Anatomy of a Hedge Fund

Last year, John Paulson, a hedge fund manager, made $5 billion dollars. There was a great deal of damage control on this news, including by Business Insider, explaining that $4 billion of that amount was gains from his own investment in his fund.

That lead me to the following analysis:

A typical hedge fund manager gets a 20%/2% to run the fund, which means 20% of the annual profit, and 2% of the value of the fund.

Assume no tax dodges, so that the investors (including the manager) pay 15% Capital Gains tax on the annual gains (directly from the fund).

Being confident in his own abilities, the manager invests his after-tax income in the fund.

At the start of a year, the investors have $M_old in the fund, the manager has $m_old, and the fund gains r%.

Capital Gains tax on the investor money is $0.15*r*M_old, 20% of the after-tax gain goes to the manager, and remainder gets rolled into the investor funds. The manager then gets 2% of the total.

For the manager, his share of the fund increases by $r*m_old, of which $0.15*r*m is Capital Gains tax. He also gains the 20% of the after-tax investor gains, and 2% of the fund, on which he pays a 35% tax rate.

Thus, we have

M_new = (0.98)*(1+(0.8)*(0.85)*r)*M_old

m_new = (1+(0.85)*r)*m_old+(0.2)*(0.85)*r*M_old+(0.65)*(0.02)*(1+(0.8)*(0.85)*r)*M_old

What is the result?

If the fund gains 20% per year, it only takes 16 years for more than half of the money in the fund to belong to the manager. At 10%, it takes 23 years.

Christine Lagarde's alter ego

Viewers of ITV's Dickinson's Real Deal will have been struck by the similarity between Chelsea antiques dealer and former drag queen Ian Towning, and the recently-appointed Head of the IMF, Christine Lagarde. Are they perhaps related?

Solar Flare Warning - world leaders go into hiding?

Ian Parker-Joseph relays news of a strong electromagnetic sunstorm that could potentially have catastrophic effects on our interconnected, electricity-dependent Western societies.

This would not be without precedent: in 1859, the strongest recorded solar storm, known as the "Carrington Event", caused telegraph systems to fail or be shut down. But the world then did not have electronics, and water and power supplies did not depend on electrically-operated and computer-controlled machinery.

The facts of the sun's storm and ejection of vast quantities of charged particles appear to be corroborated by the amateur heliological website solarham.com:

... and elsewhere, e.g. spaceweather.com, and pictures of the flare from 22 September here (example below):
Implications:

Should we avoid going outside? Not clear: according to this Wiki article, ultraviolet light replenishes the ozone layer by splitting O2, so it is when the sun is "quiet" that the layer thins and more UV light penetrates to the Earth's surface. But there may be more UV health risk if you live in high northern latitudes, where the ozone layer is already thin or holed.

Indirectly, health and safety could be compromised by the failure of electrical systems that govern and provide for so much in our urban lives. Should we lay up extra water and cold food? It wouldn't hurt.

I like IPJ's idea of cowardy-custard politicians cowering in underground shelters; let's hope nobody superglues the locks.

Humour: how the stockmarket works

CityUnslicker reproduces the following story; the earliest version online I can find is from 1st February 2001, but that references "Felix", which appears not to be the same-name student newspaper of Imperial College, London:

Once upon a time in a place overrun with monkeys, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers, seeing that there were many monkeys around, went out to the forest, and started catching them.

The man bought thousands at $10 and as supply started to diminish, they became harder to catch, so the villagers stopped their effort.

The man then announced that he would now pay $20 for each one. This renewed the efforts of the villagers and they started catching monkeys again. But soon the supply diminished even further and they were ever harder to catch, so people started going back to their farms and forgot about monkey catching.

The man increased his price to $25 each and the supply of monkeys became so sparse that it was an effort to even see a monkey, much less catch one.

The man now announced that he would buy monkeys for $50! However, since he had to go to the city on some business, his assistant would now buy on his behalf.

