Corpania Ideas

CAVEAT! I'm an amateur philosopher and idea-generator. I am NOT an investment professional. Don't take any of my advice before consulting with an attorney and also a duly licensed authority on finance. Seriously, this my personal blog of random ideas only for entertainment purposes. Don't be an idiot.

Wednesday, December 02, 2009

"Country Club Analogy" (Argument for "Fair Trade" over "Free Trade")

Let's start with the analogy and then explore how it's apropos to the debate on "Free Trade".

Your father, who manufacturers golfballs, belongs to an elite Country Club that is owned by its members. Nearly everyone around the world wants to join but it's very exclusive. All "legacy" applicants (those born to existing members) are accepted but everyone else, even the very smart/talented, has to jump through a bunch of hoops over many years for just a small chance of getting in.

Once you're in the Country Club there are all sorts of benefits. It's clean, secure, and overall really nice. People make deals there and the club takes a cut of every deal. Nevertheless, everyone seems to prosper. You and your dad are doing well because you're selling lots of golfballs to the members.

The exclusivity of the Country Club thus prevented some smart/talented people from joining. Those people started making their own country clubs better.

Historically, when it came time to attract major events, sponsors etc. there was really only one choice: your dad's Country Club. This near-monopoly had huge advantages that led to extraordinary profit-premiums for your dad's generation (he felt he was entitled to them and that they were well-earned). But over time the other country clubs got better and began to attract their own events, sponsors etc. Now the profit-margins are getting squeezed in the deals that are transacted in your Country Club. The costs of running the club keep going up (materials, personnel, equipment) and it still doesn't have some services that other country clubs offer.

Consequently, your Country Club needs to raise its fees to cover its costs. But some of the older members of the club object to increased fees. They vote to reduce the amenities and allow the importation of cheaper golfballs from another country club. You and your dad are pissed at losing so much business but you're still OK because you still sell golfballs to other country clubs. This continues and your reduced profit requires you scale back. You decide to stop manufacturing near the course and instead open a cheaper plant near another country club and import them into your Country Club. Your employees, who were members of your Country Club, are now out of work and can't afford to pay yearly membership fees anymore. This further reduces the revenue of your Country Club necessitating, according to some members, further cost-cutting. Now the club wants cheaper fertilizer, seeds and sand. Your three buddies at the club who respectively sell fertilizer, seeds and sand do exactly what you did. They close their plants nearby and open plants near other country clubs. The closed plants put out of work more members of the your club which further reduces revenues. This is a vicious cycle leading to more business going to the members of other country clubs.

Meanwhile, the booming businesses of the members of other other country clubs leads to their own "virtuous cycle" increasing the revenue of the members of other clubs and increasing the membership revenues. Those increased revenues enhance those country clubs to be closer and closer to the level of your elite Country Club.

It's all pretty simply economics. It's even "free market" dogma that buyers will buy the cheapest products from anywhere they can. The analogy is pretty obvious and "one-for-one" about global trade.

But what other options do we have?

1) "Take all the smart/talented people who apply" - This argument attempts to exploit the system by greedily taking all the best people for your Country(Club) so that the other countries are crippled by a lack of good people. Not only is this selfish and unsustainable it also DOESN'T WORK FOR THE MEMBERS OF YOUR COUNTRY. Consider this: if a better golfball manufacturer is admitted to your Country Club then you & your dad are still out of work. Yes, the club apparently doesn't suffer but the members (you & your dad) do suffer. 

Thus, using Immanuel Kant's categorical imperative (which is just a fancy way of describing "The Golden Rule") the membership shouldn't agree to burning you and your dad because they wouldn't want the same thing done to themselves. Measuring the good of the Country Club by it's size, beauty & membership's gross revenue alone ignores the good/prosperity of its members. Why would the members want any policy that ostensibly helps the club but actually hurts themselves? Let's measure how good the members lives are over time and institute policy that makes their lives better.

THE ALTERNATIVE...

2) For all intents and purposes - "Protectionism" to some degree. Your Country Club should encourage deals that keep its members employed. It should tax & discourage money earned in the club from funding ventures in other country clubs. It should not let in new members so as to encourage those applicants to go an make their own country clubs better. (Of course there are exceptions for moral/political reasons and protectionism need not be impractically extreme.)

I'm skipping a few points here in the interest of some brevity.

For those who reflexively decry protectionism in any form - What good is an "American Corporation" to America if it pays no taxes and employs no Americans? What good is a big GDP if none goes to enhancing the citizens' lives?

Note - I'm deliberately trying to be provocative here.

I'm not really claiming we shut down our borders entirely and attempt "Isolationist Fortress America". But I am suggesting we seriously decide what the purpose of government is. 

I hope we can generally agree it's to make the lives of its citizens better (which I think is a pretty modest & benign idea though one that GOP&Libertarians generally can't stand). 

Once that is settled we can define the measurements of what makes citizens' lives better.
Then, necessarily, all government policies must be calibrated against those measurements.
I contend that progressive, liberal and generally "Democratic" policies are better at enhancing citizens' lives.
Whereas conservative, Republican policies (over time) don't even help the majority in the country club.

Monday, November 30, 2009

Why Hedge Funds Are (and want to be) “Risky”

Why Hedge Funds Are (and want to be) "Risky" --- Primer & Gambler Analogy

By Daniel Lawrence Abrams

 

Primer:

 

Hedge funds have been around since 1949 and have generally functioned as high-risk/high-reward mutual funds for advanced investors.

