Here are 5 ways you’re getting screwed by Wall Street right now
From James Altucher, Editor, The James Altucher Report:
There’s a saying in poker: “If you can’t spot the sucker at the table, then you’re it.”
Well, when you invest your hard-earned money in the stock market, you can’t tell who’s the sucker at the table, ’cause we don’t know who has the inside information, we don’t really talk to the people who are making millions of trades a second, and we’re not hanging out with the hedge fund billionaires.
So we’re the sucker at the table, and every day, hedge funds are finding new ways to screw individual investors.
You might ask, “Why do they want to steal money from me? I’m just investing in the S&P. That has nothing to do with hedge funds.”
One word: fees.
You’ve probably heard of the term “two and twenty” associated with hedge funds. Two and twenty is the structure that hedge funds use to charge investors in their funds. They take an automatic 2% of your money off of the top for management fees (even if they lose money), and then they take an additional 20% of any profits.
This fee structure forces hedge funds to have to outperform other indexes by a huge margin just to stay even with them. Because of this, they often blur the line between just investing and finding illegal/manipulative ways to generate a profit, often at the expense of the regular investors dollar.
Here are a just a few of the ways that they are scamming individual investors…
One of the biggest differences between hedge funds and other investment industries is their use of leverage.
Leverage is when a fund borrows money because they believe that they have an advantage in the market (arbitrage).
For example, let’s say that you invest $1,000 in a stock and it increases by 10 percent to $1,100. You have made a profit of $100.
But hedge funds take this concept to the extreme. A hedge fund has the ability to borrow money on interest when they think a stock is going to go up. So they may invest $1,000, while also borrowing $10,000 with a 20 percent interest. If the stock goes up that same 10 percent, the hedge fund pays back the money borrowed ($10,000), plus interest ($200), and pockets the extra $800 profit.
Of course, hedge funds make this bet with millions of dollars, giving them the ability to make HUGE returns.
But, as you know, stocks aren’t so predictable. And if the stock goes the opposite direction than the hedge fund wants, their losses are huge. This is the main cause of hedge funds shutting down.
Okay, so hedge funds use leverage. But how does this screw individual investors?
In the example above, we used $10,000 dollars to illustrate leverage. But in reality, hedge funds are borrowing millions of dollars on leverage every day.
This leverage doesn’t come without consequences for the average investor.
When stocks are up and the Volatility Index (VIX) or “fear index” is down, hedge funds start taking out more and more leverage and buying more and more stock.
This purchasing rally drives stock prices up. This seems great at the time for both hedge funds and the average investor… until the day that the hedge fund decides to hold less leverage.
On that day, they close out of their position, forcing millions of dollars worth of shares into the market. This sale causes stock prices to drop, usually until the point at which the average investor’s stop-losses are hit. The sale from these stop-losses causes the stock price to drop even further, leading to a downward spiral.
There is nothing wrong with the stock—it should be worth the same, but the hedge fund’s leverage causes the average investor to unintentionally sell.
The worse part though, is that hedge funds will usually wait until the fire sale is done, then rebuy all of the stock they dumped — and more — for huge discounts.
2) Intentional Scamming
Madoff… enough said.
It’s legal for congressmen to trade on inside information. So, let’s say your congressman knows that a vote on some energy tariff is going to go a certain way he can go to his local casino table (stockbroker) and place his bets accordingly.
Guess what happened in the years since 2007 when all of America lost money in the stock market? As a group, congressmen were up 30 percent per year.
But even if our politicians aren’t directly investing on inside information, they are still being paid millions of dollars by hedge funds.
In 2009, former Secretary of the Treasury Larry Summers was paid $5.2 million in compensation from the hedge fund D.E. Shaw, plus hundreds of thousands of dollars in speaking fees at financial institutions like Goldman Sachs, Merrill Lynch, and Lehman Brothers.
