Wall Street V. Main Street Podcast–Episode 4 – Hedge Funds
Transcription – Hedge Funds – Episode 4
The following is a transcription of a recent episode of Wall Street vs. Main Street, a radio show hosted by the firm’s managing partner D. Daxton White.
Producer: Welcome to Wall Street versus Main Street a different take on the investment show with our host Dax White. Dax White is the managing partner of the White Law Group, a national securities fraud, securities arbitration and investor protection law firm with offices in Chicago, Illinois and Vero Beach, Florida. The White Law Group has represented hundreds of investors in FINRA arbitration claims against their brokerage firms and throughout this show Mr. White will shine a light on some of the tricks of the brokerage industry while also providing valuable information for investors on how to successfully navigate the investor/ financial advisor relationship.
Dax: Welcome everyone. You’re listening to Wall Street versus Main Street. I’m your host Dax White. This show is a different take on the investment show. I’m not going to give investment advice. I’m not a licensed professional. That is not what we are trying to do here. Instead I’m going to try to pass along some of the things I learned about the brokerage industry, having litigated hundreds of cases against brokerage firms on behalf of investors, to shine a light on some of the tricks that they do so the next time you’re meeting with your advisor maybe you’ll even the playing field a little bit. Ask some great questions and get some better responses from your broker. Make sure that you’re having a productive investor/ financial advisor relationship. So each week we’re going to try to tackle different topics. When we first started I felt like we were sandwiching a lot of information but maybe not giving you the quality that we’re looking for. So we’re instead going to try to just tackle one maybe two topics a week and this week we’re going to be talking about hedge funds.
It used to be hedge funds were primarily or almost exclusively a product that was purchased by institutional investors. Whether that’s banks or pensions but it was never really a concern for a show like this. Where we’re talking about Main Street investors, mom-and-pop, retired, work their whole lives, save 600 grand, and now they’re dealing with a financial advisor, looking for some income for retirement. Hedge funds weren’t something that usually came up. But over the last few years we’ve seen these products expand and certainly now it’s sold retail by a lot of brokerage firms and I have concerns about it just in terms of not the product, but in terms of how the financial advisor is maybe selling that product. What are the representations he’s making, she’s making, to make an investor feel like, “Oh, this is perfect for me.” You know they are typically very high commission products for the financial advisor so anytime you have that you run the risk that the bad financial advisors, and brokerage industries, like anything else, and not unlike lawyers, there’s good ones and bad ones. Unfortunately I deal with the bad ones and the bad ones are usually maximizing their commissions at the expense of clients and so if you have a high commission product there’s always the risk that the bad ones make improper recommendations and are trying to sell it to the wrong people. So that is sort of what we are going to touch on.
We’ve got a great guest for you today. Someone I’m really excited to bring on the show particularly for a local show, I feel like this is a big get for us. His name is Peter Phillips. He works for hedge funds. He’s a senior alternative investment professional having worked for Blackstone and Blackrock, two of the biggest companies in the world, certainly in finance. He is currently co-head of investment solutions for a hedge fund. He’s based in New York. Peter, thank you for joining us.
Peter: No problem.
Dax: I know from talking to you that you’ve spent a little bit of the last year putting together a product that will be sold retail. Is that correct?
Peter: That is correct.
Dax: Tell me a little bit about the product and just in general how are we getting from institutional investors, and now we are selling it to retail, what I like to call mom-and-pop investors.
Peter: For the most part of my career I’ve dealt with institutional investors, you had indicated initially that institutions have predominantly been to the key source of assets for hedge fund 25 or 30 years if you look at the average institutional investor they’re very well diversified across equities, fixed income, commodities, hedge funds, private equity, where the average retail investor does not have that level of diversification and a lot of that historically has been through a lack of choice or lack of options. And the hedge fund industry and some of the firms that I’ve worked with have recognized that need for diversification really is what it comes down to it if you look at over the past 15 years the average 60/40 equities fixed income portfolios been about almost perfectly correlated to equities in terms of return so the retail investor is in need of diversification and in what form that takes has really blossomed in the last few years and there has been a proliferation of liquid alternative products or hedge fund products into that space.
Dax: From the sales side I imagine that the objective then is to target investors who have a relatively substantial net worth who need that extra layer of diversification that they don’t currently have they want to get into hedge funds we’re talking 5% of their portfolio right?
