Game Plan

by Kevin D. Freeman

  GICs usually offer a higher return than bank CDs, most often 0.1 percent to 1 percent higher at the time they are bought. But they are not protected by the FDIC as bank CDs are. GICs are most often bought by investors through 401(k) retirement plans.

  Employees who invest in a company’s 401(k) retirement plan can commonly choose from four options for investing their pensions: GICs, money-market mutual funds, equity mutual funds, or the common stock of the company. For the GIC option, the company’s pension-plan manager allocates the funds to one or more insurance companies. The insurance companies then invest variously in residential mortgages; government, corporate, or high-yield bonds; and private placements.

  GICs come in two types: participating and nonparticipating. Participating GICs allow investors to participate in the risks and rewards of fluctuating interest levels, providing a variable rate of return as interest rates rise or fall. Nonparticipating GICs have a fixed rate of return. Participating GICs are therefore a better investment when it looks as if interest rates will be rising, and nonparticipating GICs are better if interest rates are high and look as if they will descend.14

  It is essential to understand that the guarantee of a GIC refers only to the promise of the issuer to pay. If the insurer fails, the investor could lose all of the investment, although some states may have funds to protect investors in GICs in such cases. If an insurance company does go belly-up, however, under most state laws the policyholders of the company will get paid before the holders of GICs. Fortunately, most big insurance companies do not go bankrupt, and the manager of a 401(k) program will likely diversify among various GICs from different insurers so the failure of one insurer would not wipe out the entire investment.15

  Bank investment contracts (BICs), are similar to GICs but are issued by banks. In this case, the investor buys the underlying securities, which are put in a trust fund and are thus untouchable by the bank’s creditors if the bank goes bankrupt. Unlike regular bank deposits, BICs may or may not be covered by FDIC insurance; it depends on how they are structured by the bank. Most banks do not cover BICs with FDIC insurance. Although BICs are insured by the bank, and GICs by the insurance company, GICs usually have a higher rate of return.16

  Do Guaranteed Investments Protect You?

  All the questions about the relative merits of the different kinds of annuities and GICs could be moot, of course, if there were a massive economic crisis in which only the strongest institutions survived. There is no FDIC coverage for insurance companies, though there are state insurance guaranty associations (GAs) that do support insurance companies if they go bankrupt. Like FDIC coverage, however, the protection provided by a GA is limited; it also varies by state. For the most part, you can demand your money from a bank at any time, but even if your insurance company survived an economic catastrophe, you would have to wait for the scheduled monthly payment to get your hands on your funds. Still, insurance companies are far less leveraged than banks, so they have less exposure in a crisis. From 1987 to 2009, only seventy-four multistate insurance companies failed. In 2010 alone, 157 banks failed, and ninety-two more went under in 2011.17

  So how do you know how strong your insurance company is? Four independent agencies—A.M. Best, Fitch, Moody’s, and Standard & Poor’s—rate the strength of insurance companies. The agencies often disagree, so you should try to find a consensus among them before you make a judgment. The ratings change day to day, and the agencies use different scales, making comparisons more difficult.18 The agencies tarnished their reputations in 2008 by giving investment-grade ratings to Lehman Brothers, AIG, and Washington Mutual until the financial sky fell on September 15. The agencies may have become more careful, but they do not deserve your blind trust.

  There are some strong arguments against annuities. They lock up your money, they lack liquidity, and their investment profits are ultimately taxed as ordinary income rather than capital gains, which can negate the advantage of tax deferral. William Reichenstein, a professor of investment management at Baylor University, cautions that investments in conservative stocks and bonds or exchange-traded funds outperform annuities by as much as 2 percent a year over the long term.19

  David Babbel of the Wharton School and two colleagues, however, conducted an extensive study of fixed-index annuity funds and quarrel with Reichenstein’s conclusions. Annuity returns, they argue, can be competitive with alternative portfolios of stocks and bonds.20

  Ultimately, the returns of a guaranteed investment depend on the performance of the underlying investment. Fixed annuities are based on debt (loaning money), so debt performance will determine how the annuity does. If there is serious deflation, guaranteed debt with fixed rates will do quite well. On the other hand, if inflation is high, debt will do poorly, and the purchasing power of your annuity returns will be harmed. In an inflationary environment, even index annuities will suffer because their returns are often capped. They will nevertheless do better than fixed annuities. If the dollar crashes, annuities will be poor investments because they are primarily dollar linked. Foreign currency annuities may offer a solution, but they lose tax-deferral benefits.

  You must conduct a proper analysis of your personal situation and work with a reputable company and a trusted, well-informed advisor who will fully disclose all the pros and cons. You must understand that you are trading flexibility for safety in some but not all areas. The challenge is to understand the effects of economic warfare and financial terrorism and how they will affect your supposedly guaranteed investments. Insurance companies can become targets of bear raids, but the stability of insurance companies is ultimately the guarantee behind annuities and GICs.

  Circumstances change rapidly in a crisis, so flexibility is the key to survival. Contracts can be changed in a crisis, and it’s usually not to the investor’s benefit. That is why you must have good advice from professionals fully aware of the economic-warfare risks.