 

Not bound by the laws and conventions of generic mutual funds, hedge funds are empowered to assume extreme leverage and place bets on complex financial instruments (e.g. derivatives) in order to achieve extraordinary returns on investment.

 

Only the best investors even attempted to start hedge funds. Those that lost money quickly disappeared. Those that made profits in excess of the market were highly prized.

 

If the S&P 500 earns 8% and a given hedge fund (after all fees) returns 9% then why not invest in that hedge fund? Savvy investors may be more concerned with ROI for a given level of risk but since the concept of risk is so difficult to reliably quantify for predictive power it all boils down to the bottom line:

If investment option "A" earns 8% while "B" earns 9%, ceteris paribus, people would rather get 9%. Hedge funds often yield substantially greater returns than the market which is why they exist in the first place.

 

Why do investment professionals start hedge funds? They have more freedom to make "riskier" bets that can yield those superior returns. Making this even more attractive is their particular compensation structure.

 

Most hedge fund managers use a traditional 2+20 compensation structure. Every year, 2% of the money invested is taken for the hedge fund managers as a management fee (maintenance fee). Additionally, 20% of the profits are also taken for the hedge fund managers as bonus compensation "performance fee".

 

For example:

$100mil invested, HF yields 30% ROI = $130mil before fees

HF managers take 2% of the initial amount = $2mil

HF managers take 20% of the $30mil profit = $6mil

Total returned to investors = $122mil (i.e. 22% ROI)

 

So there's an obvious incentive for the hedge fund managers to make their investors a lot of money (consequently resulting in an even better bonus for the hedge fund managers).

 

Now consider the following…


Gambler Analogy:

 

A wealthy gambler sees you winning at a casino. He offers to give you the traditional 2+20 HF manager compensation formula to gamble his $100k for him. He gives you one night in a particular casino that only has these 4 kinds of games:

 

1) There is a big game of no-limit hold'em poker where you only play with the other players (not the house) against whom you estimate you may have a 10% edge for the night. The blinds are 25-50 and betting is capped at $50,000 per hand.

 

2) There is single-deck blackjack where you can actually count cards and gain a legal, fair, small edge (maybe 5%) over the casino but the maximum bet is $100 per hand.

 

3) There is also "Betting on Fair Coin Flips" against the house, which is obviously entirely luck-based, that pays winning predictions 99 cents on a one dollar bet. This means the casino has an edge over you of 1%. Note that the maximum bet for this game is $1,000 per player per flip.

 

4) Finally there is "The Big Wheel" which is like a simplified roulette wheel where there are 20 spaces (19 losers and 1 winner) and pays off a winner 17 to 1.  True odds would dictate you should get 19 to 1 so you're actually giving up a 10% edge to the casino. Note that there is no limit on the amount you can bet on this game only.

 

So in this casino gambler analogy, where you are the equivalent of a hedge fund manager, on what games should you bet the $100k you were given to gamble?

 

A) If you're a great poker player against weak opponents then you should play NLHE poker because that's where you can get the greatest edge/positive EV (over 10% ideally). Consequently your 2% will get you $2k plus 20% of the $10k profit (which is $2k) totals a net profit of $4k for you and $6k for the gambler. Getting the gambler 6% ROI in one day is pretty great (it'd make a merciless mafia loan shark jealous).

 

B) If you're not as good as the other poker players but still smart then you can pretty safely count cards playing blackjack and hope/expect a 5% ROI on the $100k. Consequently your 2% will get you $2k plus 20% of the $5k profit (which is $1k) totals a net profit of $3k for you and $2k for the gambler.

 

C) If you can't play poker or count cards in blackjack then you could bet on the coin flips but you're giving up a 1% edge and so should expect to actually lose money for the gambler. Consequently your personal profit theoretically should only be the $2,000.

 

D) "The Big Wheel" may seem counter-intuitive for many so let's explore it in detail…

You know "The Big Wheel" has a negative expectation with the worst odds for the gambler's money. But let's still explore your personal "Expected Value" (as the HF manager) if you simply bet the whole $98k on one spin of "The Big Wheel".

19 times out of 20 you would lose it all and only make $2,000 personal profit.

1 time in 20 you hit then you'd win $1,666,000 on the $100,000 investment. Consequently, your 20% would equal $333k plus your $2k equals $335k.

So in 19 spins you'd get $2k each (total = $38k) and on the 20th theoretical spin you get $335k. That's $373k over 20 spins for an "Expected Value" of $18,650. WOW!

But it's terrible for the investor who's EV on the game (before the 2/20) is 90% of his $100k resulting in a $10,000 theoretical loss. After the 2/20 compensation, his expected value is less than 70% of his $100k for an over $30,000 theoretical loss.

 

Recap:

NLHE POKER: 10% POSITIVE / Your expected personal profit = $4,000

BLACKJACK: 5% POSITIVE  / Your expected personal profit = $3,000

COIN FLIPS: 1% NEGATIVE / Your expected personal profit = $2,000

THE BIG WHEEL: 10% NEGATIVE / Your expected personal profit = $18,650

 

THEREFORE: Even though "The Big Wheel" has the biggest mathematically "Negative Expectation" because of the 2+20 compensation formula it is immensely attractive to the hedge fund managers who don't have an edge.

 

CONCLUSION: It is therefore even more important to go with a hedge fund manager who has a real edge on the competition. Don't simply pick a financial "brand name" with only a recently good ROI (especially if the management has changed during its run). Such "chasing last year's winners" is a short & hind-sighted technique that historically underperforms. Instead, select an investor with at least a decade of extraordinary returns. 


BTW - if you're an "accredited investor" then you can contact me for my personal recommendations.

 

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