While the man was away the assistant told the villagers. 'Look at all these monkeys in the big cage that the man has bought. I will sell them to you at $35 each and when the man returns from the city, you can sell them to him for $50 each.'

The villagers rounded up all their savings and bought all the monkeys. They never saw the man nor his assistant again and once again there were monkeys everywhere.

Now you have a better understanding of how the stock market works.

______________________________________________

If you think this is an overly cynical view of the investment establishment, remember that it has been re-posted by a City insider.

Also, at an Oxford college reunion some years ago, long before the credit crunch, I was talking to a fellow graduate who was "something in the City" about my bearish views and my thought that the East might eventually take over the business of the Western exchanges. He boasted that the City was adept at swindling foreigners and would manage to do so for years to come.

I'm just putting that on record. Hubris?

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

The US' credit rating, the peril of interest rates and the need for wholesale reform

As you know, S&P downgraded the US' credit rating to AA+ last month. That's still a lot better than most countries in this financially shaky world. But as long ago as July 2010 Dagong, a credit rating agency working for America's biggest foreign creditor, China, rated the US "AA with a negative outlook".

Here are a few graphs to tell the story of US public debt, and the cost of paying the interest on it as a proportion of gross Federal tax collections:

This next one might be a little surprising, even heartening:

That is greatly influenced by the long-term decline in interest rates:

For the period up to and including fiscal year 2000, the average rate on public debt was slightly over 7%, and has been reducing since the recession of the early 1990s in order to stimulate (and then rescue) the economy.

Now let's look at what interest would have been payable in dollar terms, if the rate had been (say) 7% throughout:

Had that 7% rate been applied throughout, this is what it would have taken out of the gross tax collections:

That is the big worry, and why I don't doubt that there's a lot of collusion and fudging going on behind the scenes.

But that doesn't make me a Tea Partier. This is not a story about wicked old government and how we'd be better off without it altogether.

The reason why debt has become particularly dangerous over the last couple of years, is that Uncle Sam has been trying to save our bacon. Perhaps he's done it in the wrong way, and should have let gambler banks go down - you have so many more second tier banks to take over, unlike here in the UK. Maybe it's not too late to for the US to do that, in a controlled way, even now.

And yes, we all need to look at social benefits, though again I'm not with the let-the poor-starve party. For example, we might just possibly question the profits of pharmaceutical companies (with their endless me-too variants on perfectly good drugs that are coming out of copyright); the profits and contractual get-out weaselling of insurance companies; the battening of lawyers on the medical system; the training costs and remuneration of the medical profession. There is more than one way to trim the fat, apart from abandoning US citizens to bankruptcy, ill-health and premature death. Can we please get away from an Orwellian Animal-Farm-style slogan-bleating of "private good, public baaad"?

I do have an issue with both the US and UK governments, not about their power and control but the exact reverse: their failure to moderate the growth of private debt over the last 30 and more years. Counterintuitively (if you think the Right is responsible with money), it was under President Reagan and Prime Minister Margaret Thatcher that total debt to GDP soared, as I discuss at length in a previous post here, and most of that was private debt. Fighting one foe, they failed to notice the manoeuvering of another, namely the psychopathic greed of the financial industry whose aid they requested.

I am reminded how Ireland's freedom was lost because the King of Leinster invited the Normans to assist him in recovering his throne in Wexford, in 1169. Guinness-drinking Irish sentimentalists may lament "the Saxon foe across the water", but their real enemy was the bloodthirsty, land-hungry, Viking-descended Norman, and King Dermot MacMurrough, who let him in.

Both public and private sectors are due for reform.

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Tax-free inflation-protected deposit scheme (UK) still available!

Now that NS&I has withdrawn inflation-linked Savings Certificates, the Mail on Sunday looks around for alternatives. I'll give them a slightly closer look here, with links for you to click through. Please note that Yorkshire Building Society has a cash ISA version that means returns are tax-free even if you are a taxpayer!

