I’m late to Sam Jones’s article about investors who did due diligence on Galleon and decided to stay away, but I think it raises a number of silly ideas which ought to be put to rest.

First, it’s worth noting that, ex post, this kind of exercise can be done on any hedge fund. The vast majority of hedge-fund investors, and all big ones, do some kind of due diligence before investing in a fund. There’s no such thing as a fund which receives investments from everybody who does due diligence on it. Therefore, for any fund which fails, there is going to be a certain number of investors who did due diligence on it and who didn’t invest. The same is equally true, of course, for any fund which succeeds.

What’s more, the reasons given for not investing in Galleon are so weak and vague as to be all but substance-free:

“Crudely, there are three ways to make money as a hedge fund manager,” said one large multi-billion dollar asset manager.

“You can take advantage of trading technology, but few do. You can be more intelligent than others, but few are.

“Or you can have some specialised source of sustainable information. Unless that information is from fundamental analysis – and in Galleon’s case it did not all seem to be – then that’s a red flag for us.” …

“People mistake wealth for intelligence,” according to one investor.

“No one pretended Raj [Rajaratnam] was a brilliant stock analyst – he was just extremely well connected.

“And he always made that known.”

Both investors accept unquestioningly that there’s some kind of a correlation between intelligence and alpha — despite a long history of extremely smart guys blowing up, and despite the fact that no one has come close to empirically demonstrating any such correlation. On top of this dubious correlation, they then layer the assertion that Raj Rajaratnam wasn’t actually all that smart. How would they know?

What’s more, if being extremely well connected is grounds for suspicion when choosing money managers, that would probably disqualify pretty much every single Silicon Valley venture capitalist.

It’s not even clear that investors who steered clear of Galleon were smart in hindsight, for all this self-congratulatory slapping of their own backs:

Investors that did put their money in Galleon, however, can take comfort from the fact that, by and large, the companies funds’ are highly liquid and are unlikely to suffer losses as a result of unwinds.

The good thing about investing in a fund which makes large short-term bets on individual stocks is that such bets are unlikely to be crowded trades which suffer enormous losses when everybody tries to exit at once. Anybody who invested in Galleon received healthy returns over the length of their investment, and got out unbloodied at the end. The principals won’t be as lucky, of course, but the investors have nothing to regret.

(HT: Manham)

The Pragmatic Capitalist gets his hands on Galleon’s monthly returns, and finds them very suspicious:

These guys just couldn’t lose. Whether the market was up or down they cranked out 25% returns like they were printing money. It makes you wonder just how long these guys were trading on insider information?

I have run the risk adjusted returns on hundreds if not thousands of portfolios throughout my career and I have never seen numbers like these. NEVER. There is virtually ZERO downside volatility in these figures… Gauging from the returns I would be willing to bet the insider trading was going on for most of Galleon’s existence and was likely much more rampant than currently reported.

I’m not completely convinced, for two reasons. Firstly, Galleon’s returns were pretty volatile: the fund was up 14.53% in May 1997, for instance, and then down 8.54% five months later, in October of the same year. That doesn’t seem abnormally consistent to me.

More generally, if you want returns which rarely turn negative, insider trading is not your strategy. Madoff-style outright fraud works, of course: you just report fictional returns instead of real ones. But Galleon isn’t being accused of making up its returns: it has the money it says it has. It just (allegedly) used illegal means to amass it.

A sophisticated insider trader isn’t trying very hard not to lose money. Quite the opposite, in fact: he’s putting a lot of money at risk, and knows there’s a significant downside. He just also knows that he’s got an informational edge which gives him an advantage over the rest of the market. Such advantages don’t always pay out, and as a result you’d expect an insider-trading strategy to show relatively frequent negative returns. Even if, over the long term, it was very successful.

(Via)

The reaction to the news that John Meriwether is setting up a third hedge fund has been entirely predictable, especially when Sam Jones’s story deadpans that “the fund is expected use the same strategy as both LTCM and JWM to make money”. (Meriwether’s first two funds, of course, were spectacular failures.)

