Hedge funds stole money from my father — that’s why I started Collective2

The scorecard: Dad invested in a dozen hedge funds. Four were fined or shut down by the SEC. More than half lost money.

After working for 50 years, and achieving business success most people dream of, my father had a problem. What to do with his money?

Some people dismiss this as a “first-world problem” — not worthy of righteous intellectuals’ concern. But it was still a problem — his problem — and my father wasn’t alone. When interest rates are zero, and inflation is not, putting your money in the bank — whether a thousand dollars, or a million — is the exact mathematical equivalent of asking someone to remove half your cash over the next fifteen years. Think about that: work for fifty years, stick your money in a bank; and then, fifteen years later, half of it is gone.

What about the stock market? Investing in the “stock market” sounds like a good idea, until you actually study the history of the stock market. When you do, you will see that stock-market “corrections” cause a third of your money to instantly vanish, and that subsequent bear markets can — and have! — lasted for several decades at a time. A person who “bought the dip” in 1969 would have waited for 25 years to get his money back. Conceivable maybe for a twenty-year-old, not-so-smart for a man pushing 70.

You could invest in real-estate, but this was the industry in which my father had built his nest egg, and his goal was to take money off the table, and perhaps to wind down a bit and enjoy life. Real-estate investing requires diligence, and work, and brings with it endless heartache.

So what was left? What does a man with cash actually do with it, when he wants to take a break, and step back, and not work so goddamn hard?

My father found an answer. Hedge funds. Let someone else steward his capital, and make it grow. After all, hedge fund managers are financial experts. Why not leave a tough job to experts?

The Game Plan

The title of this article tips my hand, so you already know that my father’s plan didn’t work out as expected. But it wasn’t for lack of caution.

For here is something you don’t know about my father, but you’ll have to accept my word for it: my father is the most thoughtful, cautious man I know. You remember that fact I threw at you several paragraphs ago — about how stock-market corrections can make 33% of your money disappear overnight? That came from my father. He taught me that growing up. Indeed he mentioned it often, because he had lived through it, more than once, and he worried it would happen again.

His caution extended beyond investing. Growing up, whenever I came up with an idea — whether sensible, or preposterous — my father always urged me to slow down, think through the possibilities. Sure, this assumption might work out, and that goal might happen… but what if it didn’t? What if the thing you’re counting on doesn’t materialize? It’s fine, go ahead with your plan, but have contingencies. Recognize there is a spectrum of possible outcomes, and plan accordingly. My father is a living, breathing Value-at-Risk calculation. He taught me that life, and the events that unfold within it, do not always fall within one standard deviation.

So when he decided to invest his money in hedge funds, my father did so in his typical cautious, plodding — sometimes maddeningly so — way.

No rush. Think. Do research. Assume the worst, and try to minimize risk.

He placed phone calls. He spoke to people — friends, business associates, advisors, experts. He sought their opinions. He asked for references. He bought access to hedge-fund databases, which contain deep and accurate information about thousands of hedge funds strategies and performance.

He checked the manager’s records for disciplinary violations, criminal convictions, bankruptcies, judgments.

He decided to diversify. Sure, hedge funds sound great, but you can’t have complete confidence in any single one. You don’t want to risk everything on one fund, or one manager. And my father is a cautious man.

Ultimately, he invested in over a dozen hedge funds. They were a mix of different kinds of strategies, and different kinds of managers. He invested in a credit fund, a long-short equities fund, a fund that traded commodities, a fund that traded volatility, even a fund that traded live cattle. The managers running these funds were similarly diverse: a Harvard-educated amateur hockey player! A former chairman of NASDAQ! A credit expert from New Jersey! A recent Chinese immigrant with a math PhD!

The Scorecard

How did it work out? Here’s the scorecard.

  • One fund was a Ponzi scheme. All investor money was simply stolen.
  • One fund ripped off investors by using fake marked-to-market valuations. This means the manager claimed there were profits (and charged fees based on those profits), but in fact the profits were imaginary. (The fees were not.)
  • One manager borrowed investor money to pay his own personal taxes. Then he used investor money to invest in a dubious (and ultimately worthless) telecom startup.
  • Putting aside outright theft: more than half the funds my father invested in lost money.

Hedge-fund scams: Case-by-case study

Losing money is one thing; it’s to be expected when you invest in risky funds. But outright theft?

Let’s examine how my father’s money was stolen. We’ll look at each theft in turn.

The Ponzi scheme

Out of the all methods that hedge funds use to rip you off, Ponzi schemes are the least interesting. And, out of all types of fraud, Ponzis should be the easiest to spot. In a Ponzi scheme, no investing actually takes place. There is no trading. A Ponzi operator simply take the money from new investors, and give it to old investors. To spot this kind of fraud, an investigator need only walk into the hedge fund office, and ask to see the trading records. Game over.

