In The Headlines

Do Hedge Funds Face a Slow and Painful Death?

“It’s miserable, miserable,” Howard Fischer, the 57-year-old manager of $1.1 billion Basso Capital Management says of hedge fund returns over the past few years. “If that’s the normal expectation, I don’t have a business.” Fischer’s lament and ones like it are echoing through the industry. It is an existential crisis for former masters of the universe who once prided themselves on their trading prowess. Now they are questioning their wisdom and their ability to generate profits that made them among the richest in finance. The $2.9 trillion industry has posted average annual returns of 2% over the past three years, well below those of most index funds. That meager performance and complaints about high fees from pension plans and other investors led to $51.5 billion being withdrawn from hedge funds in the first nine months of the year, the most since the financial crisis, data compiled by Hedge Fund Research Inc. show. About 530 funds were liquidated in the first half, on pace for the most shutdowns since 2008.

Managers blame a wall of index-fund money and algorithmic trading for warping markets. They bemoan central bank near-zero-rate policies, political and economic decisions made overseas and government regulation for undermining their craft. Add to that global economic uncertainty and an onslaught of technology that is changing the investing process. It is enough to have the so-called best and brightest second-guessing themselves. “Many investors seem to gradually be coming to a realization that what they think they know may no longer matter,” Jordi Visser, who runs investments at $1 billion hedge fund Weiss Multi-Strategy Advisers, wrote in a June paper. “It appears to be a feeling of being trapped in an investing world that no longer makes sense.”

Craig Effron, who co-founded $1.8 billion Scoggin Capital Management in the late 1980s, shares those profound doubts. The 57-year-old manager says the past few years have been the most perplexing of his career. Algorithms and exchange-traded funds have exacerbated price movements and driven industry stocks in unison, undermining wagers on single companies, Effron says. And while he understood why subprime mortgages lost their value a decade ago, he cannot fathom what negative interest rates in Japan or Denmark mean. Last year his fund slumped 10% as what he thought were his firm’s best trade ideas turned out to be the worst and he found it hard to explain the losses. “There was a playbook based on logic that worked most of the time before 2008,” he says. “But the game has changed and logical investors haven’t got the new playbook figured out yet.” Effron is also critical of the industry, which he says is overcrowded. As many as half of the 8,400 funds in existence today will need to disappear, he says.

For some, the challenges have proved insurmountable. Richard Perry, one of the earliest hedge fund managers, threw in the towel on his Perry Capital last month after almost three decades, saying his style of investing no longer worked. Traci Lerner returned money from her Chesapeake Partners Management in June after 25 years, saying fallout from the financial crisis resulted in a hostile investing environment. Martin Taylor and Nick Barnes, who closed London-based fund Nevsky Capital in January, said computer-driven markets were incompatible with the way they trade. Some managers faced graver problems. Jacob Gottlieb is liquidating his Visium Asset Management after two former employees were charged with securities fraud. One later killed himself. Leon Cooperman and his Omega Advisors Inc. were accused by regulators of insider trading, while Dan Och’s Och-Ziff Capital Management Group LLC, one of the world’s largest hedge funds, paid more than $400 million to settle bribery charges. Paul Tudor Jones, who helped spawn the industry, was forced to trim the hefty fees he charges clients and slash employees as clients pulled money from his Tudor Investment Corp.

The frustration is felt on both sides of the Atlantic. George Papamarkakis, whose main fund at $1 billion London-based North Asset Management is down about 10% this year, likens the industry’s poor performance to a chronic disease. “There’s gloom everywhere,” Papamarkakis, 46, says during a visit to the U.S. last week. The financial crisis “was a sudden death for a lot of people, like a heart attack, but this feels like cancer to many people, a slow death.” Papamarkakis started his firm 14 years ago and is one of a group of managers seeking to profit from broad economic trends by trading everything from yen to oil, a strategy known as “macro.” Such funds have struggled to make money because bonds make up much of their trading and low interest rates across the world make it harder to profit from differences among countries. Papamarkakis says the future of hedge funds lies in being savvier about quantitative techniques. He, like Effron, also says the industry needs to shrink for survivors to make money again.

Fischer, who started his fund more than two decades ago, sees the industry bifurcating into large firms with tens of billions of dollars in assets and smaller funds like his trading niche strategies. But he says survival depends more on a change of attitude. He was, in his own words, the “stereotypical hedge fund jerk,” driving fast cars and flying around on private jets. Basso Capital, which managed a peak $2.9 billion in 2008, lost money that year for the first time and struggled to recoup assets. Fischer says he hit rock bottom “emotionally, psychologically and economically.”

