When the 'smart money' gets stupid

By Morningstar

Anyone who follows investing knows the so-called smart money isn't always so smart.

Examples of misfires by big hedge funds or acquisitive corporations have abounded in recent years. It's unsettling, though, to find out that sometimes the smart money doesn't even seem to try very hard.

After all, one assumes the big investors engage in detailed fundamental research, undertaken by talented and knowledgeable analysts, or that they rely on ultrasophisticated mathematical models. Maybe both.

The mistakes occur, we assume, when the analysis rests on flawed assumptions or the models overlook important factors. Or when the manager's ego simply runs out of control.

But a recent article in the Financial Times cites an even more troubling reason: Sometimes the analysts and mathematical models aren't even consulted. Instead, the big shots occasionally invest simply because their buddies are doing so.

The risks of a 'trust me' trade

Recently, the Financial Times reported that after buyout firm Cerberus Capital Management had purchased a majority stake in GMAC, which began life as the financing arm of General Motors (GM, news, msgs), and took that firm private, it later sold most of its exposure to a variety of other investors in order to reduce its own risk.

Fair enough. But how did those other investors decide whether they wanted in on the deal?

According to several of them, a group of hedge fund managers were invited to a private meeting with Cerberus, and most decided rather quickly to join in without making any true investigations of their own.

"It was a 'trust me' kind of trade," one investor who bought a small piece of GMAC told the newspaper. "You had no time to do real due diligence. But it was a hot deal, and everybody wanted in as part of the gang."

There was another reason, too.

"Many of the people who took part in the deal," said the Financial Times, "were friends of Steve Feinberg, founder of Cerberus, and said they invested as a sign of faith in him."

One investor who, unlike most, declined the offer to participate, now says, "There was an element of the 'greater fool' theory to it."

So far, the investors' eagerness to pull the trigger has led only to grief. (If their results had been happier, they probably wouldn't be talking to the news media about it.) A key reason is that ResCap, the mortgage-finance part of GMAC, has run into trouble, as have so many other players in the mortgage arena.

Buying a stock for all the wrong reasons

So what does this episode mean for ordinary mutual fund investors?

For one thing, it provides yet another hint that you need not envy those with the millions to invest in hedge funds and other vehicles off-limits to the masses.

It's easy to feel you're missing out because the big hedge funds -- whose minimum investment levels, I assume, put them beyond the reach of nearly everyone reading this -- must have top-notch talent, exceptional resources and first-rate connections. Well, in many cases, they do.

But human nature can foil those advantages. Hedge fund managers can still dive into a lousy deal for the wrong reasons. They aren't automatically superior to the good mutual fund managers available to all.

2 ways to judge a manager's decisions

That said, how can one know that a mutual fund manager, too, isn't simply using a follow-the-leader investment strategy?

One way is to look at the fund's portfolio and see whether it closely resembles the relevant index or the portfolios of other active fund managers with similar mandates. A fund that differs isn't necessarily going to succeed. But at least you're getting some independent thinking for your money.

To gain more insight, take a look at the manager commentaries included in annual and semiannual fund reports, and often provided more frequently on fund company Web sites.

Mutual fund managers should be able to explain clearly and persuasively why they are buying or selling -- or holding on to -- the securities in their portfolios. Does their reasoning sound logical and thoughtful? Do the moves fit into a well-established, well-articulated strategy? Or does the manager seem to be providing run-of-the-mill reasons to justify buying a popular stock that lots of other people already own?

Granted, managers aren't going to tell you they bought a stock because they're friends with the guy who pitched it to them. (Many years ago, though, a fund manager did confess to me in an interview that she had invested in a shaky foreign company -- a move that had backfired -- mainly because a big Wall Street firm had made a large, public investment in the company, and she'd figured they must have known what they're doing.)

Nevertheless, by evaluating portfolios, comparing performance against indexes and rival funds during specific time periods and reading the manager's discussions and explanations, you can get at least an inkling of whether the managers you're paying to think for themselves really are doing so.

This article was reported and written by Gregg Wolper for Morningstar.