A fund of funds gets found out

I was talking to Bert Jones (not his real name) on the phone the other day. Bert runs a $2bn fund of funds. “We’re kind of in trouble,” he told me.

“How come?”, I said. “You guys are the best. You haven’t had a down month since you started seven years ago.”

Bert is a worrier. When he says he’s in trouble it may mean something like Starbucks raising prices at his local outlet. Or, worse, like the last time he called me when he was upset that ABC had moved Lost from the 9pm slot to 10pm (“I can’t stay up that late!” he complained).

“Well,” he said, “we returned 8.3 per cent last year. We returned 8.5 per cent the year before and 7.8 per cent the year before that. So we’re beating the risk-free investment by 3 per cent per year. And, you know, we beat the market in 2005 and, of course, in the bear market years we destroyed the market.”

“Yeah,” I told him, “You suck. I can see why you have nightmares and your kids hate you.” I was kidding but I was almost angry about it.

“The problem,” he said in that slow, methodical way of his, “is that investors are starting to ask the basic question: I can get 5-6 per cent sitting in a risk-free investment like T-bills. Is it really worth getting 2-3 per cent more than that and risk dealing with fraud issues, having my money locked up for years, having to keep track of everything, etc? I’m afraid investors are going to start pulling out.”

And you know what? Bert’s investors are probably right. It’s not worth it. A friend of mine recently sold an expensive work of art and was looking to put his money to work in a fund of hedge funds. He asked me if I knew of a good one. I asked my friend: why would he want to flush his money down the toilet?

It’s double-locked up: The fund of funds and then the underlying hedge funds. And it really is fees on top of fees. A 10 per cent return in a fund of funds means that the final, underlying investments have to return approximately 18 per cent. That’s very difficult when the market itself averages about 7 per cent and T-bills are at 5-6 per cent.

There are 9,000 hedge funds out there. Nine thousand hedge funds aren’t returning 18 per cent. It would be amazing if there were an investment out there that was generating 18 per cent for 9,000 institutions while the rest of the world is making 7 per cent.

My friend didn’t like my answer. “Why are you saying that? You run a fund of funds.”

Well, what can I tell you? And I didn’t know what to tell Bert, either.

He’s got a problem. The entire industry has a problem. Well, I shouldn’t say that. Citadel doesn’t have a problem. It can return 9 per cent a year for ever and institutions will love it. When you’re big enough, you’re an institution also.

And SAC Capital won’t have a problem. How come? Because it returns 50 per cent a year. Hey, someone has to do it and they are the best, along with a select handful of others. But you can’t invest in them. I wrote to Steve Cohen once and asked if I could invest. No response. And why should he let me invest? Half his $12bn fund is probably his own money. He’s got other things to worry about. Let’s forget the fact that he’s on my IM buddy list.

But let’s invest in SAC anyway. At Stockpickr.com, a website I set up and run, I keep track of the SAC Capital positions (among others) that he’s either been increasing or are new. He’s been piggybacking Carl Icahn a bit lately, so he’s still long Time Warner although my guess is he’s reducing that, along with Icahn. But a new position as of December 31 was WCI Communities, a company for which Icahn recently made a $22 per share offer because he felt it was very undervalued.

Another new position is Ionatron. This company makes Buck Rogers-style laser weapons systems. It has $30m of cash in the bank, it loses money, but the Navy is evaluating its latest products and could decide any day. With SAC’s ability to do deep investigative investing, my guess is the managers feel comfortable the products will get sold. And with 24m shares short on Ionatron, there are an awful lot of people who will be waiting in line to cover their shorts.

Another interesting new position is Radiation Therapy Services. It provides radiation services for cancer patients. This is clearly an area that is growing. It has a forward price/earnings ratio of 14 and trades for just 11 times earnings before interest, taxes, depreciation and amortisation, making it a potential buyout candidate. Analysts expect earnings to go from $1.26 a share in 2006 to $1.64 in 2007. Revenues have gone up every year since it went public.

“Bert,” I finally said, “What are you guys going to do?”

Bert, ever the worrier, said, “I just don’t know.”

james@formulacapital.com