfolio in listed securities.
  2. N.B. I am well aware that lots of these recommendations go against a free-market caveat emptor principle. But while society is vehemently anti-market, and insists on bailouts for reckless gamblers aka "investors", "homeowners", and "banks", and shows no willingness to make them take responsibility and consequences for their own behaviour, but instead puts the cost onto me and others like me, then simple principles of economic self-defence require them to be restrained.

    If the costs of their stupidity are borne by the, it's their business. Once it becomes borne by me, it's now my business.

  3. what fees/costs are being "borne by you" ? specific examples please, not esoteric "what ifs"

  4. Cutten,

    You took a long time getting there but the answer lies in (9)

    When ever someone approaches me with the investment opportunity of a lifetime, my response always has the same two components.

    .... you must commit more of your net worth to the project than me.

    ..... I must be offered the sellout before you.

    Fees are immaterial because none of the many approaches have ever survived the first two requirements.
    Hence my Wife and I have never joined schemes or taking onboard partners since we became in a position to invest.

  5. What regulation will stop “Hunter” brothers to open 2 diff funds and go long/short on Nat gas ?
  6. Excellent Commentary All


    The payment arrangement for a stock hedge fund should be very simple....and a manager should not be rewarded for something the individual could have done on their own without any management....

    An individual can invest in TBills....

    An individual can invest in the SP500....

    Thus no management fees and a percentage of the amount above TBills for strategies that would have no downside risk to the initial principal....

    Or no management fees and a percentage of the profits above SP500 returns when profits are made....and a payment arrangement from the manager to the individual if there is underperformance of the SP500....

    These two forms are how one would truly isolate the value of management....
  7. Some excellent insights, Cutten.
  8. wasn't the great depression blamed on 10% margin in the stock mrkt,where are we now percentage wise globally,i doubt even the fed knows, when gore lost the election due to fraudulent chads, he knew it,everybody knew it,nothing was done about it because everyone had dirt on everyone,how is this speculative bubble any different, they could close that loophole in the banking sytem on monday morning if they wanted to,but too many of their friends would lose money, same old same old,same shit different day
  9. For mutuals (relative return), that works, since that is their goal; index outperformance. For hedges (absolute risk-adjusted return), it doesn't.

  10. Cutten: Great post. Agree everywhere around.

    Accountability to ones' self is the greatest motivator for judicious decision making ... I love the requirement to put 75% of liquid net worth into trading funds for money managers and anyone who controls capital.

    Although figuring out the structure for i-banks, the most egregious of offenders and manipulators might be difficult.

    The whole corporate shield is the defining trait that entitles recklessness with other peoples' money. (which in this case, often boils down to fed funds)
  11. I have thought about (3) above, but the problem is the managers would shut-down and start another fund once they have a losing year, so as not to carry forward any loss. But point (2) seems to fix it in those situations when the manager has good years prior to the loss. Great thoughtful recommendations that should be adopted in a rational world. Unfortunately, we do not live in such a world (as yet), and the operators will always find a cheap way out.
  12. seems to me like most of your suggestions call for some type of regulation, then at the end you say regulation never works.

    I agree losses should not be socialized. however, what business is it of the goverment or quite frankly anyone but the parties involved how private partnerships or businesses choose to set fees? it absolutely is not. The clawback notion? that may be something for investors to negotiate over, yet should the government mandate it? I say absolutely not. I know I would never run a fund with this feature. The general partner is Already the one taking on the unlimited liability of the fund. THis alone is worth a great deal to the limited liability partners, and personally would be all the risk I would be willing to take on a fund under my management. If one is not able to adequitely assess the character and integrity of the manager to a reasonable degree, or is so blind to their strategy it is a "black box" and is willing to accept that, or if one is investing capital in such a fund that if lost it would make a real difference in the their financial situation, i call that person a fool.

    It is true many mutual funds are poor. However, the fact is, any return above the risk free rate on long term investments is a huge benefit for most people.. people who are not sophisticated, who quite frankly need to be talked into an long term investment, because if not that its all their life savings in a savings acount paying less than inflation.

    If an investment "walks" up to you, obviously there is extra cost involved.. why else would someone be selling it if it was not going to make them money? most people are too dumb and lack the foresight to plan and invest long term.

    Lets keep working on eliminating "the socialization of losses". Ruling that out as not possible is essentially giving up the whole game. Adding additional rules just creates new headaches and takes away more freedoms. at face value, they may seem to be common sense, yet they move us in the wrong direction.

    I guess i am a lot more positive about the nature of this industry an what it offers.
  13. I disagree with this notion in particular:

    "make it compulsory for the fund manager to have 75%+ of his entire net worth in the fund."

    This may or may not be a good thing. But to actually believe the government should mandate this? just flat out ludicrous to me. the world will never be perfect, and I am afraid more rules will not make it so. just the opposite. it would kill competition and entrepreneurship in our industry.
  14. Good stuff Cutten.

    I think #1 is the most basic, but it is the one I have complained about most over the years to people I know.

    If you go to www.iasg.com and simply compare the performance fees of some of these CTA's, Hedge funds, etc., you will find that some idiot who's been around for 6 months with mediocre results is charging the same as some of the seasoned veterans.

    William Ekhardt (among others) posts his results there on a regular basis, but many funds charge the same performance fees as his for sub-standard results.

