Say Cheese - Ajit Dayal - Equitymaster

No, I am not a big fan of cheese. Not that I have anything against cheese. There are times when, for want of a good Indian paratha breakfast, I will eat a cheese sandwich. Two of them.

And I don’t really like being photographed and having to say “Cheese” to get that smile. The smile should be there because you feel it inside. If you feel happy, show it. If you’re not in a “smiling” mood, that not so happy face or tiredness should show up. But there are a lot of people out there with a lot of “cheese” smiles. It is the Holidays. And it is time to be merry.

And, if you manage a hedge fund with a “2 by 20” structure, all the more reason to be happy.

A “2 by 20” is another financial innovation that ensures the financial services industry maintains its reputation of harbouring genius and creativity. A “2 by 20” means that the fund manager gets a 2% annual fee on all assets they manage for the client (the normal fee is about 1% per annum) and gets 20% of the profits that are generated in any one year. So, if you manage an India fund and the Indian portfolio is up 60% in the calendar year 2007, the fund manager gets an additional 20% of that 60% - which means an extra 12% per annum. That makes it a total fee of 14% per annum. A regular fund manager would charge 1%. So the hedge funds earn about 14x the fee paid out by the client.

Do people pay that? Sure, remember what P. T. Barnum said, “There is a sucker born every minute.”

Not that the sucker will admit he is one.

Clients will justify the high fee paid by saying that they there fund manager is a genius. He deserves to be paid more than the idiot who earns 1%, the average guy. Problem is, in the last 5 years the number of hedge funds has probably grown from 100 to 30,000. And if there is an average of 10 fund managers and analysts per hedge fund out there, that is 300,000 geniuses.

Somehow, the financial world has created or discovered 300,000 geniuses in the past 5 years. Or maybe the lure of earning 14x the normal fee structure has created some geniuses - and some pretty average people with a good business head.

I am smiling as I write this.
And not saying, “Cheese”.
We missed out on being geniuses.
And we have not been good businessmen.

But it is year end now and, in most major markets around the world, all the fees and this profit-share (called “carried interest”) is based on what happens for the 12 months ending December 31, 2007.

Now if you are a hedge fund manager – or even a normal, regular average fund manager earning that useless 1% annual fee getting an annual bonus for the good work you did in the year – it would be in your interest to see that markets are up, up, and way up.

The 300,000 geniuses in hedge funds have lifestyles to maintain. The average fund manager not smart enough to have made it to a hedge fund also has a lifestyle to maintain. And along with the hedge fund crowd there are all the financial services providers who live off the high velocity trading typically associated with most hedge funds. Brokers, research analyst, back office settlements, lawyers, administrators, a long list that gets to eat different amounts of food in this economic food chain.

No one wants to see an unhappy hedge fund manager. Or a tense regular fund manager. That is a sign of sure trouble and job losses at all the financial intermediaries along the way. Maybe affecting 5 million jobs, globally.

So, it is the holiday season and everyone is out there walking around, visiting the malls. Checking out the new products for sale. Buying gifts. If you cannot afford something, at least you can see it: window-shopping, is what they call it.

But a Thomson Financial news item dated December 26th refers to another kind of window activity: “Singapore shares closed higher Wednesday as some fund managers, returning from the Christmas holiday, resumed their year-end window-dressing following the positive lead from Wall Street.”

Window-dressing. How innocent.

On the same day, CNN reports, “Home prices fell 6.7 percent in October, compared with a year ago, according to the S&P/Case-Shiller 10-city home-price index. It was the largest drop recorded since the index began in 1987. It marked the 10th consecutive month of price depreciation (in USA) and 23 months of decelerating returns.” The CNN report then adds a quote: "No matter how you look at these data, it is obvious that the current state of the single-family housing market remains grim," said Robert J. Shiller, chief economist at MacroMarkets, in a statement.

Oil is at near peak levels trading at USD 96 per barrel. Gold is at USD 812 per ounce. The US housing bubble has burst. The European Central Bank jumps in to pump in USD 501 billion as it injects “liquidity”, the Chairman of the Federal Reserve, Ben Bernanke, is willing to drop money from a helicopter to keep the US economy and its citizens afloat. Banks continue to discover minefields and black holes in their balance sheets.

And stock markets are heading northwards as we end the year 2007?

That’s a lot of window dressing going on.

Making everything seem good so that there is a nice profit by year-end. The 20% carried interest is secure. The 300,000 geniuses are safe. The 5 million jobs are secure.

That is a lot of smiling. A lot of “say, cheese” requests from the photographers hired to capture that moment of joy for the year-end report to clients. A lot of window dressing when share prices end higher so that the performance numbers “captured” in the year end financial statements have a lot of plus signs – and fewer minus signs.

Not happy with an “h” but happy with a “cheese” – the cosmetic kind. The one that shows all your investors that the world is fine and yes there are these bumpy rides that come one in a while but, net, net (as in “net” , after I have taken my fees and share of profits from you) the world is fine and dandy.

And the Christmas carol reminds us, “Tis the season to be jolly, la lala la, la la lala la”.