2 and 20
Hedge funds have a problem. It’s a problem I would love to have — to much money and not enough good investment ideas. We’ll at least I’ld love to have the first problem. The problem is that too many people are looking for yield in a low yield environment. To find yield, people are taking on too much risk — both interest rate risk and default risk. (I.e. people are not getting paid enough to lengthen the duration of their portfolio or to invest in the bonds of riskier companies.) Even Greenspan has commented on this problem.
In the search of higher cash returns, more people have entrusted their savings to hedge funds. Hedge funds, generally speaking, try to produce alpha or excess return. They employ a variety of strategies to reach this goal. Many of them trade often, use leverage, and try to create yield for their investors.
But the biggest mark of a hedge fund is the compensation structure. Hedge funds charge 2% of assets and 20% of profits. Of course, they don’t pay 20% of losses. (They will generously stop charging 20% of profits until they recoup previous losses.) The idea is to give the managers a large incentive to perform. The effect is often much different.
If a manager of a regular corporation had the option of betting $1mm on a fair flip of a coin, there is no way he would take the gamble. But, if a hedge fund came across the same gamble, he would be incented to take it. If he was successful, he would have an extra $200K in comp. If not, he would still get 2% of assets.
If you think this scenario is too academic, check this Reuters article out. Hedge funds have been investing in “cat” bonds for while. Cat bonds are bonds whose payments are correlated with catastrophe losses. They allow reinsures to spread the risks of their losses and give a higher yield to investors willing to accept more risk. After Katrina, I thought some of these hedge funds would realize that they didn’t appreciate the risks.
But the opposite has occurred. Hedge funds are now setting up captive reinsurance companies and trying to compete with established reinsurance companies. Good luck. They don’t have the expertise or relationships to compete. They will drive prices down, will make our insurance more affordable (thank you), and hopefully hurt their investors. Reinsurance is based upon long-term contracts and relationships; insurance companies (especially well-financed ones) do not want to change their reinsurer often. The hedge funds will have to compete on price (and probably charge significantly less) to get customers.
This begs the question: why don’t the hedge funds just invest in established reinsurance companies? The answer is 2 and 20. There is a small probability of a major event. If it occurs, they don’t have to pay — and may even liquidate and restart so they don’t have to make up their losses. If it doesn’t occur, they get 20% of a much larger gain. If they, instead, invested in reinsurance companies they would be at the mercy of the market to value their investments. It’s easy money for the managers even though there is a much better alternative for investors.
The better question is: why would investors in hedge funds pay 2 and 20 for reinsurance exposure?
Pagar said,
September 30, 2005 @ 9:25 pm
New reader of your blog. Looks like you have some good points.
Just my thoughts on what I do to increase return on my investments.
I use covered calls on dividend paying stocks in tax advantaged accounts.
Congress a few years back decided that covered calls were safe enough to use in IRA’s. Many investors fear covered calls because they are consider to be part of what many see as risk taking by using options. My thought is that they are like tires on a car. One can drive a car with no tires(Not Far). Is there a risk if you use tires on your car. Yes,if the tire goes flat.
Is the reward for using the tires greater than the risk. Absolutely. You can drive much farther.
Example; using the money his grandfather gave him because he graduated from college (No 1 in his class), and since he has been working partime while in college, he put some money in his Roth IRA last year. With the money, he is eligible to put in the IRA this year,
Saver A has enough to buy his 1st stock-100 shares of Bank of America (BAC) considered by many to be a high yield dividend paying stock, that is fairly safe. The fact that Saver A put the the stock in a Roth IRA means the dividends do not trigger a tax event when paid, and
also that Saver A will not have to pay someone else to do his taxes each year. Saver A was awake the day the professor talked about covered calls in class, so he immediately sells a covered call on his 100 shares of stock. Not wanting to be a slave to the stock market, the call is sold (written) for Jan 07 Strke $45 at $2.00. Meaning, as soon as the call is entered to his broker over his computer the broker will place $200 in to Saver A’s IRA account, Saver A gets all the dividends each quarter, placed in his IRA account. Saver A doesn’t need to do another thing to his account till the 2nd week in Jan07. All covered calls clear the 3rd Friday in the month they are written for. Saver A can then roll the Option forward to Jan 08 or let the option expire or be called, (based on the price of the underlying stock at that time. Assuming there is no change in dividend payment, Saver A has $2.50 from 5 dividend payments and $200 from the covered call he sold $450 total in his IRA on 30 Jan 07 plus the shares of BAC.
