"More Money Than God: Hedge Funds and the Making of the New Elite"

My summary of this new book by Sabastian Mallaby. :

*Hedge funds (see definition below) sometimes earn great returns for their investors.

*They can have a place for investors who have more money than God to put at risk - generally high 6 figures and up.

* They can be very risky and thus they sometimes blow up spectacularly.

*They demonstrate that carefully calculated analysis, timing and guts can result in market beating performance.

*They also show that even a room full of phd "rocket scientists" can get things wrong with devastating results.

If you are interested on how hedge funds have succeeded and how some have failed this book will give that to you. It is well documented and provides interesting reading on how these funds effected currencies, industries and whole economies.

At the end of the book, Mallaby argues that some of the structure of hedge funds may hold some guidance for financial reform. Specifically, the incentive that, when your own money is at risk, your behavior is different than the Wall St bankers who did not have money at risk and the result was the banking and financial crisis of 2008.

A hedge fund is defined by four characteristics:

1. They stay under the radar screen of regulatory authorities

2. They charge a performance fee - generally the managers keep 20% of the returns. But managers have their own money in the fund and at risk.

3. They are partially isolated from general market swings.

4. They use leverage (borrowing) to take short and long positions on markets - when most people invest in the market they invest in the hope that the market goes up, they are long. A short position is a bet that the market or stock is going down. A hedge fund will take big risks but balance it with an opposite bet in the event the risk fails.

For me, the biggest issue is whether the fees justify the risk and return. Mallaby argues that hedge funds can consistently outperform the market and that markets are not efficient. I do not think that this book closes the case on this idea.

A recent WSJ article sheds light on the performance of hedge funds and seems to counter the idea that hedge funds can consistently outperform the market.

http://online.wsj.com/article/SB10001424052748704739504576067691479405146.html?mod=ITP_businessandfinance_2

Hayek on index funds

"in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process… will hardly ever be fully known or measurable."

This quote is from the 1972 Nobel prize lecture of Austrian economist Friedrich Hayek who wrote brilliant works that explained the errors of fascism and socialism. He taught that the modern economy has too many variables for one person, or organization, to efficiently allocate its resources. Hayek argued that the price system does a better job of allocating resources than a government controlled system. Hayek's observations are part of his reflections on spontaneous order - which is the idea that order comes out of chaos when many self interested individuals are involved. This idea is played out in many areas. A recent example of spontaneous order is the open architecture software - Linux, which is written by programmers from all over the world who, in their spare time, add to the code. Linux now operates some of the fastest computers in the world and is the operating systems that runs many devices that we use in our daily life.

So how does this apply to investing?

The investing world is divided by those that believe they can predict economic and investment trends - the active managers, they believe they can predict which stocks to pick for your portfolio or mutual fund. Then there are those that believe that the stock market is too complex to make those decisions accurately on a consistent basis (the indexers). The indexers argue that the collective wisdom of all the investors in the world will average out to the best answer. The indexers, one could say, are Hayekian in their thinking. They would argue that if Wal Mart makes up 2% of the stock market, then an individual investor should own 2% of Wal Mart.

What is the collective wisdom of all investors in the investing world? Answer: index funds.

What is the record of index funds? Answer: Over time, they outperform active managers. Yes, year to year some active managers outperform the average. But it is not the same ones on a regular basis.

Spontaneous order seems to play out in stock funds. It explains why index funds outperform active managers. The collective wisdom of the many results in better investment performance than that of one or a few.

What does this mean for the average investor. It means that the best course of action has been to hold a well diversified, risk appropriate portfolio of the global stock and bond market and fund it with index funds and rebalance annually.

For a similar example "The Bagel and the Index Fund," see Russ Roberts's 2004 Business Week column :

http://www.businessweek.com/bwdaily/dnflash/jan2004/nf20040120_6180.htm

I recommend Russ Roberts's podcast: Econtalk, his blog: Cafe Hayek, and his books: "The Choice", "The invisible Heart", and "The Price of Everything."

Roberts is a professor of Economics at George Mason University

In another related article, see Jason Zweig's January 8, 2011 Wall Street Journal Column, in which he also cites Hayek in his explanation on why forecasters rarely get forecasts correct:

http://online.wsj.com/article/SB10001424052748703675904576064320900295678.html?mod=ITP_businessandfinan

How much do mutual funds really cost you?

Nathan Hale of CBS Money Watch has an interesting blog (link below) on the real cost of actively managed mutual funds. He references an article in World Economics by professor Ross Miller. Miller argues that since most actively managed mutual funds are only partially actively managed (somebody is picking the stocks or bonds) . The majority of money in an active fund is essentially an index*, so the fees that one pays is for a small portion of the fund that is actively managed.

Bottom line according to Miller: the average fee on the portion of managed money 6.34%

http://moneywatch.bnet.com/investing/blog/fund-watch/are-hedge-funds-a-bargain-compared-to-actively-managed-mutual-funds/564/

*Definition of an index fund: a fund that is made up of all the stocks or bonds that meet the criteria for a category ie. S&P 500 is a fund that holds the largest 500 US stocks. Nobody is picking the stocks to hold.

How much should I have in International investments?

The question of how much should I invest outside of The US is a good one. The short answer is 20%. Investing some of your portfolio in international funds adds diversification to your overall portfolio. It will help reduce risk and improve returns.

John Bogle, in his book "Common Sense on Mutual Funds" correctly points out that too much investing in international funds can be expensive - international fund fees are generally over 1%. They can be effected by currency fluctuations. In addition, if you have a good portion of your portfolio in large US companies (S&P 500) then you already have exposure to international economies. Bogle states that over 20% of S&P 500 profits are from outside the US.

Bogle recommends that you do not exceed 20%. I agree, I would also add that you may want to further diversify the international component by puttying 1/4th of your international funds in emerging markets - they add further diversification. They are riskier, so you will see greater ups and downs with the emerging markets. I do not advocate more than 7 or 8% of your total portfolio in emerging markets.