  Obviously, guaranteed investments can get very complicated. This book is not an all-purpose guide to investing. It’s about what to do in the event of a serious economic crisis, particularly one resulting from financial terrorism or economic warfare. That’s what the next section is about.

  CHAPTER TEN

  Hedge Funds and Other Out-of-the-Box Investments

  Many investors are looking for something different. They are tired and afraid of traditional choices like stocks, bonds, and cash. Unfortunately, many naive investors ignore the proverbial warning about exchanging the devil they know for the devil they don’t. Because some alternative investments are not subject to the same regulatory scrutiny as traditional investments, it is often difficult to get the information necessary for objective comparison. This chapter is intended to demystify the alternatives and help you understand how they might perform during economic difficulties.

  Alternative investments, according to Blackrock, the world’s largest investment management firm, are simply investments other than stocks or bonds, and they behave differently in a portfolio than traditional investments. The term encompasses different investment classes and includes hedge funds, long and short strategies, commodities, private equity, and real estate.1

  Let’s start with hedge funds. These are private investment partnerships, largely unregulated, that give the manager the greatest possible flexibility. Hedge funds can buy stocks; sell short; use derivatives; buy or sell bonds; and invest in real estate, collectibles, private equity, or just about anything else. The general partner is more often than not the fund manager, while the investors are the limited partners, usually represented by institutions and accredited investors. There is usually a limit of ninety-nine limited partners.2 Hedge funds typically have a high minimum investment and require investors to leave their money in for at least a year.

  Hedge funds started as investments for wealthy people. Alfred Winslow Jones, an Australian-born financial journalist, decided in 1949 to create a private investment partnership that he hoped would protect him from the ebbs and
flows of the market. He borrowed shares of stock, then short sold them because he figured the market was going to drop. Because it was risky if the market rose, regulators ruled that only rich people could afford to take the chance. The idea was that with the gyrations of the market, the hedge funds would have modest but less risky gains.

  Roger Ibbotson, a finance professor at the Yale School of Management, analyzed 8,400 hedge funds from 1995 to 2012 and found that they averaged a gain of 2.5 percent of alpha, which is very good. Alpha is a measure of a fund’s risk-adjusted performance compared with its benchmark index. For example, if a fund has 1.0 alpha, that fund has done better than its benchmark index by 1 percent.3 Ibbotson said, “They have done a good job, historically. Now, I think it’s overcapacity. I doubt that the alphas are completely gone, but alphas are going to be harder to get in the future than they have been in the past.”4

  Although hedge funds are for the most part unregulated, a majority of the investors in a fund must be accredited, meaning they meet a minimum annual salary and have a net worth of at least $2 million.5 Hedge-fund managers charge much higher fees than managers of mutual funds, who take an average of 1.44 percent,6 and they also charge more than people who offer funds that track stock market indices. The fees for hedge-fund management are typically 2 percent of the original investment per year, plus 20 percent of the profits in addition to the costs of trading. For the most part, hedge-fund managers, not their clients, make a fortune.7 From 1998 to 2010, the managers of hedge funds amassed $379 billion, while their investors earned $70 billion. The managers wound up with 84 percent of the investment profits; the investors kept 16 percent.8

  Hedge funds get even more expensive when investors go through “funds of funds.” The original idea was to pool investors’ dollars and distribute them among a variety of hedge funds. The fund of funds would conduct manager due-diligence, selection, and monitoring. But this arrangement adds another layer of fees and makes it even harder for the investor to win.

  Hedge funds have become an important part of the international financial market. They manage over $2 trillion, over 1 percent of all assets held in financial institutions.9 As of March 2013, forty of the world’s billionaires earned a huge chunk of their income managing hedge funds. The list of these supermanagers includes Carl Icahn, George Soros, Ray Dalio, James Simons, John Paulson, Steven Cohen, David Tepper, Leon Cooperman, and David Einhorn.10

  Despite the glamour, most investors would do well to avoid hedge funds. The S&P 500 outperformed the average hedge fund every year but one from 2003 to 2012. The equity-bond index doubled in that period, while hedge funds only gained 20 percent. The sole exception was 2008, when both hedge funds and the stock market were big losers. That year hedge funds lost a little less.11 Hedge funds only returned 3.5 percent in 2012, according to the HFRX Global Hedge Fund Index; the S&P 500 stock index rose 16 percent. From 2007 to 2012, the hedge-fund index lost 13.6 percent, while the indices rose 8.6 percent. From January 1 to May 23, 2013, hedge funds rose only 5.4 percent, while the stock market rose 15.4 percent and mutual funds rose 14.8 percent.12

  The Hedge-Fund Mentality

  Early in the life of a hedge fund, its managers are hungry, motivated, and often humble enough to know what they don’t know. This tends to be the best time to put money in, but also the hardest, as the funds tend to be very small. Stage two occurs once the fund has achieved some success, when those making the decisions have gained some confidence but aren’t yet so well known that the fund is impossible to get into.

