7 posts tagged “investment”

Our determination of buy/sell points is based on a logical understanding of the structure of the market and of the behavioral patterns of fellow market participants. We are not concerned with waves, angles, astrological configurations, or other such data, which by some magical force are presumed to be satisfactory indicators of future prices.

The purpose of our timing technique is to help facilitate our objective to take the monies of others in a repetitive, consistent fashion that minimizes risk in actual market endeavors. We have no interest in theoretica abstractions in that time so spent can only detract from fulfilling our of objective. At this point, we are attempting only to ensure acceptable accuracy in forecasting changes in the major market averages. The final goal is to develop profit consistency for our stock positions at the percent- age level we have chosen (90 percent minimal) within the average holding period we have decided to use (four to six months).

Because of the upward bias in the specific stocks we utilize, we do not need k the probabilities for accurate timing of the popular averages to be as high as those associated with the specific stocks. As discussed in the previous sections, our 95-percent accuracy rate with individual stock issues needs only around a 78-percent or better accuracy probability relative to the popular averages.

In actual market participation, decisions must be made quickly and without emotion. Our timing technique, therefore, must not be influenced by emotional "subjectivity," and it must be easily and quickly calculated to avoid time lags that would take away from maximizing the number of available opportunities.

Market timing is nothing more than reviewing statistically valid data to derive probabilities for future price moves. Consequently, because of the probability variances at any given time, not all buy/sell points are created equally.

The relative strength of any buy/sell point can be compensated for by altering the "investment level," that is, by varying the percentage allocation between stocks and cash.

At this juncture, our objective is to develop buy/sell points that meet our minimum requirements related to the purchase or sale of specific common stocks. Application to options, index futures and more speculative trading strategies require adjusting our timing probabilities upward from those that are the focus of this discussion.

Our discussion of the technique, at this time, is designed for the process of buying specific stocks, then selling. The basic elements are buy indications that increase the percentage of funds allocated to common stock investment (that is, increasing the investment level), a holding period, and then sell indications that would result in selling specific positions to adjustto a lower investment level.

This buy-to-sell aspect is stressed because you cannot assume the processcan be automatically reversed. That is, the same criteria cannot be used in reverse for short selling with the same degree of accuracy in specifi_cpositions—selling short on sell indications and covering (buying back the short positions) on buy indications. The reason it cannot be reversed automatically is because of the upward bias in the stocks we utilize. For accurate short sale techniques, alterations (to be discussed) are necessary to eliminate this upward bias.

In this discussion, we are going to fully describe the criteria that w_e actually use. Some of the criteria might appear rather complex, and the information to implement exact duplication might be difficult for many investors to obtain. However, after such detailed descriptions, greatly simplified methods within reach of almost all investors will be described. In fact, the basic timing method can be compacted so it takes less than one hour each week without any need for complicated equipment. Nothing is necessary beyond the ability to read.

The factors we use to determine buy/sell points are of two types: essential (or primary) and ancillary. There is only one essential factor, and it must be present for any buy/sell indication. There are twelve ancillary factors; any six (or more) must coincide with the essential factor to have a buy/sell indication.

Although the emphasis is to assist individuals in developing and implementing their own investment strategies, we do not mean to imply that all money managers should be avoided. There are many competent managers.

Yet the selection of a manager cannot be taken lightly. The fate of the monies entrusted is most likely sealed at the time the manager is selected. It is no time to blindly follow friendships, media hype, or personal emotion. Almost all of the difficulties associated with the selection process can be eliminated by following three simple guidelines.

1. Familiarity with the Investment Technique

Money is a tangible: Either you have it or you don't. Generating money from money is a very specific process: Specific investments, must be chosen and the investments managed under specific techniques. Irrespective of how money is applied (even hidden in a mattress), there is an element of risk. To place the element of risk in a context suitable to individual resources, needs, and goals, it is mandatory that investors understand the specific investment techniques determining how monies are invested.

Obviously, avoid managers who stipulate techniques that have not produced suitable results when back-tested over a long period or who stipulate that their methods are proprietary (secret to all but themselves). Despite the glaring dangers, people seem to be attracted to proprietary "systems," the bait probably associated with greed. The fact is that the markets have been around for a long time. There is little that is not known and has not been adequately tested. In other words, would you entrust your life to a brain surgeon whose operational procedure was his own little secret? Suffice it to say that, within the financial community, there is ongoing communication among the ethical elements to provide clientele with superior products.