Right after being paid millions of dollars from hedge funds, Larry Summers was chosen as the Director of U.S. Economic Council under President Obama. He was even a possible candidate to take over Ben Bernanke’s position as Chairman of the Federal Reserve.
4) High frequency trading
Day trading is old news. Seconds trading is the new reality.
This is trading for people who hold for one trillionth of a second.
Here’s how it works. Let’s say you want to buy some shares of IBM. These high frequency trader guys have computers with cables hooked right into the exchange. They are able to see what you want to buy, slip in the middle and buy the shares of IBM before you can. They then sell the shares you originally wanted at 1/10 of a penny higher and make a sliver of money. They do this on millions of trades a day; pocketing fractions of a penny on every trade by simply making the individual investor pay more for their stocks.
These guys make millions of dollars every day and it’s a race to the bottom: who can get there faster and more deftly to screw you out of 1/10 of a penny every time you make a trade? And by the way, these guys do probably more than 50 percent of all trades on the stock market and a single mistake (think: flash crash) can start the market reeling within seconds.
Now though, high frequency traders are investing in microwaves (a kind of electromagnetic wave) to do their trading, which are milliseconds faster than using cables.
It’s bad enough that microwaves hit me all day in my kitchen, now I have to deal with them while walking around NYC. So hedge funds aren’t only screwing you out of your money, they are probably giving you cancer, too.
5) ‘Beating’ the Index
More people than ever are investing in index mutual funds. They think that it’s safe to invest in a fund like the Vanguard that follows the S&P 500.
But hedge funds have now found a way to screw you out of money through index funds as well.
The technique is similar to the high-speed trading example above. Hedge funds are able to front-run (trading on advanced information that others don’t have) these stocks by buying shares before they are added to the S&P 500. They have inside information on when a stock is going to be indexed.
An index fund like the Vanguard 500 is then required to purchase a stock once it enters the S&P 500. Hedge funds know this and are able to take advantage of it.
This technique cost index funds and investors around $4.3 billion in 2014.
So you can’t beat ’em… join ’em?
Let’s take a look at the average returns of hedge funds.
From 2004–2014, the average return for hedge funds was 6.53 percent, according to the Barclay Hedge Fund Index.
6.53 percent. Not bad. But let’s take a closer look.
First, we need to immediately knock 2 percent each year for “management fees” (this includes years even when hedge funds have a negative return).
Then we can take away another 20 percent every year that the hedge fund has positive returns above 5 percent (this is called an incentive fee).
Why 5 percent? Most hedge funds try to show at least a little good faith by guaranteeing that they won’t charge the extra fee unless they return more than 5 percent on your money.
So, remember that 6.53 percent that the hedge funds had reported to indexes? Their actual yearly return was on average 3.05 percent (A 44 percent decrease in reported earnings).
When you really look at the numbers, you can see how quickly these fees begin compounding.
Over that same 10-year period, if you had managed $100,000 yourself without the incentive and management fees tacked on by the hedge funds, you would have pocketed an extra $43,370 (43% of your initial investment).
And that is before you account for the fact that when hedge funds shut down, they are not included in any indexes. This is called survivorship bias and it is reported to overstate hedge fund returns by 2–3 percent a year.
Oh!… and this is before you account for inflation.
So by this point you are probably in the negative.
Are All Hedge Funds a Scam?
I have spent my entire time in this article describing how hedge funds are trying to screw you and all of the different ways that they scam you out of your money.
But, truthfully, not all hedge funds are scams. Most are, but not all.
I would know—I ran a fund of funds for years and I never tried to scam or screw over anyone. But I saw the men behind the curtain and I knew I had to get out.
The problem is, the legitimate funds are hard to find for the average investor.
I spent 15 years in the industry and I still have a hard time spotting the legitimate ones.
But I can and I do. I am still in contact with many funds and I get hundreds of reports a month that only hedge fund managers are supposed to see.
If you can trade like a hedge fund without investing in one, you can replicate their big wins without having to pay their huge fees.
It is finding these investments that is the critical component.
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