But really this isn’t a third hedge fund at all, it’s just a reincarnation of the second one, minus the high-water mark. Kid Dynamite explains:

JWM Partners closed last year after losing 44% amidst the market turmoil of 2008. Hedge funds typically have “high water marks” which means that investors don’t pay performance fees to the fund manager in subsequent years unless the fund surpasses its highest point. Thus, the solution for fund managers whenever they have a bad year is to liquidate, wait a bit, and form a new fund?!?! Anyone who was invested in the old fund and the new fund thus pays fees twice: you paid when JWM Partners reached its high water mark, and now you’ll pay again if/when Meriweather Cubed (not the real name) manages to make money - the same money JWM Partners effectively lost after reaching its high water mark.

This is great for John Meriwether, of course. And perhaps, in an attempt to goose his AUM, he might even give investors in JWM a break on his fees. Mostly, however, it’s just an indication of the same delusion that we’re seeing in the leveraged-loan market: the idea that the status quo ante was “normal”, and that now we’ve rebounded back to something very similar. After all, if the financial crisis was a once-in-a-century event, we won’t see another for 99 years, right?

You’ve got to give this to Meriwether, though: the guy’s clearly a spectacularly good salesman. That’s a key attribute of hedge fund managers which they tend not to talk about: after all, they love to give the impression that people are giving them billions of dollars just because of their unsurpassed investment prowess. The truth is clearly very different.

For a while now, hedge funds have been creating share classes denominated in gold. By far the biggest fish in this pool is John Paulson, and as a result he’s been buying gold, literally, by the ton. (With gold at $1,050 an ounce, and 29,167 ounces per ton, Paulson’s $4.3 billion gold investment would buy him 140 tons of gold.)

I’m a little unclear on how these share classes work, but it seems similar to a portable-alpha strategy. The problem with gold is that while it fluctuates in value, it doesn’t generate any kind of returns unless and until you sell it. But with these share classes you get to have your cake and eat it: you’re essentially parking your money in gold, while at the same time investing it in obscure and wonderful trading and investment strategies across all manner of other asset classes.

Hillel Aron has a friend who was just at breakfast with John Paulson, being sold on investing in his funds:

His conclusion - not a shocker here - there will be a rush into Gold. Paulson personally has all his own assets in Gold and his funds own 5 different Gold Mining Stocks. By the way, Paulson notes, of the 200 Trillion dollars of investible assets in the world, only 800 Billion of that is Gold.

This means, I think, that Paulson’s own investments in his funds are all in the gold-denominated share classes. And I can see how a multi-billionaire would do something like that: when you have that much money, the only things which can wipe you out are hyperinflation or outright confiscation. Gold is a good way of protecting yourself from both eventualities.

For people with less dynastic amounts of money, however, I’m less keen on the gold-denominated share classes. For one thing, there are substantial hedge-management costs involved. But more to the point, if the price of gold falls, then you can end up in the very painful position where your investment loses money in dollar terms and you still have to pay a large 20% performance fee, since it could still have done well in gold terms. Ouch.

Nathan Vardi, to his credit, doesn’t use the term “naked shorting” in his story today about a dispute between Carl Icahn’s High River Limited Partnership and Goldman Sachs. But that’s what he’s talking about — and, interestingly, the securities in question aren’t stocks. They’re bank loans:

“High River apparently ’sold short’ the bank debt, anticipating that the market price of the bank debt would decrease,” Goldman says in its lawsuit…

“Neither the fact that High River did not own the bank debt at the time it entered into the contracts, nor the fact that the market has moved against High River, nor any other reason, excuses High River from meeting its contractual obligations,” Goldman says.

High River of course says it will contest the lawsuit. But would naked-shorting Delphi loans even be illegal? They’re not exchange-traded securities, after all, and all we’re really talking about here is a bilateral contract between High River and Goldman under which High River agrees to sell certain loans at a certain price. It’s foolhardy to enter into such a contract if you don’t actually own the loans in question. But is it illegal? That’s less obvious.

It’s been obvious that Citi had to sell Phibro since April, so the first reaction to today’s news is “what took you so long”.

Interestingly, we now, finally, get to see some numbers on just how profitable Phibro has been:

From 1997 until the second quarter of 2009, Phibro averaged approximately $200 million per year in pre-tax earnings, while over the last five years Phibro’s earnings averaged $371 million per year. Phibro has been profitable each fiscal year since 1997, attaining profitability in 80 percent of all quarters.