In effect, the investment method being utilized by the manager should be the same method you would personally use had you not decided to entrust the day-to-day investment routine to the expertise of others.

2. Familiarity with the Individual Analyst

Little known to the investing public, there has been a prolonged and ongoing battle within the financial community over full disclosure to clientele as to the specific identity of individual analysts managing the clientele's money in larger institutions.

Institutional management generally favors anonymity, stating that specific investment decisions (unless very bad and some underling is selected for blame) are a "team effort," and no one individual should be singled out as being better or worse than the team.

Many analysts counter that the "team" argument is a joke. It allows the institution to maintain fat salaries for dead wood ("good old boys") while inhibiting the advancement of truly superior individual analysts—sort of a slave labor relationship. These analysts further contend that the institution's desire for anonymity is to keep monies under institutional management. If the better analyst, known to clientele, were to leave the institution, _the clientele would also leave to keep their funds with the superior analyst.

To us the bottom line is simple. You should know the specific analyst who is involved with your money and have some means of individual _communication. It is your money and you have a right to know both the investment methods being used and the individual making the investment decisions.

In the world of investment techniques, the originators of the methods often manage money using those techniques. In effect, the investor often has access to the source. If the source is not in the money management business, he or she will probably be willing to direct the investor to a manager who has demonstrated a familiarity with the originator's work. If the originator is dead or out of business someone else will likely emerge as the best known analyst following the technique who can personally provide (or personally recommend another for) appropriate discretionary management. If you want the best, nothing can be lost by seeking it.

Although we find the basic Time Overlay method satisfactory in achieving our objectives of profit consistency and return, several factors can significantly increase return in actual market endeavors.

1. Rotation.

The published models are very strict. They will only change positions during outright buy/sell points that can only occur on the Report's publication date. The models completely disregard price movements between the predetermined, published mechanical buy/sell periods. Almost invariably, better prices are available at times other than the instant of a published buy/sell indication.

We know, by the results derived over the many years of the modeling's publication, what the average percentage return per position is by strictly adhering to the published buy/sell points. We also know that each stock selected has an equal chance of concluding profitably irrespective of price fluctuations between the predetermined buy/sell points. If we can get equal or better prices than those of the published models between buy/sell points, there is no reason not to capture gains before an outright sell signal.

Knowing that prices fluctuate, we can attempt to take advantage of the intervening price movements by rotating our positions. For example, let's say there is a buy indication and two stocks (A and B) appear equally suitable for purchase, and both are selling at 20. We purchase stock A. Rather than wait for a sell signal, we decide that we will take our profit if we realize a 10-percent gain. The 10-percent profit would capture a return greater than that averaged by the published models for individual positions. (Any parameter can be used, it is a matter of personal preference). Now, let's say that our stock (A) advances to 22, meeting our 10-percent objective, and that stock B has stayed at 20. We do not want to reduce our investment level because there has not been a sell indication. We sell stock A, taking the profit and move to stock B. Then, let's say stock B goes to 22 providing us our 10-percent profit, and stock A has fallen back to 20. We sell stock B and rotate back to stock A, and so on, until there is an indication to sell out entirely and/or reduce the investment level.

In actual managed accounts, the rotational process is utilized and, to date, without exception accounts incorporating rotation have outperformed the published Time Overlay models. During exceptionally volatile periods, the incorporation of rotation can create very active trading. However, during such periods and/or during extended market cycles, the use of rotation can dramatically improve results.

2. Optimizing Rotational Selections.

In the previous rotation example, the rotational selections were made from stocks selected at the time of buy indications without consideration of the other issues on the Master List.

This is an unnecessary constraint. It is possible that, at the time a purchase is warranted because of a rotational sale, there might be a stock on the Master List that is a better bargain than any of those selected at the time of a buy indication. In actual rotational trading, we move to whatever stock appears most undervalued from all those on the Master List, irrespective of whether they are being held as open positions in the published modeling. This wider selection generally expands return.

3. Delaying Buying.

The published modeling is designed to be early. That is, lower prices are available after buy indications and higher prices are available after sell indications. As discussed, this is necessary to assure that compensation has been made for transaction costs and to provide sufficient price latitude so that the method can be duplicated in actual trading.

At the time of a buy indication, each specific stock selected has an equal chance of concluding profitably. Price fluctuations between the predetermined buy/sell points are of no concern to the strict models because nothing is going to happen between the buy/sell points.

