What's worse – losing a dollar or not making one? Inflation for gold or deflation for bonds?
IN A FORMER LIFE, I used to call myself a hedge fund manager, writes Eric Fry, reporting from Laguna Beach, California, for the Rude Awakening.
The year was 1995, and – together with two partners – I oversaw a modest investment management business.
One fine day, one of the partners got the idea that the firm should expand its marketing efforts by hiring an expensive, New-York-based marketing firm. This partner also argued that I should facilitate the marketing effort by conducting all the face-to-face meetings with prospective clients.
"Eric, you're great with clients," this partner explained. "And you're the one who oversees the portfolios. So YOU are a natural to do most of the marketing."
I did not agree with any part of the plan. I did not want to hire an expensive marketer, and I certainly did not want to travel all around the country to meet with prospective clients. But still, I reluctantly agreed. And a short time later, I found myself on a cross-country flight to New York to attend a variety of meetings that the expensive marketing firm had arranged.
First stop? Rye, New York, to meet with Tremont Group Holdings, a firm that placed money with selected hedge funds.
"Eric, what can you tell us about your investment strategy?" the kind folks at Tremont began. "Why don't you just give us a little background and tell us how your strategy operates."
I responded very matter-of-factly, providing the broad outlines of his long/short global equity investment strategy. After about 30 minutes of back-and-forth, the Tremont folks said something like, "Well, this sounds very interesting, Eric. You have a very unique approach. But we've got a couple of concerns."
"Okay, let's hear 'em," I politely replied.
"Well, because your firm is relatively small, it does not possess the kind of risk control infrastructure that we would like to see. Furthermore, since you don't really have extensive checks and balances within the portfolio management structure itself, the strategy relies too heavily upon the instincts of one individual. So we'd need to see more assets under management, a longer track record and better risk-controls in place before we'd consider an investment."
"Okay, thanks for the advice."
As I exited the meeting, I turned to the expensive, New York-based marketer and said, "What a bunch of BS...! What is risky about a three-man shop with completely transparent books? I told them I'd give them a direct feed from the prime broker, if they wanted it. So what's the risk? Either we make money in the markets or we lose it?"
"Yeah, I know," the marketing guy agreed, "But Tremont likes to see better risk controls in place."
During the next few months, a version of this story repeated itself innumerable times. But my firm never received a cent from any of the institutional hedge fund consultants with whom we met. Mercifully, the contract with the expensive, New York marketer expired and I returned to the quiet serenity of his Bloomberg screen.
In fact, I had all but forgotten that chapter of his life until yesterday afternoon, when I happened to spot the following headline: "Tremont Invested $3.3 Billion, More than Half Its Assets, With Madoff Firm..."
According to Bloomberg News, "Tremont's Rye Investment Management unit had $3.3 billion, virtually all the money the group managed, allocated to Madoff."
Bernie Madoff is, of course, the investment management firm that bilked investors out of $50 billion by running what the founder himself called "a giant Ponzi scheme."
Every investor makes mistakes, of course, but big institutional investors seem to make the big, institutional-sized mistakes. Why, for example, would a sophisticated hedge fund consultant place more than half of its entire assets with one manager? Here at the Rude Awakening, we have no ready explanation. But we do have a theory...
Some sophisticated investors are so sophisticated that they begin to believe their own marketing materials; they begin to believe that placing $5 million with a three-man investment shop that provides complete and continuous transparency is riskier than placing $3.3 billion with a large investment shop that dresses its books in a burqa.
The irony is that a genuinely sophisticated investor knows that he doesn't know. He knows that he will almost always operate with imperfect knowledge and/or a fuzzy perspective. And because he knows these things, he cares first about avoiding losses. Profit is a by-product of caution.
In today's treacherous markets, the unknowns seem even more unknowable than usual...which makes the task of cautious investing even more challenging than usual. Forget about trying to make a dollar; what's the best way to avoid losing a dollar? Should an investor prepare for deflation or inflation? In other words, should he be buying 10-year Treasury notes that yield next to nothing to nothing, or bars of gold bullion that yield absolutely nothing?
Rarely have investors faced such extreme choices.
The deflationary threat is grabbing headlines at the moment. But the inflationary threat will not lie dormant for very long. The Federal Reserve's unprecedented monetary expansion (read: money-printing) all but insures a powerful new inflationary trend, it would seem to us.
Interestingly, the financial markets seem to be reaching the same conclusion. As the nearby chart illustrates, inflation-sensitive securities have sprung to life during the last couple of weeks, even though Treasury bond yields continue to plummet. Something is wrong with this picture.
Either the resurgent Gold Price is "right" about a growing inflationary threat, or the tumbling bond yields are "right" about the growing deflationary threat. Personally, we're fans of the inflation trade. But at least we know that we don't know.