So how was my father fooled by this? Today, years later, he’s the first to admit his mistake was silly, and that he should have been more suspicious. But in fact he was suspicious. The monthly returns for this particular fund were so good — almost too good — that they raised concern. And yet… and yet. This was not some fly-by-night startup hedge-fund that had just recently popped into existence. It had been operating for over a decade. It was run by a famous man. Its investors included other wealthy and famous people. The authorities knew of this fund. They knew about its excellent returns. This fact, more than any other, gave my father comfort: if there was something illicit going on, then surely the SEC would have discovered it, during the many years the fund had been operating. They didn’t.

Marked-to-Market Shenanigans

Now let’s turn to another hedge fund that my father invested in, and another way hedge funds can steal your money.

The term “marking to market” means deciding how much something is worth. When you buy a stock — let’s say, one share of Microsoft — you know how much that share is worth. You paid $20 dollars for it. So at the moment you buy it, it’s worth exactly that: $20 dollars.

Imagine six months pass. Now how much is your share of Microsoft worth? Determining this is equally simple: just look at the stock-market price of Microsoft. If it’s $30 dollars, you just made a profit of ten dollars. You don’t have to actually sell your share to calculate the profit. And if you’re a hedge fund manager, you can feel completely justified in charging your clients a portion of this ten-dollar profit. This is your business model, after all: make profits for your investors; keep a portion for yourself.

But the thing is, a lot of hedge funds don’t invest in plain vanilla stocks. Indeed, the appeal of some hedge funds is that they invest in exotic assets which are complex, hard to find, and not simple to trade. After all, anyone can buy a share of stock using his Ameritrade account. Why should you pay high fees to a hedge fund to do that?

Therefore many hedge funds seek, and invest in, complex assets that regular people have a hard time buying and selling.

Like, for instance, a PIPE. A “PIPE” is the acronym for a “private investment in a public equity.” Without bogging down in detail, let’s describe a PIPE as a financial instrument that is a combination of debt and equity.

The actual mechanics of PIPEs aren’t important. What is important is that there isn’t a stock-exchange for PIPEs. If you’re a hedge fund, and you want to invest in PIPEs, you call up small companies in distress, and you negotiate with their CEOs, one-on-one, and at the end of that negotiation, you walk away with a piece of paper that cost you, say ten million dollars. You hope that piece of paper will go up in value.

Now, a year passes, and you need to decide how much that piece of paper is worth. This is an important question, because the answer tells you how much you can charge your hedge-fund clients at the end of the year. Remember that hedge funds charge, typically, 20% of profits.

So, to take a simple example, if your PIPE investment makes a profit of $10 million dollars, you can charge investors $2 million dollars in fees. Which is very nice, because it helps pay for your house in the Hamptons, and your kids’ private schools, and maybe a jet card.

But it does raise a troubling question. How exactly should a hedge fund decide how much a PIPE is worth? Sure, you paid one million dollars for it, but a lot of time has passed. Maybe the company you invested in is doing well. Maybe it’s not. Who can be sure?

There’s no “PIPE Stock Market” where you can look up the current price of a PIPE. In fact, the PIPE you now hold is a one-of-a-kind financial creation. Who knows how much it’s worth?

I think you can spot the problem. How do hedge funds “mark-to-market” their investment in PIPEs, or fine art, or collectibles, or private companies, or whatever? How do they determine what things are worth?

I’ll tell you how. They pick a number out of their ass, and declare, “The PIPE is now worth X!”

And they say this with great conviction. And lo and behold — guess what? — somehow, miraculously, that number is never lower than the price at which the PIPE was purchased. Never.

And the hedge fund manager writes a warm and heartfelt letter to his investors, explaining that the fund enjoyed a terrific year, and that its investment in PIPEs yielded a +20% return. Oh, and that, the hedge fund manager will claim his fair share of that profit as his fee.

To be fair, sometimes a hedge fund hires a “valuation expert” who is paid by the fund to offer an arms-length, third-party opinion about how much a PIPE is worth. These valuation experts use complicated math, and formulas, to make valuation decisions.

You remember the thing I told you about how hedge-fund managers have a house in the Hamptons that needs to be paid for? Well, valuation experts also have houses that need to be paid for. Maybe not in the Hamptons. Maybe in Sayville. But still.

Guess what happens if the valuation expert doesn’t come up with the “correct” valuation after being hired by a hedge fund? He is fired by the hedge fund. Another valuation expert is hired in his place. The new valuation expert understands the lesson. Somehow, miraculously, his complex math comes out “just right.” The PIPE is worth more today than it was yesterday!