Price fluctuations (both up and down) between the predetermined buy/sell points can be significant and, since each position has an equal chance of concluding profitably, there can often be some advantage in waiting until after a buy signal and then selecting issues that are demonstrating relative discounting. For example, let's say that there is a buy signal and two stocks (A and B) are selected, each at a price of $20. Instead of buying one immediately, we wait and see that stock A is remaining at $20 and stock B has declined to $18. We then buy B because it is relatively discounted, having an equal chance of being above its initial published purchase price as does stock A when specified to be sold.

In our real time application of the Time Overlay portfolio modeling, we do not wait until after a buy indication to begin expanding the investment level. Although better prices become available after the buy indication, we usually get them anyway because of the rotational aspects. In fact, because of the rotational advantages, we are often a bit more aggressive in our investment level than the Report. However, for those wishing to avoid the sometimes rapid trading associated with rotation and/or the added analytical time, delaying buying and emphasizing the most discounted issues can often significantly increase return.

In our method of stock selection, we first determine which specific stocks warrant investment consideration. Qualification for consideration does not necessarily translate into actual investment. Consideration is only the first step. The actual implementation of purchase and sell decisions depends on a number of other factors which will be described after we have determined the general group of stocks we want to utilize. The qualification process is a filtering technique, through which thousands of different stocks are condensed down to a manageable number. This is not a hypothetical process. It is the actual method we use, and it is the basis from which our extraordinary high degree of accurate price forecasting was developed.

While very logical, the stock selection procedure is possibly too lengthy for the average investor. Do not be alarmed. After explaining the long method, we will describe a greatly simplified approach that is easy and quick, and that approximates the results of the longer method. The following lengthy explanation, however, is necessary for an understanding of the logic of the selection process.

The Criteria

The following qualifications are considered mandatory for the stock of any corporation to be of sufficient quality to warrant possible inclusion in our market strategy.

1. Earnings Predictability.

If you are involved in a serious hunt for a dangerous prey, your primary concern is the reliability and working condition of your weapon. Our weapon is common stock, and its specific selection is a serious (core) concern. The probability of error must be minimized to help assure survival.

Earnings are generally the most important factor in the value of a corporation. It was also mentioned that earnings generally are not easily predicted. Some corporations, however have demonstrated a consistent record of earnings predictability. Because of the existence of such corporations there is no need to rely on corporations whose earnings are less predictable.

As a rule, we consider the earnings predictability factor acceptable if the corporation has managed to meet earnings projections ±15 percent during each of the previous seven years. Disqualifying corporations that have not demonstrated a satisfactory past predictability as to earnings helps to eliminate fundamental surprises, as well as about 80 percent of all common stocks.

2. Earnings Growth.

Predictable earnings does not mean acceptable earnings. Because of the availability of corporations with demonstrated patterns of earnings growth, it is only logical to direct investment toward these issues.

The reason for this criterion is deeper than psychological reassurance. Corporations with demonstrated earnings growth get wider publicitywithin the investment community, and consequently they are considered for investment by a larger number of investors, both individual and institutional. It is from other investors that profits are taken. The greaterthe number and different types of investors involved, the easier the task of prey identification.

Keep in mind, however, that past earnings growth in itself is not enough. Future earnings projections must also indicate a pattern of growth. Themarket is most influenced by anticipation of the future. Limiting investment to corporations with both earnings predictability and earningsgrowth concentrates attention on quality, which can (but won't necessarily) help in supporting market price.

This earnings growth criterion generally halves the number of issues that were able to survive the test for earnings predictability.

Remember that the list is designed to isolate issues that are suitable to be considered for investment. The actual selection during any given buy point depends on a variety of factors.

How much time is necessary to spend on each stock to employ the methods? Very little time need be spent. The only thing you need to do is to note the stock's price and volume at regularly spaced time intervals. That's all. The information is in the financial pages of most newspapers. The spaced time intervals depend on the individual investor. At this point, however, note only that the most optimal intervals for individual investors can be anywhere from one week to several months, depending on the chosen level of involvement in trading activity. The lower the level of trading activity, the further spaced the time intervals will be.

It may appear that our filtering process is nothing other than the application of a subjective, academic process to isolate stocks that have demonstrated superior fundamental quality, which could be of little benefit in the "ever changing" investment environment. This is not the case. The use of the list is far more practical than theoretical for several reasons.

