At the conclusion of my October 31st radio show I received an e-mail with an advance copy of an article that was to be published in Barron’s magazine. The article, Hedged Bets, by Suzanne McGee proceeded to bring my blood to a slow boil. It was my fault. Saturday at 10:00 AM ET my work week is over. Those are the family rules. Well, I broke them and I found myself aggravated by this piece throughout the rest of the weekend. For disclosure purpose, I am not a fan of Barron’s. They have proven time and time again to be nothing more than a marketing rag for the financial services industry. This time Barron’s really out did themselves in a piece that could have been written by a Madison Avenue advertising agency. There is an all-out effort to mainstream the hedge fund industry. We have outlined the tremendous risks involved in these investment vehicles over the past two years and despite the endless examples of countless investors losing their collective shirts the media has ignored the problem. The media is completely unwilling to report on the big bank shopping spree, where the major investment houses are buying up hedge funds at a breakneck pace. Investment firms realize the incredible profit potential in hedge funds, and their friends in the press are once again more than willing to apply the lipstick to the pig. We have uncovered more egregious examples of hedge fund fraud this past month. Remember these when your local snake oil salesman call upon you with their next “brilliant” idea.
Charles L. Harris describes the way he ran his hedge fund Tradewinds International as a “charade.” His confession rambles on with words like “stupid, mistakes, and lying.” Ironically, those descriptions are used by Charles Harris on himself. Peter McKay of the Wall Street Journal reports that Charles Harris made a DVD mea culpa while sailing the Caribbean on a 62-foot yacht after defrauding his investors of as much as $25 million and then fleeing the country. $25 million represents almost the entirety of the hedge fund. You have to give credit to Mr. Harris, he does have some cohones. On the DVD, speaking to the camera sporting a black baseball cap he asks his investors to stick with him and promises to recoup their losses in 12 to 18 months. James D. Wilson the attorney representing several Tradewinds investors states that Charles Harris did little to no trading at all and used investors funds to pay for personal expenses like 62–foot yachts. Under the brand new useless SEC hedge fund rules Tradewinds would be exempt from regulation because of its size.
Investors in the Sterling Watters Group hedge fund must have had ear to ear smiles from 1996 to 2003. The president of the group Angelo Haligiannis told investors that the compounding annual gains of the fund amounted to an enormous 1,565 percent! However, as often is the case with “land of make-believe” returns, the reality of the situation tends to be quite different. In an indictment handed down by interim U.S. Attorney for the Southern District, David Kelley states that Mr. Haligiannis and his Sterling Watters Group lost investors everything. Jenny Anderson of the New York Post reports that between 1996 and July 2004, Haligiannis raised $26 million from 80 investors promising them stellar returns and stating the fund had more than $180 million in assets when in fact the fund was losing money hand over fist. In 2000 Sterling Watters reported that the funds assets had grown by 41% when in reality they lost $17 million. The hedge fund was nothing more than another “Ponzi scheme,” where Haligiannis used new investor’s funds to make distributions to existing shareholders and of course to line his own pockets.
It is said that only certainties in life are death and taxes, I would like to add Wall Street fraud to that. Our nemesis Citigroup/Smith Barney has once again added credence to my hypothesis. Citigroup will pay a measly $250,000 to settle NASD allegations it used fraudulent sales material pitching hedge funds. Forbes Magazine reported that more than 100 pieces of sales literature distributed by Citigroup between July 1, 2002 and June 30, 2003 touted rates of return of 12 percent to 15 percent a year without providing any proof. They also neglected to disclose the
tremendous risk involve with the investments. Citigroup/Smith Barney copped their usual plea of neither admitting to nor denying wrongdoing.
We have reported that the hedge fund industry has been dramatically inflating their performance numbers, and this past month a study by Princeton University’s Burton Malkiel is proving us right once again. Burton Malkiel the author of “Random Walk Down Wall Street” states in a new paper that the hedge fund index returns are not only inflated, there is also a tremendous amount of bias in how the returns are reported. “We conclude that hedge funds are far riskier and provide much lower returns than commonly supposed.” One of the major findings of the study highlights a practice called “backfill bias,” which allows funds to add favorable returns to an initially lackluster record which tends to embellish overall fund returns.
“Managers will establish a hedge fund with seed capital and begin reporting their results at some later date and only if the initial results are favorable. Moreover, the most favorable of the early results are backfilled in the database along with reports of contemporaneous results. On average, the backfilled returns are over 5 percent higher than the reported returns.”
John Wasik of Bloomberg reports that the Malkiel paper also contains a survivorship bias. Survivorship bias is when dead or failed funds such as Tradewinds or Sterling Watters are not included in the indexes. By removing the worst of the worst from the hedge fund batting average gives an absolutely ridiculous and inflated picture of the true value of hedge funds. Of the 604 hedge funds that reported data in 1996 only 124 were still in existence in 2004. More than 10 percent of hedge funds go out of business each year.
J.P. Morgan was the latest firm house to demonstrate the enormous attraction between big brokerage firms and hedge funds when they bought a majority stake in Highbridge Capital Management. The two issues that are driving this boom is the desire for hedge funds to be mainstreamed and desire by the big brokerage firms to tap into some serious profits (Hedge funds sport some very high fees.) Take these two issues along with the fraud and complete lack of transparency and you have quite the witch’s brew. Be afraid, be very afraid.