The dirty tricks of the investing trade

Fabrice Taylor, CFA, publishes the President's Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here .

Buying an investment fund is one of the biggest decisions we can make, yet too many of us do more due diligence on a new TV than we do on a money manager. Fund companies and managers often profit from our ignorance, and the devil is usually in the math.

Most of us understand basic caveats, such as avoiding mutual funds with an excessive annual management expense ratio. But there are many other ways to get stung, so you have to be constantly on your guard.

Let's start with how your money manager is paid. Most of them get a salary and a bonus of some sort. Some funds reward managers for re-lative performance–how well the fund does compared to an index or comparable funds–rather than absolute return. One hedge fund manager I know says that when he worked at a large, long-only fund (i.e. it didn't allow short selling or leverage), "I literally didn't care what my fund was doing. I had a spreadsheet on my desk that showed how I was doing compared to my competition, because that dictated my bonus." He could be down 25 per cent, but if competing funds were down 30 per cent, he was still rewarded for outperformance.

Here's another mathematical quirk: A manager can wipe out hundreds of millions of dollars of value and still enjoy a sterling investment track record. How? Suppose a company launches a fund with \$10-million and the manager returns 100 per cent in the first year, doubling the assets to \$20-million. That stellar return attracts \$500-million in new investment at the beginning of the second year. But the manager then loses 40 per cent, or just over \$200-million. Yet the average annualized return over the two years is still about 9.5 per cent, and the fund can use that number in its marketing, despite having destroyed a massive amount of money.

That is a fairly common phenomenon among hot fund managers. Often they are specialists, but as a fund grows, they have to change tactics, notably by investing in bigger companies. That, almost by definition, erodes returns. Their skill isn't scalable as a fund swells out of its original niche.

Another trick I've seen a lot in recent years involves early investments by hedge funds in junior resource companies before they go public on the stock exchange. The funds usually get in on the cheap because of the risk inherent in small companies and the lack of liquidity–it's hard to sell shares in an unlisted company. These investments were often followed by an IPO within a few months. The "lift" from that offering–the value of being liquid, plus some stock promotion–boosted trading volume and the share price, allowing the manager to sell at a big profit.

Those profits would attract more money to the fund, but two problems often arose: The fund would grow so big that there weren't enough good private deals available to move its overall return needle. Worse, when the junior resource sector hit the skids, IPOs dried up. Funds were left holding shares that weren't even worth the pennies they paid for them.

The subject of big wins and later losses shines light on another problem: Many hedge fund managers get a fat share of any yearly profits–often 20 per cent. So if the manager doubles the value of a \$10-million fund, he or she gets \$2-million. But what if the \$10-million shrinks to \$5-million the next year, and then climbs back to \$10-million the following year? Should he or she be paid \$1-million for that?

Many investors would say "no," and that's why the so-called high-water mark was invented. It means that a fund manager is only paid a bonus when the unit value of the fund climbs above its previous peak. In many countries, high-water marks are permanent, but a lot of funds in Canada reset the high-water mark every year. This means that managers can be paid a bonus even if many of their investors are still under water.

It may seem like you're only losing a sliver of your investments from each questionable pay practice, but those slivers add up.

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Value

Dundee Industrial REIT

6.1 per cent Annualized yield at recent unit prices

REITs seem to grow on trees, but most of them are focused on residential or commercial property. There aren't many in the industrial space. Dundee's newly listed vehicle aims at acquiring factories, warehouses and the like with stable cash flows. If history is a guide, this REIT will start hoovering up properties and hosing out shares, making it bigger and more liquid, and generating bigger distributions. Industrial may not look pretty, but it's where smart money is going.

Growth

Canadian Energy Services & Technology Corp.

267 per cent Three-year revenue growth

North America's oil and gas sector has struggled over the past year or so, yet Calgary-based Canadian Energy Services keeps expanding and pumping out profits. Credit two of its specialized strengths: horizontal drilling and drilling fluids. And regardless of what Barack Obama wants to do with energy taxes, he also desperately needs to boost conventional production.