1. A major cause of investor disappointment is misdirection created by confusion. It is virtually impossible for an individual investor or money manager within the largest institution to personally be able to differentiate the merits of the tens of thousands of specific alternate investments. Those who espouse such ability have transcended both physical and mental possibilities. So be warned.

By focusing on the Master List, you reduce the entire spectrum of alternate investment types to a manageable number. In effect, the list becomes your investment world. Nothing outside that world matters. Almost all industry groups are covered. Transaction costs can be minimized. You can buy within this world in anticipation of higher prices or sell (short) within this world in expectation of lower prices, or employ a variety of other techniques. Although the "market" has been condensed to reasonable proportions, there has not been a proportionate reduction in the number of opportunities. In fact, by confining investment to a core of basic alternatives, the probability of profit in any given transaction, as well as higher annualized return over time, is greatly enhanced.

2. The market is largely a brain game in which the decision to buy or sell can be greatly influenced by emotion. Psychological pressure can displace logic and thereby enhance the possibility of error. Our goal is to attempt to eliminate error.

For most investors, the problems associated with mental stress are complicated by the financial press, which (in doing its job) concentrates on the sensational. The sensational, by definition, is not the rule. However, because of the constant media attention to the exceptions, such exceptions can easily become misjudged and become the "rule." The investor can begin to chase exceptions, losing sight of basic realities and eventually becoming trapped by the professional. Neither the exceptional nor the sensational are consistent. Consistent profit is our objective.

By reducing the number of corporations that warrant investment consideration to a relatively small number, the investor is provided with the benefit of familiarity, which greatly reduces possible errors induced by emotion.

However, most positions were taken directly against prevailing analytical/media sentiment. From this it might be inferred that, because we have profited in 48 of 50 positions taken, the dominant feeling among analysts and the media is in error around 95 percent of the time when dealing with our stocks. Having pocketed their money, we feel that is exactly the case, the Master List being our primary bulwark against enticement by emotional nonsense.

Price decline, therefore, is not usually the result of brokerage firm's direct sell recommendations. The decline in stocks that had been advanced by concentrated sales efforts within brokerage firms can be the result of sales emphasis shifting to another stock (or group), with a corresponding lessening of the sales effort in the previously favored stock (or group). The buying demand is lessened, the selling supply begins to dominate, and down goes the price of the stock.

Our intent is not to make you suspicious of the ethical motivations of brokerage firms or their research. Most brokers are quite ethical and constantly attempt to serve their clientele well: To do otherwise (except for the scummy types who have no intent on long-term broker/client relationships) would effectively hurt the broker's business. However, if a brokerage firm's research is consistently wrong and/or is presented in such a manner (primarily nonspecific in forecasts or untimely) that it cannot be used in market endeavors, it is only reasonable to avoid the research whatever the cause of its inaccuracy or uselessness.

Bad research does not mean the brokerage firm is extracting trading profits through its influence on the buying and selling of clientele. As mentioned previously, many widely accepted theories on market pricing are erroneous and the researcher may believe in such theories. Or the researcher may simply be stupid. The possession of fancy suits, plush offices, academic credentials, and other such status symbols do not make the difference between investment success and failure. The differential is who ends up with the other guy's money.

The trading activities of brokerage firms themselves are difficult to monitor beyond their published research and sales promotions. The degree of such influence varies and as such cannot be incorporated as a constant factor in developing personal strategy. However, the effect of brokerage firms, specifically their advertising, on the buying patterns of their individual and institutional clientele is easy to observe; allowing the true professional advantage because of the institution's effect on aggravating short-term pricing. Yet, it is not a consistent factor in developing total strategy.

If an investor is comfortable with a specific investment technique and has firsthand knowledge of the individual analyst employing the technique, significant benefits can be achieved by aligning directly with the brokerage involved. In these arrangements, the client is functioning in direct conjunction with the research on a timely personal basis, not after the fact, which functions to expand profitability. There is no loss of control because the investor knows the investment technique(s) being employed and the individual analyst(s). Such close relationships are generally not possible in large brokerage firms: The large number of different financial instruments sold by such firms tends to inhibit specialization. The optimal application of specific investment techniques is usually confined to relatively small specialty firms, with generally an established clientele whoseaccounts are under discretionary management and do little or no advertising.