1. Post Office Inflation Linked Bond - N.B. closing date 16 September (or earlier if fully subscribed)

• Single lump sum investment, £500 min., £1 million max.
• 3-year term: RPI+0.5%, annually, OR...
• 5-year term: RPI+1.5%, annually
• Backed by Bank of Ireland.
• RPI adjusted once a year in August, according to UK Office of National Statistics RPI index.

Drawbacks:

• No withdrawals allowed during the term
• Interest is taxable (but remember that you or your partner may not be a taxpayer)

2. Cambridge Building Society Inflation Linked Bond Issue 1 - N.B. closing date 15 September (or earlier if fully subscribed)

• Single lump sum investment, £5,000 min., £85,000 max.
• 5-year term: RPI+1.0%, annually
• Runs from 16 Sept 2011 to 16 Sept 2016
• RPI calculated according to UK Office of National Statistics RPI index over the investment period

Drawbacks:

• No withdrawals allowed during the term
• Interest is taxable (but remember that you or your partner may not be a taxpayer)

3. Yorkshire Building Society Protected Capital Account (PCA) Inflation Linked 8 Plan - N.B. closing date 15 September (or earlier if fully subscribed)

• Single lump sum investment, £3,000 min., £85,000 max.
• Managed by Credit Suisse International on behalf of Yorkshire Building Society
• 6-year term: greater of RPI and 16%, i.e. minimum return is 2.5% p.a. even if inflation is zero or negative!
• RPI calculated according to UK Office of National Statistics RPI index over the investment period
• Can also be accessed as a cash ISA (max. £5,340), for tax-free returns
• Can transfer other cash ISAs into YB inflation-linked cash ISA
• Can invest in cash ISA as well as non-ISA bond

Drawbacks:

• Early exit fees apply
• Interest is taxable (but remember that you or your partner may not be a taxpayer), UNLESS you opt for the CASH ISA VERSION

4. Santander Inflation Linked Bond Issue 5 - N.B. closing date 5 October (or earlier if fully subscribed)

• Single lump sum investment, £500 min., £2 million max.
• 6-year term: greater of 105% of RPI (over the term) and 8%, i.e. minimum return is 1.29% AER p.a. even if inflation is zero or negative!
• RPI calculated according to UK Office of National Statistics RPI index over the investment period

Drawbacks:

• Early exit fees may apply - contact issuer for details on 0845 765 4321
• Interest is taxable (but remember that you or your partner may not be a taxpayer), however according to the Mail article an ISA version is available - contact issuer for details

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Should Americans dump their dollars?

Karl Denninger comments today on Greece's alleged failure to roll-over her debt, Germany's weakness and the fatal over-extension of debt in the American economy.

I respect Karl's expertise and information, but am often put off by his (to me) excessive use of bold type, underlining and capitalised words, dramatic language etc. Nevertheless, he's making a couple of radical predictions.

One is a very severe US stockmarket drop ("half -- or more", "try a 90% loss on for size"). Another is the consequent failure of insurance-based guarantees, including (a) annuities and (b) the FDIC.

Unlike here in the UK, where bank deposits are guaranteed by the Government, in the USA depositors are protected by a company, the Federal Deposit Insurance Corporation, so the value of the guarantee depends on the value of the assets held by the FDIC.

I touched on this question of FDIC underfunding in 2008 (following "Mish") and 2009 (following Karl himself) and if Karl is right, the moment of truth could be drawing near.

Yet there are others, including Charles Hugh Smith, who contrariwise expect the dollar to strengthen as the world trading system unravels, or at least to survive because its collapse would properly collapse the system.

We do live in uncertain times. My instinct would be to hedge my bets, but the conventional methods employed by investors - insurance-type hedging - may not work in a very unstable situation. Consider counterparty risk.

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.