TO A REMARKABLE MAN....

Nelson Mandela

Detecting the Scam

 

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and Chapters 1-3

 

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(May 7, 2011)



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common sense:
hedge funds and the subway test

So that guy in the subway with the fake Rolex has another deal for us:

You see, he has this hedge fund that is run by some real players. They are all Harvard business school grads. They’ll invest our money for us and will charge us 2% of whatever we invest with them and then 20% of any profits. He tells us this is the standard deal that hedge fund managers charge.

What he laid out was indeed a typical hedge fund manager deal. If any reputable person with an established hedge fund with luxurious corporate offices in the Plaza District in New York had offered us the same deal, we would probably have felt quite comfortable…

The Duck School is here to shine the light of common sense on what we do. Think of the second rule of The Duck School — the one about ignoring how wealthy, well-educated and successful the messenger was. What questions would we ask the messenger?

Our first question might be this: How easily could we get our money out?

Many hedge funds do not allow us to get our money back easily. This is known as “gating” investors. Personally, if I couldn’t get my money out easily, this deal wouldn’t be too attractive…

The second question might be a tad uncomfortable for the fund manager, but we would ask it anyway:

We understand that the manager should be given an incentive to make us a profit. But why shouldn’t there also be an incentive for him not to lose our money?

So, we’re totally fine with him being our 20% partner with respect to profits, but he must then also be a 20% partner with respect to losses. If he isn’t prepared to do this, the result is way too weird. If we invested $1 million with him and he makes a profit of $1 million over a year, he would receive $200,000. After the first year, this would leave us with $800,000 and him with $200,000. If he then lost $800,000, this would leave us with no profit and him with $200,000. This is way too weird…

What’s the conclusion here? Are hedge funds scams? No, just as we weren’t scammed when we bought that fake Rolex in the subway, so too here we weren’t scammed. We knew what the deal was. If we agreed that we couldn’t get our money out easily and if we agreed that he would share only in our profits, we weren’t scammed. We just made lousy deals…

The Duck School can help shine a light on common sense, but it can’t prevent us ignoring what we see…

Go back to Common Sense home page.