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Fundamentals of Fund Investing

Investment schemes with a 'profits-I share-but-losses-are-yours' structure are problematic because they bring about a separation of interests between the investment manager and the investor

Recently, an American hedge fund named Amaranth has been in the news for having lost a lot of money. And I really mean a lot. This fund apparently lost USD 6 billion (Rs 27,600 Crore) out of its total corpus of USD 9 billion in a matter of days. To put it in perspective, the amount of money it lost was equal to the ten largest equity funds in India put together. However Amaranth was not a mutual fund but a hedge fund and in its collapse lies the lesson that all investors would do well to understand.

A hedge fund (there are no hedge funds in India, at least not under that name) is a lightly-regulated investment fund that escapes most regulations by being a sort of a private investment vehicle being offered to selected clients. The big difference between hedge funds and mutual funds is that hedge funds don't reveal anything about their operation publically and they charge a performance fee. Typically, if they outperform a benchmark, they take a cut of the profits. Of course, this is a one way street, any losses are borne by the investors themselves.

Some readers would have realised by now that in both their secrecy and their one-sided profits-I share-but-losses-are-yours structure they are actually pretty similar to the various 'portfolio management' or 'wealth management' schemes that are touted in India by names big and small. Loosely speaking, this is correct. Such schemes are the closest thing in India to hedge funds.

These one-sided arrangements are fundamentally problematic because they bring about a separation of interests between the investment manager and the investor. The investment manager in such a vehicle has every incentive to follow a high-risk high-returns strategy because if the risk pays off he makes money but if it doesn't then, well, it's OK, its someone else's loss. But won't making losses mean that other people won't invest with that investment manager? That's where the secrecy comes in. As long you have a slick marketing machine and don't have to reveal NAVs publically like mutual funds have to, you can always find two new murgas to replace each ex-murga who lost money with you.

The underlying principle--that a separation of concerns between the investor and those providing him with various services is actually much broader than the above example and investors would do well to examine all their interactions while thinking critically of the other party's motives. Does the previous sentence sound like a polite way of saying that you should start off by considering every financial intermediary as an unscrupulous individual out to get your money? Yes it does and that's exactly what I'm saying. I'm not saying that this is actually the case but I really think it's better to start of by presuming the worst and then being pleasantly surprised than the other way around.

So when an insurance salesman approaches you, tell him clearly that you know that his primary goal is to maximise the commission he will get for a given amount of premium. With a mutual fund salesman, state clearly that you know for a fact that his advice is tailored to maximise his brokerage and not your returns. This is not just something I'm just saying. It actually works. If you follow this advice you'll find that the fishy ones will all vanish and only the truly honest will have the guts to do business with you.