Peter: Yes, 5% – 10% at most. If you look at the performance over the past 25 years what they’ve been able to, at least good ones you alluded to that, good ones can generate an attractive return with far less volatility in return than you might see in equities. But most importantly you look at the average hedge fund returned in periods of market stress. Take 2008 for example, the average hedge fund was down 19%. Now they do lose money, I think that’s the misconception a lot of people investing in hedge funds thinking that they always make. It will lose money but they can insulate a portfolio. Where equities were down depending on the index 40-45% 2008 the average hedge fund was down 19. Some hedge funds made money in 2008. I think that’s was driving the demand.
Dax: I guess my concern would be, and I will segue it into my follow up question, my concern would be that you have an investor who simply looks at the returns as well as come a 37% last year, the S&P was at 20 or whatever the numbers might be, and they are thinking, “Give me more hedge fund, and do we have financial advisors who are saying “no” pump the brakes here, we’re really only permitted to put 5 to 10% of your portfolio here. I just I don’t know if you are going to see those safeguards. Maybe it’s in the sales agreements that you’re getting with retail and you could speak on that, and that will be one question. Second question, would be what are the minimums typically for an investor to get in?
Peter: Sure, so I’ll talk about sales agreements initially and I was not as involved in that aspect of the negotiation. I think to your point, which you are getting at, there is the risk that the financial advisor does not have his client’s best interest in mind and can overweight an allocation hedge fund. I would look to the brokerage firms to have safeguards in place to prevent that type of risk but obviously you know better than I did some brokerage firm are better than others doing that. The minimum typically will depend on the product so your most will be anywhere from $25,000 to $50,000 minimum investment which most hedge funds are used to two million-dollar, five million dollar minimums on institutional side so it is quite a difference.
Dax: Tell me why the hedge funds would be interested in a $25,000 investment because now they’ve got that many more clients they have to service and deal with. Are the brokerage firms aggregating and saying, “Here’s our 5 million from all our clients or are the hedge funds directly having to now have this relationship where client services becomes a huge issue
Peter: Most of it as you indicated is aggregated at the brokerage level. I think the reason hedge funds are getting into the space the given level of scale so they’re willing to take smaller minimums because there’s such a vast amount of capital out there that has historically not been invested in hedge funds. Whereas most institutions have been invested for quite some time. I think those markets as they become saturated hedge funds have to look to retail as a way to diversify their business, even at lower minimums.
Dax: Talk to me about fund quality because I know from talking to you, and your background, I think it was when you were with Blackstone, where you worked for a fund of funds were you basically vetted a variety of funds and then sold a mutual fund (that was the wrong word) basically what it was to institutional investors saying “Hey, we’ve vetted them for you these are the good ones.” Talk to me about fund quality because I’m sure there are a lot of hedge funds out there that want to raise money but they’re not necessarily very good at what they do.
Peter: I think you hit the nail on the head. The biggest risk in hedge fund investing, and having done this for the past 13 years, is that the dispersion of returns between the very best and the very worst hedge funds is significantly wide. If you think of an active equity management benchmark to the S&P for example, you get a pretty good idea based on how broader equity markets perform how that manager will perform. And the differentiation between the best and worst is not that significant. It’s even less significant with fixed-income where it’s very difficult to outperform benchmarks. In hedge funds it’s completely different. So to give you an example, in the equity hedge fund world over the past 15 years or so you can see variability in returns of almost 30% between the best and worst performing manager. So if you’re picking bad managers in hedge fund space almost assuredly you’ll be disappointed in returns it’s very important to pick good managers and have access to good managers. So that’s why the fund to fund approach, even in the mutual fund side, might be very attractive to the average retail investor because your investing through an experienced established manager who’s going to select the initial hedge fund managers for you. And they have robust processes in place to be able to select the best managers. Again you touched on fees, it is going to be even more expensive through fund of funds but you get a higher quality of underline manager that way with risk management operation details that’s all thing they are doing on your behalf.