  In stage three, the fund’s success becomes well known, and there is no room for more investors. Finally, in stage four, the fund manager who has been wildly successful becomes overconfident, and the fund is too unwieldy to move quickly. As Jim Kyung-Soo Liew, assistant professor in finance at the Johns Hopkins Carey Business School, said, “The bigger a fund gets, the more difficult it gets to maintain strong performance. That’s just because the number of opportunities is limited in terms of putting that much money to work.”13

  Then, of course, there are the numerous stories of hedge-fund managers who have acted in a criminal fashion. The most famous, Bernie Madoff, with $50 billion, could well have been the world’s best hedge-fund manager if he weren’t a complete fraud.14 (It turns out that his firm wasn’t even structured properly to be a hedge fund.)15 Raj Rajaratnam, who founded the hugely successful Galleon Group hedge fund in 1997, was later sentenced to eleven years in prison for the largest hedge-fund insider-trading scheme in history.16 Steve Cohen, the head of the $14 billion SAC Capital, saw his firm charged with a five-count criminal indictment that seemed to be ultimately targeting him.17

  Some argue that the hedge-fund mentality encourages criminality. Lynn Stout of the UCLA School of Law explains that hedge funds, by their very nature, suppress “prosocial” behavior. Hedge-fund managers tell their traders to maximize portfolio returns. Traders are competitive and would rather boast of their achievements than sacrifice gains if there is an ethical conflict. And since traders don’t see the victims of their crimes, they remain indifferent to the consequences of acting unethically.18 There’s so much money and so little control that the temptation to cut corners or do whatever necessary to attract clients or increase returns becomes extremely powerful.

  Hedge-Fund Economic Warfare

  That’s another risk—it’s rarely clear what the motives of the hedge-fund manager might be. In Secret Weapon, I showed how large pools of wealth can influence hedge-fund investments. Sometimes, big-fund managers have objectives other than making the most money for clients. The famous George Soros is a case in point: In 2003 he said that removing President George W. Bush from office was the “central focus of my life” and “a matter of life and death.” He said he would sacrifice his entire fortune to defeat President Bush, “if someone guaranteed it.”19 There are other reasons to question Soros’s motivations. He was convicted of insider trading in France, and the conviction was upheld after years of effort to discredit it. He has also more recently been investigated for possibly violating U.S. insider-trading laws.20 Has Soros been investing for himself or for his clients?

  As the Soros example shows, hedge funds may be dedicated to values different from yours. Some are focused on compliance with Islamic law, and their clients include enormous Middle Eastern sovereign wealth funds. Sheikh Yusuf Talal DeLorenzo has become a key player in developing Islamic financial products in the United States. In 2000 he joined the Guidance Financial Group, which now offers U.S. Muslims a competitively priced mortgage that complies with sharia law. The company had raised $1 billion in financing by 2007. Sharia, he said, has “essentially been in a coma for several centuries. . . . It desperately needs reviving.”21

  The anonymity of hedge-fund investors can be a problem. You might not know what your fellow investors believe, and the fund could be used to pursue values you don’t share.

  We should not be surprised if sovereign wealth funds use their assets to pursue objectives other than simply making money. As the former Treasury secretary Lawrence Summers said: “Suppose a country ran an active trading operation and found itself in an investment much like George Soros’ short position in the British pound in 1992. Would we be comfortable with the concept that nation X found that the fixed exchange rate of nation Y was untenable and wanted to launch a speculative attack against it?”22

  If you don’t know your manager, you may be investing against your own interests. If you don’t know who else is in the hedge fund, you may be unaware of powerful interests pushing a conflicting agenda. You could be funding your own enemies.

  Should You Use a Hedge Fund?

  This is not to say that hedge funds are always bad for investors. But they can be expensive ways to invest in alternatives. You need the right manager, with the right strategy, at the right time. A handful of hedge funds actually averaged returns of 50 percent per year over a recent three-year period.23

  There has been a push to make hedge funds accessibl
e to retail investors. Two major investment firms, Fidelity and Blackstone, have recently combined to offer hedge-fund alternatives with expense ratios lower than those of typical hedge funds and minimum investments as low as $50,000. They also removed some of the withdrawal restrictions.24

  Some experts nevertheless believe that hedge funds are a bad idea for retail investors. Adrian J. Larson, the president and portfolio manager of Pathlight, found that in the ten years between 2003 and 2013, someone who invested $1 million dollars in the S&P 500 index gained $661,070 more than an investor in the HFRI Fund of Funds Composite Index.25 Hedge funds, he concluded, represent “an investment style that is simply not worth the money.”

  In any case, investing in hedge funds requires professional help. These funds can be nothing more than glorified mutual funds—underperforming, overpriced mutual funds at that. A fund that sticks to stocks and bonds requires a truly exceptional manager to beat the market by enough to justify his keep. The hedge funds that stand out focus on alternative investments. To evaluate such funds, you have to understand the alternatives in which the fund is investing.

  Alternative Investments

  There are several basic categories of alternative investments. You can invest in financial assets like corporate stock, which is equity. You can lend money, which is debt. You can invest in real estate, commodities, or collectibles. Or, you can hold cash in various currencies. Every investment can be affected by the world around it. Economic warfare will have a substantial effect on all investments. Depending on the type of attack, the effect could be positive or negative.