The mention of the existence of specialty firms is not to suggest the investor must seek them out. Indeed, investors who learn to function professionally are specialty firms unto themselves. Brokerage firms can be classified as members or nonmembers. Member firms are those that own a seat on a stock exchange, regional or national. Nonmember firms do not have an exchange seat and are members of the NASD (National Association of Securities Dealers). Most nonmembers have arrangements with member firms to trade stock on stock exchanges. There is no strict difference as to which better serves its clientele. As long as the accounts are adequately insured, the benefit of any firm to the client depends on the expertise of the brokers/analysts involved, not on the member or nonmember classification.

What really roils me is that so many Americans have their necks overexposed to the risks of common stocks to start with. By that I do not mean that stocks are generically too risky, although I do recommend staving out of the overpriced U.S. stock market and dollar-denominated stocks. Stocks that are selected conservatively and pay high cash dividends are, in fact, my favorite investment alternative, especially where there is the prospect of currency profits, as I'm going to discuss later in detail.

But Wall Street has led the American public to think stocks have the safety of bonds. There's a huge difference, of course. Stocks carry all the risks inherent in business ownership Bonds are contractual loan obligations that must be paid before owners get anything. Because stockholders have all that risk, they should naturally expect a higher rate of return than bondholders. But Wall Street has fostered a myth that because shareholders enjoy unlimited upside (capital gain) potential, they Should settle for a dividend return that, if it exists at all, is often far lower than the interest rate on comparable bonds.

I also feel Wall Street puts an unhealthy value on potential Capital gains. Just look at the widely used formula for setting up an individual's investment program. You take 100 and subtract the investor's age. That determines the basic asset allocation. If the customer is 20 years old, you recommend 80 percent stocks and 20 percent bonds, and then adjust the proportions as the investor gets older on the reasoning that youth justifies risk and advancing age requires safety and income.

My problem with that kind of thinking is that it assumes stocks rise in value as a function of time, that they are always a good buy regardless of valuation, and that there's always going to be a pool of people that you can sell out to so you can buy bonds and retire on the interest. As we'll see, though, the market has a well-earned reputation for perversity and there have been long periods when prices remained flat or declined.

Call me old-school, but I've seen enough of self-serving corporate management to make me want cash on the barrelhead. I want stocks that pay cash dividends and provide a higher yield than bonds do.

Wall Street has also muddled the distinction between investing and speculating. The argument that growth stocks of companies that plow all their net earnings back into the bussness reward shareholders with future capital gains assumes that the objectives of corporate managers and shareholders are the same that the two interests are in alignment, to use more elegant language. Now I'll grant that there have been many companies over the years where this has been true, and where investors profited handsomely from capital gains that, until recently, were taxed at a more favorable rate than dividends.

But to overpay for stocks that don't produce income and derive their attractiveness from the promise of future capital gains that may or may not materialize to my mind smacks more of speculation than investment Some stocks will gain, of course, but only at the expense of other companies, whose earnings shrink. If the market is trading at a given multiple, there have to be stocks whose earnings go up and stocks whose earnings go down. They can't all be winners.

Conflicts of interest are rampant on Wall Street and in corporate America, and the victim is the little guy. I started out as a broker with one of the big investment banks, and know from firsthand experience how Wall Street's symbiotic relationship with corporate America has operated to the disadvantage of retail investors. Year in and year out, the risks of common stocks are played down by firms that make their real money from advisory or underwriting services performed for client corporations.

Brokers are paid extra commissions to push certain stocks as favors to corporate clients or to move positions held by their firms acting as dealers. "Suitability rules" designed to protect investors from undue risk are treated perfunctorily as brokers pass spoon-fed recommendations off to trusting customers who think they're getting thoughtful advice.

On the research side, although stricter regulation has resulted from recent scandals, analysts are under pressure to favor existing , or potential corporate clients by assigning higher ratings than their shares warrant or failing to assign negative ratings to inferior stocks that retail investors might otherwise avoid.

Lately, the interests of corporate executives and shareholders have diverged to a point bordering on or actually constituting scandal. The most infamous example, of course, was Enron, where shareholders walked away with nothing after criminal _activities by top executives that were so complex and extensive they are being analyzed to this day. Here’s the point, though, and it’s a big one: if Enron had been forced to pay cash dividends, it could never have pulled that paper off!