Dax: We talked at the beginning about how this is sort of a new proliferation where hedge funds obviously incentive for them as they got this new capital resource hey let’s go direct to clients. Tell me exactly how much this is has proliferated at this point because obviously you’ve worked for some of the biggest finance companies in the world. The fact that Blackrock might put together this product doesn’t necessarily rings huge bells for me. But I have dealt with a number of small hedge funds where it’s really just two or three guys. We see it a lot in Florida in particular because they love to set up shop here where they can put all their money in their house and they got the homestead exemption, and you find out they have been ripping people off and you can’t sue them and there’s no money. So how far away are we from those guys being able to go to brokerage firms and saying, “Hey, will you sell my product I’ll pay you in the top end of the commission and suddenly we’ve got mom-and-pop Investors in that type of hedge funds.
Peter: I think it’s a risk I will say that one of the benefits of proliferation is that some of the bigger better more well-established firms like Blackrock and Blackstone are now getting into the space. If you rewind four or five years ago and not many hedge funds and virtually no fund to funds were launching mutual fund product, I thing the selections are less, of a far lower quality. I think it is a good thing for the industry. The likes of J.P. Morgan, Blackstone, Blackrock, are launching products in the space because you can count on a high quality of investment service as a result of that and you might squeeze out some of these smaller players who are not as high quality. I definitely think it’s a risk. One thing to keep in mind is if you’re a hedge fund this aggressively raising money from retail, you might want to ask a question why is that, are they having trouble raising money elsewhere, do they see retail as a path of least resistance?
Dax: I’d much rather start with a person who has 100 million to invest as opposed to Mom-And-Pop who has 25,000 so you don’t have to land one I Completely agree with you. Before I let you go Pete, I was going to touch on this after the break but I bet our listeners would rather hear it from you. Tell me just in a minute or two, what makes a hedge fund a hedge fund versus a mutual fund? Are we talking complicated strategies you know derivatives trading? What makes a hedge fund?
Peter: So this is great question. A question I’ve gotten many times years over the past 13 years. I think the word hedge fund is somewhat of a misnomer. Hedge managers are really not doing anything that a traditional investment manager is doing, the key differences is they are doing it with fewer constraints. That’s why in the past you tend to find hedge funds only limited partnership because there are fewer constraints and regulations on limited partnerships so the ability is short, the ability to use leverage, things that are traditional in manager would have a harder time utilizing. Hedge funds, I think of it, have more tools in their tool chest to enact their strategy. The biggest difference would be they’re typically not benchmarking themselves to broad market index. They are targeting of absolute return, using as many tools as they can to achieve that return. That’s where you tend to find low correlation diversification benefit is that if the markets up or down 25% depending on the strategy of the hedge fund that may or may not have an impact on the returns
Dax: Tell me just briefly how are hedge funds, what’s the compensation structure? I know we touched on a little bit last week in terms of what the brokerage firm might make for raising the money, what’s the hedge fund taking?
Peter: So typically in the structure that we have worked on, in the mutual fund space, a hedge fund is earning a flat fee. They do not earn incentive fees. The typical structure for an institution will be management fee plus incentive fee. On average that can be as high as 2% management fee 20% performance. In the mutual fund space you’re going to see a flat fee. We’ve see that in the range of, as low as 80 to .8% to 1% flat. The managers that we were utilizing at our multi-manager strategy were on average about 90 basis points or .9%.
Dax: So if it’s 2% flat and that’s basically covering administration costs insert client services etc., and then 20% performance. The concern I would have it as somebody who works to protect investors, is that would make a huge incentive for a hedge fund to have a huge return, and maybe that’s not the objective of all their clients. But if their compensation is based off of 20% of their return for the year. Aren’t they trying to maximize return absolutely in every situation?
Peter: You know I think it depends on the fund. One thing to look out for , for investors to look out for, at the very least is to make sure that managers have high watermark structures in place, such that if they have a dramatic loss they have to recoup all that loss before the can earn that 20% incentive fee again. Those types of structures will, and have, led to less of that incentive to go shoot the lights out to earn a high performance fee. Because by the same token, if you lose significant amount of money you have to recoup that loss before you’ll earn that incentive fee. Many hedge funds in 2008 that lost significant capital found it easier to just shut down than try to recoup those losses so that they can have a material impact on business.
Well Pete I really appreciate you joining us. Thank you for giving us the perspective of somebody who’s actually been in the business and has been involved in putting together these products for retail. I really appreciate you joining us.
