James Altucher is one of the least arogant and most knowledgeable hedge fund managers I have come across. He is a great investor but has also started some great businesses like stockpickr.com. In addition, James has written several books on investing. The Kirk Report has just run a long interview with James:

“The only three things that are important are discipline, persistence, and psychology. Without those three things there isn’t a strategy in the world that will work for you. With those three things, just about any strategy will work.(…)No human or strategy can consistently beat the market. The best traders I know are some of the most humble guys out there and have no arrogance on their market opinions at all. They are able to switch opinions and strategies very quickly. I would say that over the years any arrogance I had about any strategy has probably disappeared and now I’m appreciative of just about any strategy out there as long as it comes with persistence, discipline, and positive psychology.”

Very  wise words, indeed.

Once upon a time, quant funds were THE investment vehicle every sophisticated investor had to be in. For instance, in 2006 Kiplinger, one of the big personal finance platforms, argued that quant funds were a revolution in active investing, taking the emotion out of investment decisions:

“Human emotion and behavior are too often the enemy of sound investment hygiene. You probably should be buying when the herd is selling and selling when the herd is buying. Many investors fall deeply in love with the stocks they own. Fund managers and Wall Street security analysts often behave like cheerleaders for the companies they’re supposed to be dispassionately analyzing. All this emotion partly explains the growing interest in so-called quantitative funds, mutual funds largely managed by soulless computers that crunch the numbers.”

So far, so good. But what happened to the quant funds of all those math whizzes? Morningstar just published an analysis of quant funds and the results are devastating:

“The carnage has been widespread. For example, seven of Bridgeway’s eight actively managed funds that rely exclusively on quant models land in the bottom third of their Morningstar categories over three years through July 28, 2010. The same is true of six of Goldman Sachs’ eight quant funds with three-year records. JP Morgan has a lineup of eight Intrepid brand quant funds, and each has lagged its typical category peer over the past three years. Vanguard’s quant group has struggled, as has AXA Rosenberg–its four Laudus funds will soon be liquidated.”

How come? Basically, quant funds use many different and complex variables to predict stock market success that showed good performance in the past. Yet, history never repeats itself exactly. The crash began in the summer of 2007. Most quant funds lost substantially and, after changing their strategies over the course of the crisis, they were then not able to profit from the upswing since 2009.

Not surprising and another confirmation that active investing will not be able to beat the market over extended times. Tragically, investors have often paid exorbitant fees to the quant funds as many of them used hedge-fund-style compensation models.

…what the German football team is to the English: a nimbler, more skilful exemplar serving to highlight the latter’s plodding predictability.”

I am not sure if this quote is more flattering to the Germann football team or to the hedge fund managers. It is from a book review in the Guardian about More Money Than God. Whatever you may think about German and English football, the book is worth a read.

Morningstar carries a report that long-short-funds are becoming a red hot product for fund companies as many have launched long-short products.  In simple words, a long-short-fund is a financial product that can bet on falling or increasing asset prices. Particularly during falling markets such products become popular as they can make a profit or limit the losses. Long-short-strategies used to be typical for unregulated hedgefunds but regular mutual funds are more and more using these strategies.

The success of long-short-funds rests largely on the right timing and stock-picking decisions of the fund manager (even more than for long-only funds). As markets increase the fund manager has to go long. When they fall the funds short positions must increase.

Yet, study after study has shown that about 80% of fund managers will not beat their market benchmark in any given year. Plus, those that beat the market are usually not the same fund managers over a period of several years.

So, why then are long-short-funds becoming so popular with fund sponsors?

“In 2009, long-short funds took in a record $10.3 billion last year and they are on track to break that record this year. Through April 2010, they took in $6.3 billion, which makes it the seventh most popular fund category in 2010.”

It seems to me that this flow of new money  is the real reason behind the boom of long-short. 10 years from now most of these funds will have gone to the same place where all the Internet and technology funds have gone a few years ago. Not to mention all the other fund fads that didn’t make money for investors (but a lot for the fund industry). In this sense the present wave of long-short funds should be seen by the rational investor as a contrarian indicator. Especially as these funds often carry higher fees compared to regular mutual funds (not to speak about index funds).

The New York Times Magazine has interviewed Harry Markopolos, an investment manager and math whizz who spent nine years to track the machinations of Bernie Maddoff’s hedge fund.  He concluded  early on that Madoff must be a fraud.  In November 2005 he sent a memo to SEC regulators titled  “The World’s Largest Hedge Fund  is a Fraud.” It described his suspicions about Madoff in more detail and asked the SEC to check his fraud theory.

In the NYT interview, Markopolos judgement of the SEC is a harsh one:

Q: “Why do you think the S.E.C. failed to wake up to Madoff’s $65 billion Ponzi scheme until he turned himself in?”
A: “They weren’t even asleep at the switch; they were comatose. They didn’t respond to heat and light, much less evidence of wrongdoing. They were not engaged in the fight.”

The whole story is a great example how dysfunctional huge regulatory administrations have become in the financial industry. They are not even able to uncover a fraud scheme when someone else does the analysis for them.

Governments around the world are busy these days to develop grand schemes for new regulatory bodies and laws. No doubt, they will be even less functional. The dysfunctionality will most likely be proportional to the complexity of the law and the number of new bureaucrats hired.

Yet, ordinary investors should really take one learning from the Madoff story: Don’t trust the government to see the red flags and protect investors. It won’t happen. Or more precisely, it will happen but far too late. There is only one way for investors to protect themselves from fraudsters - do the critical analysis yourself,  and keep a very skeptical eye on the ocassional fund management Wunderkind.

Hedge Fund veteran and renown blogger Rick Bookstaber is going to Washington to become a senior policy advisor in the new SEC division of Risk, Strategy, and Financial Innovation.

The New York Times reports:

“He will be a member of the S.E.C.’s Division of Risk, Strategy and Financial Innovation, along with Adam Glass, the founder of the law firm Linklater’s structured finance and derivatives practice, and Bruce Kraus, a mergers and acquisitions lawyer at Wilkie, Farr & Gallagher.”

We think this is great news for the financial world, especially with the ever more growing role of complex and leveraged hedge fund products in todays markets. Rick has also given a great interview to MyPrivateBanking.com on Hedge Funds and how private investors should look at them: “Don’t Trust the Numbers Coming out of Any Hedge Fund.”

We congratulate Rick and the SEC to this wise decision!

A paper from the Stern School of Business reports:

“We find that misrepresentation about past legal and regulatory problems is frequent (21%), as is incorrect or unverifiable representations about other topics (28%).”

The researchers have looked at 440 hedge funds that had to undergo due diligence. We are not surprised - given the non-existent transparency of the sector. What we find even more annoying is the fact that wealth managers keep pushing these products into the portfolios of their clients. In our Private Banking Report 2009 we found that about 20% of assets were allocated to so called “alternative products” in the investment proposals of the banks (this category includes hedge funds and private equity among others).