At a certain point, this kind of marking-to-market fakery comes to an end. In the case of PIPEs, perhaps the company you invested in goes bankrupt. Or maybe the private firm in which you bought stock is itself acquired for a much lower price in a legitimate market transaction which cannot be ignored.

But this can take many, many years. And in the meantime, the hedge fund manager has pocketed millions of dollars of fees. Perfectly legally.

Side Pockets and Lock Ups

Hedge funds specialize in investing in risky, illiquid, hard-to-value stuff. But sometimes, fund managers decide to invest in something so freaking “out there” that even they feel the need to differentiate it from their run-of-the-mill investments.

Take Philip Falcone. Please. After making a fortune calling the 2008 housing-market crisis, Falcone’s hedge fund, Harbinger Capital, enjoyed a sterling reputation. Falcone was a Harvard grad, a college hockey star who turned pro for a while, and a prescient investor with balls of steel. My father had heard about his hedge fund, and he wanted in. Be careful what you wish for.

Almost as soon as my father invested, things went south. Falcone declared that he would invest $2 billion dollars of investor money in a telecommunications startup with a risky business plan. The plan was: to take spectrum already allocated by the government for satellite communications, and without permission, to re-purpose that spectrum for use by cell phones. For the plan to work, everything had to go just right: the regulators needed to approve, and the science needed to work. Neither happened.

It turns out that the cell-phone technology interfered with GPS systems — causing Garmins to direct drivers off the road, and military drones to veer off target. The government, unsurprisingly, rejected Falcone’s plan.

But the point is, those of Falcone’s investors who didn’t want to go along with such a half-assed, risky scheme, had no choice.

Falcone set up what the hedge-fund industry calls a “side pocket.” These are special side deals where investor money gets funneled. When investors’ money is locked up in a side pocket, investors cannot ask for it back. (Technically, they can ask. But the side pocket is constructed specifically to prevent investors from getting money back. Side-pocket money can be locked up for decades.)

The theory behind side pockets is: some deals are very complicated, and they take a long time to come to fruition, and in the meantime, they are completely illiquid. (When an investment is “illiquid” that means it’s hard to sell. If you try to sell an “illiquid” investment in a hurry, you’re going to take a big haircut on its value, and lose money which you wouldn’t necessarily have lost if you were more patient.)

Side pockets are perfectly legal, but they have a well-deserved reputation for being unfriendly to investors. I mean, look, maybe I do want to invest alongside Phil Falcone — he went to Harvard! He was a hockey star! — but, maybe I’m not super-enthusiastic about trying to violate the spirit of FCC spectrum allocation rules, okay? And maybe I don’t want to invest in a Vietnamese casino, when gambling is not yet, you know, legal in Vietnam. (Yeah, that also was in a Falcone side pocket.)

The point here isn’t to make fun of Phil Falcone, whose investment in LightSquared, the telecom firm, went to a value of zero dollars, and who… well, wait, actually, that is the point.

Because in addition to losing my dad’s money in that cockamamie scheme, Falcone was also accused by the SEC of “borrowing” $113 million dollars of investor money to pay his own personal taxes. And also, of trying to manipulating bond prices. Falcone admitted wrongdoing and settled with the SEC.

The little guy in the story, my dad, lost over a hundred thousand dollars in that fund. He lost that money because, even after my father lost faith in Falcone’s investment strategy, and even after my father asked for his money back, Falcone refused to return it.

The “refusing to return investor money” part of the story? That part is perfectly legal, by the way. It’s just the way hedge funds operate. Like it or lump it. You want to play with the big boys? You have to accept the big-boy rules.

Let’s destroy hedge funds and replace them with something better: Collective2

I started Collective2 in order to destroy the hedge fund industry. Collective2 is a fully transparent, open, investing-and-speculating platform. We use the internet, and software, to make risky investing more transparent, less subject to fraud, and — frankly — a lot more fun.

Every problem I describe above — Ponzi schemes, valuation games, side-pockets, lock-ups — is eliminated by Collective2.

Here’s how.

The first thing you need to know about Collective2, and maybe the only thing, is this:

Your money stays in your account.

At Collective2, you never give your money to anyone to “manage.” You never write a check. You never wire money, or deposit it elsewhere. Your money stays in your brokerage account. Period. End of story.

Through the magic of Collective2 software, trading strategies are “executed” within your brokerage account. You choose which strategies get deployed, and at what quantities. You select these strategies by examining hypothetical performance statistics on the Collective2 web site.

Of course this is still risky, and of course you can lose money. But the point is, when you don’t actually hand your money to a stranger, you don’t need to worry about that stranger stealing it. Losing money is one thing. Having it stolen by a crook is something very different. Collective2 eliminates that problem.