If Andrew Hall was really in line for a $100 million bonus this year, that’s an enormous chunk of Phibro’s medium-term profitability. Paying Hall on the basis of average annual earnings over the past five years makes a certain amount of sense, but paying him 27% of average annual earnings over the past five years is more than a little excessive.

In any case, you can see why Citi says, in its own news release , that the numbers here “are not material to Citigroup’s earnings”: by the time Citi offsets Phibro’s annual profits (after payouts to Hall) with the amount that Oxy is paying for the company, the most important result here is that Citi has managed to lose its highest-paid employee (who owns a castle). That’s going to be very helpful when it comes to pay negotiations with Kenneth Feinberg.

Market Folly has the 24-page second-quarter letter from Elliott Associates, while the 16-page memo from Howard Marks of Oaktree is here. Both have moments of brilliance, and are better financial writing than anything you’ll read in a newspaper or magazine this month. Of course, they’re openly talking their book. But you guys are smart enough to discount for that, and come away with some pretty sharp insights.

Atticus founder Timothy Barakett cited “solely personal reasons” in his letter saying that he was closing down his flagship fund and embarking on the philanthropic part of his life. By sheerest coincidence, the letter comes in the wake of his fund losing 31% of its value, which means that it would have to rise by 45% just to reach its high-water mark and start generating performance fees again for Mr Barakett.

A disinterested observer might conclude that Barakett was quitting on the grounds that he had no interest in working hard as a hedge fund investor if he wasn’t going to be paid lots of money to do so. But since Barakett says that his reasons are “solely personal”, it can’t possibly be that.

Maria Woehr has a rather confusing column on Andrew Hall and his $100 million bonus. It’s worth reading, however, for two reasons: firstly, she’s aggregated a lot of good links, and secondly, she serves as a good guide to what the received opinion on such matters is on Wall Street.

Woehr believes that “the figure that the government would like to see Hall accept is something like $0″ — which I suspect is only true if, like Hall, you round to the nearest $50 million. There’s no reason to ask Hall to work for $1 or forego his bonus entirely, as the bank’s executives did, because he (unlike they) is not responsible in any way for the billions of dollars that Citigroup has managed to lose over the past couple of years.

But I think this is entirely wrong:

What’s sad is if Citigroup loses Hall and Phibro due to the bonus issue, it could pose more embarrassment for Citigroup’s CEO Vikram Pandit. The bank will be losing one of its most profitable unit and most likely suffer losses because of it.

It’s not at all embarrassing for Pandit to sell off an in-house hedge fund for a large sum of money. Citi isn’t and shouldn’t be in the business of running hedge funds, and the great thing about Phibro (compare and contrast Old Lane) is that the bank will have not only made billions of dollars in total profits to date but will also make a large gain on selling the business as well. How Woehr can spin that as Citigroup suffering losses I have no idea. All it will have done is remove a big risk factor from its list of businesses: like most highly-profitable hedge funds, Phibro has a lot of tail risk. If it can make billions, it can lose billions too. And since that tail risk can’t be hedged, it’s time for Citi to sell Phibro.

Dan Gross is much more succinct and correct: “When a company fails, it has to sell valuable assets,” he tweets. The good news for Citi is that not only is Phibro a valuable asset but it’s also an asset which Pandit should be looking to sell in any case. This latest flap over Hall’s pay just makes that decision easier.

Tom Cahill, June 24:

Christopher Cooper-Hohn’s $9.5 billion hedge fund proposed cutting fees and easing withdrawal limits to retain clients after top executives quit and it lost 43 percent last year, according to three investors…

TCI earmarks a portion of its fees for the Children’s Investment Fund Foundation, a charity run by Cooper-Hohn’s wife, Jamie. The effective fees, split between the fund and the charity, had been 2 percent until losses in 2008, said the TCI investors.

Matthew Bishop, June 26:

As The Economist went to press the Children’s Investment Fund Foundation, a charity based in London, was due to announce that it had received a whopping £495m ($812m) in the 2008 fiscal year from TCI, a hedge fund, under covenants built into the fund when it was founded by Christopher Cooper-Hohn in 2003.

$812 million is 8.5% of $9.5 billion. Just sayin’.