There were so many other examples of corporate skullduggery at the expense of shareholders-WorldCom, Global Crossing, Adelphia, et al.-in the early 2000s that it really serves no purpose to go into them.

More significant than the laundry list of major scandals are practices we read about every day. Executive stock options that are timed and structured in ways that give managers incentives to make corporate planning decisions designed to maximize their personal profits at the expense of shareholder values are now commonplace. Just the salaries of top corporate executives have become so outsized as to penalize shareholder returns. Stock repurchase plans are often timed to create capital gains to benefit managers.

As this is written, a scandal seems to be breaking that involved the back-dating of executive stock options to capitalize on favorable stock price movements.

Wall Street has conditioned the public to think about stocks simply in terms of their prices. According to Wall Street, prices can only go up if one simply holds them for the long term. Most investors regard low-priced stocks as being cheap and high-priced ones as being expensive. The real fundamental value of the business those shares represent seldom comes up. This general misconception concerning stocks is evident even among my own clients. Whenever I call one to recommend a stock, the first question that I am usually asked is "What's its price?" My typical response is "What difference does price make?"

By itself, the share price confers no real information about the underlying value of the stock. Price is meaningful only when related to other factors, such as earnings, sales, book value, and shares outstanding. When such factors are considered, a stock selling for $5 per share can be expensive while another selling for $100 per share can be cheap.

That's why the public is so confused about stock splits, where a stock's perceived value is enhanced simply by reducing its price, with investors ignoring the increased number of shares outstanding. Stock splits originated because under the old system of trading and commissions odd lots (increments under 100 shares) were expensive to trade, so splits made it easier for small investors to trade in round lots.

For similar and equally foolish reasons, investors believe that it is easier for a stock selling at a low share price to double than for one selling at a high price. However, price is meaningless, as a company's earnings would have to double for the real value of its shares to double, which of course has nothing to do with price. If it were really easier for low-priced shares to rise, perpetual stock splits would rule the day.

The only reason low-priced stocks tend to move faster is that most are less liquid and often manipulated. If it were true that low prices meant faster appreciation, all high-priced shares would split, not at $50 or $100, but at $10, $5, or even a dollar. In most Asian markets, share prices below $1 are the norm, even for billion-dollar companies. However, their prices appreciate no faster as a result of prices being lower.

Wall Street's failure of responsibility is glaring even where clear conflict of interest isn't the issue. I strongly believe Wall Street deserves much more opprobrium than it got for its failure to discourage in a proactive way the naive investor behwior that drove the dot-com bubble. Sure, brokers were only giving customers what they wanted, but I strongly feel they had an implicit fiduciary responsibility to make investors aware of the insanity they knew they were witnessing.

At the risk of sounding unctuous, I don't mind saying that I personally sleep at night with a clear conscience. When other brokers were riding the tech-stock wave, 1 spent many hours persuading my clients to avoid the foolish risk of buying stocks without earnings. "But it's a long-term investment," I'd hear. "Sure, in a company that will not even be around in the long term," 1'd tell them, and more often than not I was right. At Euro Pacific Capital, I do no investment banking. I don't make markets or act as a dealer. I am purely a retail broker specializing in stocks that pay cash dividends, and I plan to keep it that way.

But Wall Street, I'll say again, is rigged against the little guy and I see no signs of that changing, either.

Mutual funds are an overrated investment heavily promoted by Wall Street. During the latter 1990s, as I was still cold-calling prospective clients, a typical question I would ask those who professed to be invested in mutual funds was "What is the yield you are earning?" Of course it was a loaded question, as dividend yields at that time were next to nothing, if not zero itself. Even if the stocks that the funds owned paid some minimal dividend, they were not high enough to offset the fees charged by the funds. However, the typical answer to my question was "My funds are yielding about 20 percent per year." What my prospects were doing, of course, was confusing yield with past performance. How much a fund's share price had risen over the years has nothing to do with its dividend yield.

However, shareholders typically confused illusory price appreciation with actual dividend yield.

Another major problem with mutual funds, and one rarely understood or seldom discussed, is the concept of relative versus absolute performance. Investors of course should be concerned with the latter; however, managers are far more concerned about the former. That often overlooked conflict of interest is vitally important and is the principal reason that most mutual funds will underperform the market in the long run.