Peter: No problem, thanks for having me.
Producer: And we’re back with Wall Street versus Main Street I’m your host Dax White.
Dax: Welcome back everybody. Hopefully you enjoyed the interview with Peter Phillips whose co-head of institutional sales for large hedge fund in New York and has previously worked for Blackrock and Blackstone so certainly I think he’s got a great perspective. If hedge funds was something that interests you and hopefully we touched on some of the concerns I would have as we start getting down this proliferation toward smaller investors because hedge funds again, I feel like it say this every week, but every product has a time and place, you know if the institutional investors even that are investing in hedge funds, huge pensions, it’s usually a very small percentage of their investment. So those are the concerns I have when we start talking about mom-and-pop, let’s make sure you know that somebody who frankly has that the net worth that is indicative of somebody that should be in hedge funds, and even then let’s make sure that it’s a small percentage of your portfolio to just give them that extra layer of diversification. Hopefully we got that across.
The next topic I want to talk about, because again each week the objective is to sort of pass along information that I think would be helpful to investors based on my experience as a securities attorney who sues brokerage firms, and one that I thought was pretty obvious that we haven’t talked about yet is how do I sue my brokerage firm.
You know, not everyone out there realizes that they even have the ability to do it, a lot of people that we talk to think “O’I lost money I took my lumps on that,” and that may not be the case. In some situations that absolutely is the case, because just because you lost money doesn’t mean you have an actionable claim against a brokerage firm that is something you need to talk to a securities attorney about to really evaluate it. The reality is that in 2008, regardless of where your financial advisor put your money you are going to lose money. There were no safe asset classes. That doesn’t mean you have a claim. If you had a beautifully blended portfolio that was well diversified between equities and bonds and cash and all these other elements you still probably lost money but if you track the market your broker didn’t take advantage of you, or your broker wasn’t negligent, you probably don’t claim. But for people who were taken advantage of, again a lot of people don’t realize, “I have recourse.” The answer is yes you do. That recourse is a process called FINRA arbitration. Whether or not you realize it when you establish your brokerage relationship, somewhere buried in the fine print of your agreement with them, was language that said something, and I’m paraphrasing, with something to the effect of if you have a dispute with us you agree to waive your right to sue us in court and instead to sue us through FINRA arbitration, or formerly called the NASD arbitration. That’s been in virtually every brokerage agreement for decades now. So if you have a relationship with a brokerage firm you can’t sue them in court, you’re going to be stuck suing them through the FINRA arbitration process. FINRA is the self-regulatory body for the industry. They’ve got a regulatory component that actually go out and audit brokerage firms to make sure they’re complying with securities rules. But they also have this dispute resolution forum where you file the claim through FINRA and then you’re going to list of potential arbitrators and eventually three are going to be appointed to hear your case. They operate as basically the judge and jury for your dispute, where they make evidentiary rulings, they make rulings on what evidence can come in, and they also make fact-finding. They ultimately will tell you whether or not you’re entitled any kind of recovery. It’s a very, I call it the Wild West, it’s very different than court litigation. They’ve got their own code of arbitration their own rules so it is important that you are working with of an attorney that does that type of work. There are only about 100 to maybe 200 throughout the country that that’s all they do. There’s lots of lawyers that will take a half-million dollar case on contingency fee that doesn’t mean that they understand the FINRA arbitration business, that doesn’t mean they understand the brokerage industry, and there’s only, it’s a very small community only maybe 100 to 200 and that’s all they do. They’re in the trenches every day fighting with brokerage firms. It’s important to know brokerage firms definitely defend these claims. They are going to hire some huge firm in New York or Miami or wherever. They are going to pay them a lot of money and they’re going to make you do a lot of work, if you’re on your own and don’t have a lawyer. They treat, even though it is arbitration and not court. They treat it just like its court in terms of the effort they put into defending these claims, that something to consider. The reality is you actually don’t have to have a lawyer for a FINRA arbitration case, but that’s something to consider about whether or not you should get one
Producer: You’ve been listening to Wall Street versus Main Street. The views expressed by the participants of the program are their own and do not represent the views of, nor are they endorsed by the White Law Group, its officers, directors, employees, agents, representatives, shareholders, nor any of its subsidiaries. None of the content should be considered legal advice, as always consult a lawyer
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