A leadership course he took three years ago changed his life. Now, Fischer says, he’s less of an eat-what-you-kill capitalist and more of a social-impact investor who reads books on the environment, watches TED talks, and shuns private-jet travel. At his hedge fund, which is up 4.8% this year and trades convertible bonds, a smaller market has allowed him to exploit mispricing opportunities. And lower-fee funds have attracted investors, helping to bump up assets. While Fischer was able to turn things around, many competitors are out of business because of their arrogance and inability to adapt to a changing investing world, he says. He compares the hedge fund industry to big-box retailers like J.C. Penney Co. and Toys R Us Inc. that were once aggressive, innovative, and highly profitable. Now they are too large and commoditized, with little chance for growth, he says. Fischer recommends that his peers take a break and put their skills to a different use that may help them feel better about themselves. “They can be convinced not to be a jerk for the rest of their lives,” he says.

Citations

1. http://bloom.bg/2edhrf6 – Bloomberg
2. http://bit.ly/2eC84md – Forbes

Auto Insurers Contemplate a World of Self-Driving Cars

Now that self-driving cars look likely to hit the mass market in the next few years, the question is being asked, who will be responsible for the car in the event of an accident? Elon Musk, Chief Executive Officer of Tesla, announced recently that all of its new vehicles will come with built-in self-driving hardware. He also said that the car company would not be liable if there were an accident with a car in self-driving mode. “That would be up to the individual’s insurance,” a Tesla spokeswoman said, confirming what Musk said on Wednesday when asked about it. “If it’s something endemic to our design, certainly we would take responsibility for that. But you know, I think one should view autonomous cars much like an elevator in a building. Does Otis take responsibility for all of the elevators around the world? No they don’t.”

The statement differs from Volvo, which said last year that it would take full liability for any of its cars while they are in autonomous mode. Not just Volvo and Tesla are grappling with this issue. Auto insurers and car companies are not entirely certain just yet who will be left holding the check—and they may not be certain until these cars have been in the market for a while. “The U.S. auto insurance industry has decades of claims experience with driven cars and yet a very small sample when it comes to claims generated by self-driving cars,” said Michael Barry, Vice President of Media Relations at the Insurance Information Institute, a consumer education group. “I don’t think auto insurers will know the risk until they see the types of claims that will come in.”

And the dilemma is becoming increasingly urgent. The first autonomous vehicles could be in showrooms as early as 2018 and 2019, according to a report by auditing firm KPMG. Right now, automotive and technology companies including Ford, Audi, and Google have been building and testing their self-driving cars. Semiautonomous cars, those that beep when things appear in blind spots and automatically apply brakes when the car in front gets too close, are already on the roads, such as those from Tesla, Infiniti, and Subaru. Some cases may end up getting complicated when car companies, insurance firms, and drivers try to determine who or what was at fault at the time of the crash. “All but the most fully automated vehicles will be controlled, at least some of the time, by human drivers,” a 2014 Brookings research report stated.

Insurance firms must prepare for what could be a turbulent transition period, since driverless cars will be “detrimental” to the auto insurance industry, Tom Wilson, Chairman and Chief Executive of The Allstate Corporation, said during a Sanford-Bernstein conference last year. The company expects revenues to be up marginally for the next 10 years and then begin to drop, he said. Some good news: Bloomberg reported last month that car insurance premiums may decline as much as 40% by 2050, when self-driving cars are expected to be in full swing, according to insurance firm Aon. That, however, depends on there being a drop in accident rates for driverless cars compared to traditional vehicles.

There were more than 5.3 million car crashes—2.2 million of which injured people and killed another 32,367—in 2011, according to the National Highway Traffic Safety Administration (NHTSA). Another NHTSA report found most accidents were the result of human error. Tesla’s first fatal accident involving a semiautonomous car in May sparked concerns over driverless car safety. The Tesla car did not use its automatic braking system because it did not detect a tractor-trailer that came from two lanes away turning in front of it. Tesla claimed it was not the fault of its Autopilot system. There were other fatal Tesla crashes this year, as well—one in the Netherlands, where Tesla said its Autopilot feature was not on, and another in China, which is under investigation.

Such accidents might not have happened if it was fully autonomous, partly because drivers would relinquish control to the vehicle entirely. “The Tesla involved in the crash in Florida was not a self-driving car, it was a vehicle with semi-autonomous features that is intended to operate in very limited circumstances,” said Russ Rader, spokesman for the Insurance Institute for Highway Safety, a nonprofit group funded by auto insurers. Driver-assisting technology currently on the market is helping drivers stay safe, Rader said. Automatic braking and forward collision warning are reducing front and rear-end crashes.