    I've always thought that if I started a fund, I would charge something like a percentage of my gains over the % gain of the sp500 for the year/quarter, and maybe a small % to cover fees.

    But here's the other side of the argument: If you run a small fund, and you need to pay a lawyer, an accountant, and a small staff, you need to collect 2% just to cover expenses. And THEN you need to make some money for yourself by collecting % of the gains of the fund.

    I've never bought into this other side, and I've never understood why these supposedly brilliant young fund managers, managing 750 thousand dollars didn't simply go prop, and make themselves millions.

    If they have millions under management to start with, then how'd you raise it? you must have a track record of your own and money in the bank.

    I think the answer is obvious to all.
  15. Response to Cutten:

    Those reckless gamblers you are talking about are banks, brokerage and investment banks, hedge funds, insurance companies, pension plans, etc. Todays sub-prime mess was caused by greed of all those banks that were selling packages of sub-prime loans. You sound like the mortgagee should do his own due diligence and tell the bank, "You know, if I were you I would not loan me the money for this mortgage, because I really am not a good credit risk". Not goanna happen! Banks are supposed to do their own due diligence. The reason they did not is because they were planning to sell these mortgages to other organizations. This took away their incentive to perform due diligence. It is no ones fault but the banking industry and the Federal Reserve for ignoring this problem for 3 years.

    The sub-prime mess was caused by banks putting together pools of sub-prime mortgages and taking them to other banks for loans. The Federal Reserve allows banks to borrow against sub-prime mortgage pools with only 10% equity. They can borrow 90% while putting up equity of only 10%. So when the values of these CDO's, SIV,s etc started to fall banks and brokerage firms that had pyramided their mortgages could not meet their margin calls.

    The Feds solution was to charge the cost of this to the American Taxpayer by way of bailing out Bear Stearns and allowing brokerages, hedge funds, etc to borrow from the discount window as banks are allowed to do. This attempt at supporting liquidity in the sub-prime market did not extend more credit to consumers. Indeed, banks have pulled by their credit extension because of their own mistakes. However, in the end we taxpayers will have to pay this bill.

    Because the Fed did not do its regulating job, we are paying the price by less credit availability resulting in lower GDP growth. This is not the fault of sub-prime borrowers but the fault of the organizations that created these types of investments. They are the ones who could not meet their margin calls, which the Fed is allowing the American taxpayer to meet.

    Just some food for thought!

    I enjoy reading your post. Keep it up.
  16. I completely disagree with that as well. If the fund's strategy is to take on high risk positions, and as long as the fund holders understand that, than large drawdowns are a very real possibility. In that case, any investor would be insane to have more than a small percentage of their portfolio in the fund in order to diversify. So why would you force the fund manager to commit suicide in his own fund if everybody knows it is a high risk based fund.

    Secondly, I also disagree with the statement about hedge funds. Hedge funds aren't supposed to outperform indices. They aren't supposed to be correlated with indices period. Thus they may or may not match the returns. The purpose of a hedge fund should be to decrease volatility in a portfolio, NOT to get exhuberant gains. But I would agree that the management fees in hedge funds are much too high though. Again, since I view hedge funds as being a way to diversify, paying outrageous fees defeats the purpose again.

  17. a blast from the past:

  18. According to professional who talk to oil traders everyday they say that "You know, when we talk to refiners and other industry contacts, they consistently come back and say without speculation oil would be in the $65-70 range today." http://www.iptv.org/mtom/story.cfm?Lid=1127

    It is not logical for oil to be this high, except that traders only have to put up 2% of their own money and are allowed to borrow the rest. Speculators are coming out of the wood work according to articles I have read.

    Start a web site called "Friends of the Oil Companies" if you feel sorry for them.

    Thanks for your comments,
  19. funds do a wonderful job of convincing public that they need a professional to manage their money for a fee producing 5% ananual returns.

    some private hedge funds make 50%

    so the need for gov't regulations in fees is ridiculous.

    people who buy some funds like balance funds making 5% know they won't get rich and know they won't lose much if any. cause those funds are diversified and usually for 5 years or more ...

    the risky hedge funds producing 50% annually have more risk and for accredited investors so they know the fees and risk.

    i don't need the gov't how much a business can charge it's customers.

    the gov't can't even regulate market maniuplation and rampant fraud in the market


  20. you are welcome. best wishes to you. oil is going to come back down, just wait and see....
  21. Another problem with point 3 is it also gives the manager the incentive to stop trading the fund if the drawdown is viewed as too high to overcome. If it would take 2 years, for example, to get back above a 30% loss where's the incentive to keep trading the Fund and receive no income during that 2 year period? The manager would be better off to start another fund, like you mentioned, or even trade his or her own account and keep 100% of the profits.

    And, a 2%, 20% is not a bad deal if the 2% is based on profitability. Agree with the OP, no fund manager should get paid for losing investor's money. The 2% on profitability does, however, give the manager an incentive to deliver a nice return without over-exposure to risk. If the manager collects only the 20% then he has an incentive to juice up the position sizes. If a manager does 25% or 30% or even a sliding scale he/she also has an incentive to take on more risk. Giving the manager 2% based on profitability is a good deal because the manager doesn't feel the need to swing for the fences and reach a 100% return to collect an additional check. Theoretically, the managed capital will exceed profit capital so it gives the manager an incentive to work, but not the incentive to go too large.

    Excellent post by the OP!