We've long warned our readers about the pitfalls of investing with hedge funds... It's an expensive way to earn mediocre returns. (It's expensive because most hedge funds charge 2% of assets under management and 20% of profits.)
In a world of expanding credit and falling cost of capital (the bond bull market between 1980 and 2010), returns came easy. Hedge-fund managers could produce acceptable returns by borrowing money at low interest rates and investing that cash into high-yielding fixed-income assets (known as a "carry trade"). Hedge funds would magnify those returns with leverage.
Because bond yields were falling and money was flowing, borrowers were able to refinance and roll over their debts.
Meanwhile, hedge-fund managers made obscene money as their assets under management – and subsequent 2% management fees – grew.
Eventually, credit dried up. Generating returns is much more difficult when the global credit bubble is deflating. Money is still cheap, though we're just now seeing interest rates creep up. (Last week, the yield on the 10-year Treasury passed 2% for the first time since last April.)
However, high-yielding assets are harder to find...
Some of the smarter fund managers saw the writing on the wall and closed shop. Billionaire Stanley Druckenmiller closed his hedge fund, Duquesne Capital, in 2010. He was facing the first down year in his 30-year career. Here's what we wrote:
Stanley Druckenmiller is hanging it up. Facing the first down year in a 30-year career as a hedge-fund manager (his main fund is down about 5% this year), Druckenmiller has decided to return his clients' capital and retire. We think you'll see more of this – that is, more hedge funds going out of business – as the global credit bubble deflates.
Druckenmiller's career happens to correlate perfectly with the largest inflation in history. As credit multiplied between 1980 and 2010, folks like Druckenmiller were paid unbelievable sums for managing the resulting capital flows. But... the credit spigot has been tightening up, at least for private capital. Now, the only bubble left is the one being blown up by Washington in the form of Treasury obligations.
Billionaire George Soros also closed his flagship Quantum Fund to new "non-family" money for the first time in the firm's 38-year history.
Fellow billionaire fund manager Louis Bacon, founder of Moore Capital, announced he would return approximately one-quarter of his fund ($2 billion) to investors last August. He cited 18 months of "disappointing" returns...
"I am more comfortable taking down the size of the fund than increasing the size of the positions in order to give clients an adequate return given the fees they are paying. I found myself trying to make money in a much less liquid environment, with less instruments to trade – it's very frustrating," he wrote in a letter to investors.
Druckenmiller, Soros, and Bacon (among many other hedge-fund managers) won the game... They rode a massive wave of credit and collected billions of dollars in management fees along the way. But they understand the glory days are over.
Speaking from the World Economic Forum in Davos, Switzerland, Soros says he doesn't think hedge funds can continue to beat the market because there are too many in existence (and many follow the same trading strategies). It's even tougher to beat the market once you factor in high fees.
Still, hedge-fund assets are at a record $2.2 trillion (as of the third quarter of 2012). And we'll bet that number grows for the next few years... There's a lot of liquidity, thanks to central banks' money printing. And because cash has a negative real return – meaning the rate of inflation outpaces what you'll earn in the bank – money is shifting into other assets (like stocks, as Porter pointed out in Friday's Digest).
Hedge funds will benefit from that shift. And given the pathetic returns in cash today, investors' expectations will be lower. But we're still avoiding the high-cost investment pools. Consider these stats from The Economist newspaper:
The S&P 500 has now outperformed its hedge-fund rival for 10 straight years, with the exception of 2008 when both fell sharply. A simple-minded investment portfolio, 60 percent of it in [stocks] and the rest in sovereign bonds, has delivered returns of more than 90 percent over the last decade, compared with a meager 17 percent after fees for hedge funds.
Like many of the best hedge-fund managers (David Tepper, for example), we're bullish on equities today. But we're not paying anyone to invest in stocks for us.
We like insurance, which Porter calls "the best business in the world." In his latest annual letter to investors, superinvestor Warren Buffett explains what makes the insurance business so special...
Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers' compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call "float" – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit...
If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit occurs, we enjoy the use of free money – and, better yet, get paid for holding it.
Take a look at today's "new highs list" below (which reflects Friday's close)... It's loaded with insurance companies – Berkshire Hathaway, Loews, Chubb, Travelers, Alleghany, and Navigators.
Blue-chip, World Dominator stocks – which are also making new highs – are another safe place for capital... Hershey, Automatic Data Processing, and Procter & Gamble are all at new highs. These companies, which have rock-solid brands and "fortress" balance sheets, will benefit as capital flows into equities.
We'll bet a portfolio of these stocks will outperform most hedge funds over the next few years. (The smart funds will simply buy these stocks, but again, they'll charge huge fees to do so...)
If you'd like to load your portfolio with World Dominating companies, we'd recommend a subscription to Dan Ferris' 12% Letter. You can learn more about a subscription – and access his elite list of cheap blue-chip companies that are trading under their buy-up-to prices – here...
New 52-week highs (as of 2/1/13): Berkshire Hathaway (BRK), Morgan Stanley China A Share Fund (CAF), WisdomTree Japan Hedged Equity Fund (DXJ), iShares Australia Fund (EWA), iShares Germany Fund (EWG), Fidelity Select Medical Equipment & Systems Fund (FSMEX), Cambria Global Tactical Fund (GTAA), iShares Insurance Fund (IAK), iShares Biotechnology Fund (IBB), SPDR International Health Care Fund (IRY), ProShares Ultra Health Care Fund (RXL), Sequoia Fund (SEQUX), ProShares Ultra S&P 500 Fund (SSO), Automatic Data Processing (ADP), Ericsson (ERIC), Consolidated Tomoka (CTO), Hershey (HSY), Chubb (CB), Loews (L), Travelers (TRV), Alleghany (Y), Blackstone Group (BX), Kohlberg Kravis Roberts (KKR), Becton-Dickinson (BDX), Medtronic (MDT), BLADEX (BLX), Cheniere Energy (LNG), Procter & Gamble (PG), Walgreens (WAG), and Emerson Electric (EMR).
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I touched on this briefly in last Friday's Digest, but I'm really excited about the data I saw showing the increase in oil shipments on the railroads...
But there's another important number: there was a 47% year-over-year increase to petroleum shipments. That's an enormous increase, and shows you that as this oil boom has taken place – particularly in the Bakken shale in North Dakota – we don't have the pipeline capacity yet to efficiently utilize this resource that we have. So it will take some time before the oil boom hits the real economy, but we know it's coming because it just showed up in the rail data...
For now, just take a look at the railroad stocks. My Investment Advisory readers are already up 22% on Union Pacific (UNP, the blue line on the chart) over the last year, and I wouldn't be surprised to see other railroad companies do much better as well. Take a company like CSX (the black line), which hasn't seen its share price explode like others in the sector...
We know demand for oil shipping will cause rail infrastructure prices to increase across the board. And that will push up shares like CSX. It takes a long time to build pipelines, so you could potentially see this as a solid uptrend for the rail companies for the next three years.