Saver B also got a 100 shares of BAC stock that his grandfather had been giving him at the rate of a few shares per year, but they are not in an IRA account. By Jan 07, Saver B will have received the dividends, same as Saver A, But Saver B paid taxes on dividends received from the stock in 2005 and again paid taxes on dividends received in 2006. Plus the dividends made his taxes complicated so he paid someone else to do his taxes. So on Jan 30 2007, Saver B has what’s left of the $250 received from dividends, less taxes and tax return preparation fees.
Each saver holds on to the shares till their retirement. Which Saver do You think can afford to retire early. Which saver gets a Christmas card from his tax preparer every year?
Covered calls make a high dividend stock investment program better.
Don’t know enough about covered calls? www.888options.com
has more info than one can absorb, but covered calls is the only option info the dividend investor needs.
Don’t know enough about taxes, trade in tax advantaged accounts (IRAs) and spend less time worrying about taxes. But start young so that you can maximize your income.
Just my thoughts, hope it helps someone.
Brian said,
October 1, 2005 @ 9:17 am
I agree with you that using an IRA versus a taxable account can help you compound your returns faster and help you retire earlier.
However, I don’t think selling covered calls is as obviously profitable strategy as you think. Selling a covered call gives you immediate income but does limit your upside in the future.
Taking your example, selling a Jan 07 call on BAC at a strike price of $45, means that you are limiting the the ruturn you can earn from price appreciation to $2.90 (or just under 5.5% annually). So you are trading away a lot of possible future price appreciation.
I don’t know if you are getting a good deal or not selling BAC options. That’s for you to decide. But I hope you and everyone else reading this understands that this strategy can work but requires research to be successful.
The strategy only limits your upside and doesn’t expose you to any more risk than owning the stock. (In fact, if you use the ivory tower definition of risk, volatility, you reduce risk.) If you are interested in options trading, selling covered calls is a low risk way to get started. But, don’t kid yourself, it takes a lot of work to be successful.
On a side note, I’m a little worried about Saver A’s propensity to make trades based on a lecture. The best advice I can give throughout this blog is that you need to do your own research to convince yourself that you are doing the right thing. If you trade/invest based on other’s recommendations you are doomed to follow the crowd and have no idea when to sell.
Good luck with your covered call strategy.
Pagar said,
October 1, 2005 @ 2:58 pm
Enjoyed your reply. before offering my thoughts on your points, permit
me to say that when I comment on a financial blog my remarks are intended to give some info that I haven’t seen on the blog and that may benefit some one. No way do I think I have all the answers or that I have found the true path to wealth and there is no other.
Maybe I did not spell out clearly that I do not own BAC, I simply used it as an example of a stock that many people are familiar with, and for people that are somewhat familiar with the market, many may consider it a fairly safe stock with a dividend over 4 % which meets their determination of a high yield. The highest selling price of the year was $47.44 last reach in Jun. Could one miss some future price appreciation?
Yes, however it’s also possible that one would not. If one were watching the account, there are ways to overcome sudden price rises, but if one was not, and the stock were called away one still has more than the person who held the stock for that period of time, if the
stock had not risen more than the strike price. Holding BAC, thinking that one was going to get rapid stock price increases, would not be what I hope to teach my grandchildren about investing.
Almost every investment strategy requires research, and a comfort
zone. My sister invests in CDs, spends a lot of time figuring out the
best yield, would never invest in stocks, not comfortable with them.
In my mind, once one has made the decision, which dividend yielding stock to buy, the covered calls decisions are easy and profitable. I have no desire to go past the covered call portion of option training. I’m not confortable with any of them. I spend a portion of almost every day reviewing my account. I have done it for some years and
feel that it has worked for me
As for saver A’s trades, the point I was trying to make was that Saver
A somehow got the information that covered calls were avaiable, and could increase one’s return from the stock market.
Saver B never got that information. If one watchs any of the stock boards that have a variety of investing types posting , you see msgs
such as “this stock on pays a dividend of 4% , how can I make more”
or “I can’t sell because of the tax consequences” . It took me years (before the internet) to find out that I did better with covered calls and when IRA’s became available I did even better. What I see on many financial sites is that there are still people who don’t know that.
I’ve given freely of investing information that works for me; as is readily evident by this blog site, you have given freely of info that works for you.
May you have continued success in life.
Canadian Capitalist » Carnival of Personal Finance # 16 said,
October 27, 2005 @ 7:31 am
[…] 2 and 20: Financial Reference discusses the problems with hedge fund compensation structures and why hedge funds are not suitable for average investors. […]