Investing with the Big Boys

May 16, 2018

Investing

Nosson Green wasn’t wealthy, but his uncle was, having sold a new medical product for many millions. This uncle had recently confided that while the many exclusive investment managers he used usually didn’t accept small sums, they would make an exception for his family. Using his uncle’s connections, Nosson could now invest his relatively modest portfolio ($100,000) into hedge funds and venture capital offerings usually reserved for the very wealthy. However, after reviewing some of the documents, Nosson got cold feet. They were full of disclosures that the offered investments were complex and risky, designed for sophisticated investors. On the other hand, he knew his uncle invested in these deals, and Nosson didn’t want to miss out on the opportunity.

Should he jump into complicated investment offerings like hedge funds or stick to the typical investment options available to all?

You’ve Been Warned

Americans love suing each other. Warning labels stating the obvious to satisfy nervous lawyers, like “This beverage is hot,” or “Don’t place this plastic bag over your head,” are attempts at preventing lawsuits. This doesn’t mean, however, that all warnings can be safely ignored. Investments can and do lose money, and getting into things designed for accredited investors (who are assumed to be able to protect themselves) means forgoing many of the protections that the law provides for everyone else. Whereas wealthy investors can afford to hire professionals to review each investment, Nosson’s money will be in much danger if he tries anything fancy without access to proper financial and legal advisers. Nevertheless, even if Nosson can share his uncle’s research and legal assistance, he still doesn’t belong in the shark tank.

Eggs in Too Few Baskets

There are many ways in which regular people who overreach can get hurt while investing. One area where this is often seen is the aleph-beis of investing: diversification. While it’s easy to properly diversify small sums within mutual funds, doing so using professional business deals or hedge funds is much harder. The minimum investment in these accredited investments is generally $250,000–$1 million. While those with millions to invest can spread their money over many accredited investments, in Nosson’s case, even if he puts just $25,000 into each deal, he can invest in just four. Therefore, whereas the rich participants in each deal will be able to ensure that their money is well diversified into many other baskets, Nosson, who has only a handful of investments, faces terrible returns if even just one or two of them fail.

When Your Cash Gets a Call

Another problem Nosson may face by investing with the “big boys” is cash calls. In private equity and business venture investments, managers may require their investors to put additional money into a deal to meet an unforeseen obligation months or even years after the initial outlay. The notice for such a request for cash can be sudden, and those who don’t put in their share are financially penalized. While all investors dislike cash calls, they are usually just an inconvenience rather than a financial calamity for the wealthy. Nosson, however, is very unlikely to meet his commitments and will have his stake substantially diluted or even forfeited, even if the deal ultimately stabilizes and is very profitable. The big boys play for keeps and are not sympathetic to those who don’t pay their fair shares.

Hedge Funds: More Risk for Less Reward?

The truth is, being shut out of the complicated high end of the investment market is not such a bad thing anyway. Investors in hedge funds and the like face the same disappointment that one would feel after spending a fortune in a fancy restaurant and finding that the experience turned out to be anything but exceptional. Due to exorbitant fees, most investors in hedge and private equity funds don’t earn extraordinary returns, despite the extra risks and headaches. For example, gains for the average hedge fund portfolio have been under 5% for many years, way below the stock market’s 15%. It’s no wonder, therefore, that many of the world’s largest investors, like insurance companies and pension managers, have turned their backs on hedge funds. While they can surely handle the risks, these professional money managers don’t think private hedge funds can earn them high returns. Ironically, this thinking has the pros shifting their money into the same lowly mutual funds Nosson is currently considering cashing out of!

For years, Warren Buffett has publicly called out the hedge fund industry on its poor investment performance. In 2007, Buffett offered any comer a $1 milllion bet that over 10 years’ time, investments in a simple mutual fund (as measured by the S&P 500 index) would beat any preselected portfolio of hedge funds. Of thousands of hedge fund managers only one, Protegé Partners, was willing to put its money where its mouth was. The bet ended in 2017, and the results weren’t even close: during the previous decade, Protegé’s “exclusive” hedge funds grew by only 36% versus the markets, at 125%! While Buffet donated the bet’s proceeds to charity, his thoughts on the lesson of the wager may prove to be more valuable to the public good. Says Buffett, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index mutual funds.”