Still, self-driving cars won’t be the norm even after they are first introduced. Cars on the roads now are 11 years old on average, and turnover takes time, the Insurance Information Institute’s Barry said. In the meantime, drivers should focus on driver-assisted technology, not fully self-driving technology, Rader suggested. “They should put self-driving cars out of their minds,” he said. “What they should be thinking about is crash avoidance features available now that are making people safer.”

Citations

1. http://on.mktw.net/2edMlnL – Market Watch
2. http://bit.ly/1ysTHnI – Insurance Information Institute

The Good News Is . . .

• Mortgage application volume 0.6% gain on a seasonally adjusted basis last week from the previous week, according to the Mortgage Bankers Association. The tally includes an adjustment for the Columbus Day holiday. Applications are now 18.5% higher than a year ago. Mortgage applications to purchase a home increased 3% from the previous week, seasonally adjusted and are now 13% higher than the same week one year ago.

• PepsiCo Inc., a leading food and beverage company, reported earnings of $1.40 per share, an increase of 3.7% over year-earlier earnings of $1.35 per share. The firm’s earnings topped the consensus estimate of analysts by $0.08. The company reported revenues of $16.0 billion. Management attributed the results to strength in its core beverage products and an improved gross margin.

• British American Tobacco made a $47 billion takeover offer to buy the stake in Reynolds American that it does not already own, a deal that would create a tobacco giant with a significant presence around the world. The deal would create the world’s largest publicly traded tobacco business based on net sales and combine companies with brands that include Camel, Lucky Strike, Newport and Pall Mall. It comes with the industry facing a shift toward so-called next-generation products such as e-cigarettes and vaping products. Under the terms of the deal, British American Tobacco is offering $56.50 a share in cash and shares.

Citations

1. http://bit.ly/2ePDwlY – Mortgage Bankers Association
2. http://cnb.cx/1gct3xa – CNBC
3. http://bit.ly/2dH9qic – PepsiCo Inc.
4. http://nyti.ms/2eZWKVb – NY Times Dealbook

Planning Tips

Guide to Understanding ABLE Accounts

A new type of account for disabled persons has recently become available. The ABLE (Achieving Better Life Experience) accounts are designed to help disabled persons pay for their healthcare expenses. These accounts are a major step forward for those who are struggling to pay for expenses related to a disability. They allow disabled persons and their families to save and invest money on a tax-advantaged basis in order to pay for expenses related to their disability. Below are some guidelines for ABLE accounts. Be sure to consult with your financial advisor to determine if these plans are appropriate for your situation.

How do ABLE accounts work? – The money that is placed into an ABLE account must be used for “qualified disability expenses.” The definition of what qualifies as this type of expense is very broad, and includes housing, transportation (such as to and from therapy or treatments), education, job training, medical expenses and any other costs that are directly incurred as a result of the account holder’s disability. One major advantage that these funds have is that the first $100,000 that is put into them is not counted as an asset for the purpose of qualifying for Supplemental Security Income (SSI), Medicaid or food stamps. Contributions to these plans are made on an after-tax basis, and distributions are tax-free as long as they are used to pay for qualified disability expenses.

Who is eligible for an ABLE account? – Anyone who receives SSI or Social Security Disability Insurance (SSD) is allowed to open an ABLE account provided that their disability began before age 26. Other disabled persons may also be eligible if they meet this age requirement and also meet the criteria for the governmental definition of being functionally limited that is certified by a doctor. Only one account is allowed per person, but anyone can make a contribution into this account.

How much can be contributed annually to an ABLE account? – Contributions are limited to $14,000 per year, the same amount as the annual gift tax exclusion, and some states also offer a deduction for contributions up to a certain limit. If the account balance in an ABLE plan rises above $100,000, then SSI payments will stop and will not resume until the account balance drops back below this amount. Most states have set a limit of how much can be placed into these accounts of around $300,000 to $400,000.

How can the money in ABLE accounts be invested? – The investment choices in these accounts are limited to a conservative, moderate, or aggressive model that invests in index funds. Savings and checking accounts are also available in some state plans. In most cases, funds can be switched between the investment accounts twice a year. But account holders can move money from the savings account into the checking account more often than that.

Are ABLE plans used in lieu of special needs trusts? – ABLE plans ultimately stand as a simpler alternative to special needs trusts, which require the services of an attorney to create. However, these accounts can be opened as an addition to these trusts with no legal or financial conflicts. Most states have now passed resolutions to offer these accounts. Their exemption from assets that are counted for SSI and SSDI will make them a very attractive option for many families with disabled members.

Citations

1. http://bit.ly/2biqbAQ – ABLE National Resource Center
2. http://bit.ly/2biqbAQ – US News & World Report
3. http://bit.ly/2duWkpM – Investopedia
4. http://intuit.me/2dWqLBn – Intuit
5. https://nerd.me/2euOeeq – NerdWalletcom