This conflict arises from the way fund managers are paid and the way funds themselves are marketed. It's all about short-term quarterly performance, relative to either a benchmark or competitive funds with similar objectives. Therefore, no manager wants to underperform and no fund wants its recent performance to compare unfavorably to the performances of its competitors. This reinforces speculative behavior and causes fund managers to chase performance by buying overvalued stocks, the prices of which keep rising as more funds buy.

Then those funds buying such overpriced shares post impressive relative performance numbers, which results in increased inflows from performance-chasing investors. Those funds need to be invested in those same overvalued shares that goosed the performance in the first place, and it is a self-reinforcing cycle. When it ends, of course, the share prices collapse, and long-term investors lose big. However, the managers already earned their bonuses, and since all the funds collapse together, no one cares as no one's relative performance suffers.

Assume a diligent fund manager, with the good sense not to buy the overvalued shares, who instead invests in undervalued companies. The prices of such shares could languish for years before finally rising to reflect the true value of the companies they represent. While such a strategy is fine for investors, it Could be disastrous for fund managers, who would likely lose their jobs long before such investments paid off.

In the final analysis it does mutual fund investors no good to pay managers big-time fees for impressive short-term perfor malice when by the time investors need their money it's all gone. What is important to investors is absolute, long-term performance, which is the furthest thing from the minds of most fund managers.

If you think mutual funds aren't a flagrant enough example of conflict of interest, try hedge funds. Once relatively obscure bastions for the superrich, hedge funds, which are largely unregulated and exempt from disclosure requirements, have become the current rage, now numbering around 9,000 and holding over $1 trillion in assets. Their managers, the latest crop of gazillionaires, conventionally charge a 1 to 2 percent annual management fee plus 20 percent or more of the quarterly profits. You heard right: 20 percent or more of quarterly profits.

Since "hedge" means to protect against risk, it's ironic that the conflict of interest in hedge funds exists because of heightened risk taking, the very thing hedging was supposed to minimize.

Although, to be sure, the hedge fund universe has its share of exceptional managers, too many of the impressive returns boasted by the industry are produced not by outperforming investments, but by investments with ordinary returns that excessive leverage has turned into huge dollar windfalls on which managers base their 20 percent performance fees.

There's actually very little hedging being done. Most hedge funds would be more accurately termed "risk funds" or "ultra leveraged funds." For example, a yield of 8 percent might be achieved by buying junk bonds. But leverage it up 10 times by borrowing

money at 4 percent, and you magnify the return over fivefold.

In other words, simply by assuming additional risk, an 8 percent return is transformed into a 40-plus percent return through the magic of leverage. If a$1_ billion hedge fund specializing in junk bonds merely leverages up 10 times, an 8 percent return becomes a windfall of more than $400 million, That gives the manager a payday of $80 million.

Hedge fund investors, trusting the expertise of hedge fund managers, are accepting risks they would never assume on their own and giving away 20 percent into the bargain. The hedge fund managers are taking a ton of risk, but with other people's money, not their own. When the risks pay off, the manager gets 20 percent. If the risk goes bad, the manager doesn't lose anything; he just doesn't gain anything. The investors take the hit. Heads, the manager wins. Tails, the investor loses.

Sure, when losses occur the fund managers have to get back to the last high-water mark before they can start collecting performance fees again. But the effect of this is a moral hazard even greater than existed before the loss: Now they have an even stronger incentive to push the risk envelope.

So that 20 percent performance fee creates a powerful incentive to use leverage and, since hedge funds tend to pursue similar strategies, they create short-term market momentum in the direction money is flowing. This tends to increase the paper gains for funds already positioned in those strategies, creating a lot of performance fees in the process.

The problems will arise when everyone tries to get out. The big paper profits will quickly evaporate when the momentum reverses, but that's the investor's problem. While the managers were raking in their 20 percent of profits each quarter on the way up, it's not as though they'll have anything to lose on the way down. They will gain as long as there's a profit. Managers can press a trend until it ends. There's no need to get out early, because there's no way they can lose. They can have their cake and eat yours, too.

Take the recent example of Amaranth, the $10 billion hedge fund that blew up in September of 2006. It lost better than 60 percent of its capital in a few short weeks as some highly leveraged natural gas bets went south. As those bets were paying off the managers made millions, but when they finally blew up, it ",as their investors who got creamed.

Did the Amaranth managers really earn their fat incentive fees for strategies that ultimately caused their investors to lose lots of money? Do you think they're going to reach into their personal pockets to help cushion the blow for their shell shocked investors? Don't hold your breath.