Thursday, August 18, 2011

Hedge Fund Investing Part 2 – The Fine Print

Recent market volatility has caused many investors to consider investing in hedge funds because of their ability to be both short and long the market. BlogOnWealth in Part 2 of our series on hedge fund investing discusses several items you need to be aware of before signing the hedge fund’s contract.

Liquidity and transparency. As many investors learned the hard way in 2008, there are few constraints that prevent a hedge fund manager from investing in very illiquid assets. The larger the fund, the less likely the smaller investor will get full transparency on those illiquid positions. A number of fund of funds have yet to provide investors with full liquidity on redemption requests made in 2008. Investors should be well compensated for investments that have no transparency and uncertain liquidity.

The market’s reaction to these problems has been for many hedge funds to offer a mutual fund version of their hedge fund that provides daily liquidity and price transparency. These hedge fund/mutual funds have attracted more than $6 billion of client assets in the first six months of 2011.

After Tax Returns: There are significant tax considerations that the taxable investor needs to keep in mind. While a five-year 14% annualized return might look pretty good, if those returns are 100% taxable every year, the after-tax returns look much more pedestrian. Indeed, the difference in after-tax returns for a 14% investment that is 100% taxable annually compared to one that has 100% unrealized gains is about one percentage point (at top marginal tax rates) over a five-year period. The power of compounding does not get suspended just because it is a hedge fund!

Liquidity for tax payments. The negative impact of 100% taxable gains is compounded if you have no liquidity. For example, if your hedge fund has a lock-up, you will have to find cash flow from other investments to fund the tax payments. There are obviously circumstances when high taxable returns are desirable: If an investor has other investments that generate substantial tax losses or if there are significant tax losses from prior years that need to be “harvested.”

Alignment of incentives: Look at the other investors and don’t mistake their objectives for yours. While the presence of large endowments, foundations and other tax-exempt entities might make the taxable investor comfortable that the smart money has done the due diligence work, these investors have different objectives and constraints than most taxable investors. If the majority of the investors don’t pay taxes, then the taxable investor’s need for after tax returns will not be a priority for the investment manager.

Hedge funds can be a helpful portfolio addition, but you need to read the fine print of each fund before you invest. Don’t forget 2008!

Tuesday, August 9, 2011

Fighting Back Against A Common Nemesis: Insecurity

What accounts for the mediocre performance of so many companies and individuals? If you look beneath the surface, insecurity is often the common culprit.

Seth Grodin called insecurity the work of our lizard brain, the pre-historic lump of gray matter responsible for fear and rage. The lizard brain holds you back when you want to go forward. It reflexively fears the unknown.

Steven Pressfield refers to insecurity as the resistance. The resistance is the voice in our heads whispering caution, to go slow, to compromise. It is also the impulse that makes us drag our feet or keeps us from finishing what we started. Worse, the resistance, seems to get stronger the closer you are to making a necessary change.

Not Pretty

Call it whatever you want, but we are all dogged by fear of change.

For individuals, insecurity appears in the need to be liked by everyone. We all know that never works, and it often backfires. For politicians, insecurity rears its ugly head in the overpowering drive for election or re-election. History is littered with examples of well-meaning pols who sold out their principles to keep their elected office.

For corporations, insecurity breeds incrementalism. An executive may know that to succeed in the long term there may be significant short-term pain to change a business model, kill a product or invest in an unproven solution. But the fear of losing one’s job frequently quashes a leader’s better instincts to take a bold step.

Wealth advisors are not immune to insecurity, either. Like corporate executives, many advisors realize that their firm has serious shortcomings, for both themselves and their clients. But advisors may be just comfortable enough, so they stay put – even if they know a better future is very possible.

The Solution

How do you vanquish insecurity? One of the most effective ways is to mimic Silicon Valley. The whole ecosystem in the Valley is focused on isolating things that can be done better. Then, the doers charge ahead. The bumper sticker version is “No Fear.”

Silicon Valley is all about disruptive ideas and technology. Many ideas are tried and failed, but many others produce spectacular results.

Google is a perfect example of a Silicon Valley company who gets it. Google gives employees something known as Google Time. Employees can devote 20% of their time to developing something new and original of their own making. Gmail and Google + are among the innovations born from Google Time. Google has managed to institutionalize the better angels of our entrepreneurial spirit.

Living and working in San Francisco and Northern California, one gradually sees risk-taking as part of the natural landscape. Striking out on one’s own is what people do, and it’s invigorating. With so many other risk-takers in close proximity, there is security in the number of people who are confronting their own insecurity.

I was recently reminded of that by the principal of an advisor team who recently hired Sanctuary. “You take for granted just how entrepreneurial people are here. It's just not like this everywhere.”

The Unstoppable Tide of Human Aspiration

At the end of the day, the only real cure for insecurity is action. The self-confidence that comes from taking the initiative can overwhelm the reptilian corner of your brain. Conversely, the positive experience of successful change is a great motivator. It also has the corollary benefit of tapping that other instinct in us: the human drive for greatness.

For advisors who are thinking about breaking away, client uncertainty shouldn’t be the reason to hold back. In our experience, a large majority of clients who work with independent advisors are themselves entrepreneurs and serial risk takers. They appreciate advisors who have the gravitas to make a move that is all long-term gain.

Tame the lizard. Go out and make it happen today.