No more Ponzi schemes

The mark of a Ponzi scheme is that the trading strategy which the manager claims to be using isn’t actually being used. Typically, in a Ponzi scheme, no trading is actually done. It’s all imaginary.

Here’s the thing about Collective2. That simply can’t happen. Your money stays in your brokerage account. You can see every trade as it happens.

Every trade.

As it happens.

In real time.

When I speak to industry veterans from the world of hedge funds, and I explain this part of Collective2, they are astounded. “You mean, when I execute a trade, every client sees the trade as it happens? And they can see my strategy’s profit and losses as they happen?”

Are these hedge-fund veterans made uncomfortable by this notion — that customers can see what they’re up to? Perhaps.

Because not only does Collective2 prevent Ponzi schemes (of course it will be obvious when a strategy doesn’t place any real trades, since you can see all trading activity within your account); Collective2 also lets customers understand when “style drift” occurs — that is, when strategy managers promise to trade in one fashion, but actually trade in another.

And because you know how strategies are performing minute-by-minute, you don’t have to wait for your end-of-quarter investor report to receive bad news. You can see instantly that a strategy isn’t working, and can pull the plug that minute.

No wonder hedge-fund veterans grow uncomfortable when they hear about Collective2.

No more lock-ups. No more side pockets.

Let’s talk about how this process of “pulling the plug” actually works in practice.

Let’s say you use Collective2, and you choose a strategy, and you decide, after some time, that you don’t really like the strategy you chose.

Guess who you need to talk to? No, you don’t need to place a phone call to a hedge-fund IR representative, asking for your money back. You don’t have to write a certified letter to anyone, begging for a redemption.

You just speak to… yourself. You say, “Dude, this strategy isn’t working so great. Let’s stop.” And that’s it. Maybe you shut off Collective2 completely, or maybe you choose another strategy you like better. It’s your choice. Because it’s your money. And you never have to ask anyone’s permission to stop trading.

No more “Harvard Grad” “Hockey Stars”

The weirdest thing about the hedge-fund industry is how obsessed it is with credentials.

Which isn’t so surprising, when you consider how easy it is for hedge funds to steal investors’ money. And how common it is for hedge funds to defraud investors (recall my father’s personal scorecard: four of the funds my father invested in were fined or shut down by the SEC). Given the prevalence of fraud, perhaps we should not be surprised that investors gravitate toward people with fine “pedigrees.”

But wait. The largest Ponzi scheme in history was operated by a former chairman of NASDAQ.

Phil Falcone, who used my dad’s money to pay Falcone’s personal taxes, and who refused to return the money when asked, went to Harvard.

Which raises the question: What good are credentials, when they don’t seem to mean anything?

In fact, you could make an argument that fine credentials not only are useless, but also are counter-productive. If every investor seeks out only Harvard-educated hedge fund managers, and there aren’t enough of them to go around, then won’t every investor in the world be slicing the same small pie? Won’t everyone be piling into the same conventional trades?

Wouldn’t it be better to seek out strategies operated by people with unusual backgrounds, or with deep experience in vertical industries, or with novel philosophies and ideas?

I mean, look, I wouldn’t write a check to some guy in a Moscow basement, who hasn’t studied in the United States… but, maybe, just maybe, I might use Collective2 to “allocate” a small piece of my capital to him. Because remember how Collective2 works: the gentleman in Moscow can’t access my money, and he can’t abscond with it. All he can do is apply a trading strategy to it. And I can watch every trade as it happens. And so, who knows. Maybe I’ll take a flier on him. Maybe he’ll lose. Maybe he’ll win. But at least I have the opportunity to see how he does.

This is perhaps the most exciting aspect of Collective2. Collective2 is an open platform. Anyone with a strategy can run it on Collective2.

“Anyone can run a strategy on Collective2? That’s crazy!”

But wait. If anyone can manage a strategy on Collective2, how do you know who is a good manager, and who is not?

Simple. You look at the Collective2 track record. Every trade is there. You can see which investors, if any, followed each trade. (Sometimes trades are not followed by any real-life investors, which of course should make a potential investor more cautious.)

For those strategies that are followed by real capital, you can see how much capital is following each strategy, each trade, each position! You can see which trades were executed at which brokers, at which prices, at which quantities. And of course you can see how well or poorly each strategy has performed overall.

Let’s put hedge funds out of business

The asset management industry manages over two trillion dollars. No, Collective2 won’t put hedge funds out of business overnight.

But the history of the internet is a story of small firms with big ideas, who somehow overthrow the traditional way of doing things. And if there’s one industry that deserves a bit of overthrowing, it’s hedge funds. Just ask my dad.

The hedge-fund industry is fundamentally broken. Let’s replace it with something better. Something like Collective2.

— Matthew Klein is the founder of Collective2.com