Here is one asset management strategy:
1) Gather capital from investors.
2) Deposit the funds in your personal bank account.
3) Generate statements showing nice returns that keep your investors happy. The “returns” are fake. The funds are sitting in your bank account funding your lifestyle.
4) Since you’re publishing fake returns, make them compelling. This makes it easy to solicit new investors.
5) Prospective investors are enamored with your “past performance.” They deposit more funds into your bank account.
6) If old investors want their money back, pay them with the funds deposited by your new investors.
7) If inflows from new investors exceed distribution requests from old investors, no one is wise to your scheme.
8) Enjoy the high life until distribution requests from old investors exceed new investor inflows.
9) Jail.
This asset management strategy is called a Ponzi Scheme. Invented by Charles Ponzi, popularized by Bernie Madoff.
On a completely unrelated note, here is another strategy:
1) Gather capital from investors advertising your fund paying some astronomical distribution rate. Say something like 50%.
2) Buy call options and sell put options on a stock to create low-cost synthetic long exposure. The income from the put options pays the cost of the call options, so you get the same economics of owning a stock – participating in the upside if the price rises and the downside if it falls – without deploying capital to buy it. You have exposure to the stock, and you still have all your investors’ cash.
3) Sell call options on the synthetic position to generate income. This is known as writing covered calls.
4) Charge a fee on your investor’s cash.
5) Pay investors an astronomically high distribution rate composed of option income on the stock (from the covered calls) and return of their own capital (remember, your long position is synthetic – you still have all the investor’s cash). If the call options generate 4%, pay the investors the 4% income the options generate and then hand them back 46% of their own capital. 50% distribution rate!
6) Publish lots and lots and lots of disclosure about the fact the distribution rate is so high because you’re often just handing people their own money back. No one reads disclosures.
7) Advertise, advertise, advertise the 50% distribution rate. Prospective investors are enamored with your “yields.”
8) If inflows from new investors exceed distributions to old investors, the total assets in your fund grow.
9) Total assets are what you charge fees on.
There are funds out there advertising distribution rates in excess of 50%. Very compelling, ceteris paribus. Of course, all else is not equal. We have a rule of thumb around here: if it sounds too good to be true it probably is. Dig a little deeper into a fund advertising a 50% distribution rate and you will probably find the majority is derived from “return of capital.” The disclosures are all there. This is not a Ponzi Scheme! They're handing people their own money back, not someone else's. It is perfectly legal. If you see a fund with a distribution rate of 50%, read the disclosures! Much of it may be a return of your own capital.
On an annualized basis, here's how that math works out:
1) You invest $100
2) You pay $1 to the fund (1%)
3) The fund pays you $50
4) But... $47.50 of that is simply a return of your original $100 investment
5) You now have your $50 distribution and $51.50 (net of fees) still invested in the fund. That's $101.50 on your balance sheet
6) That works out to a distribution rate of 50% and an annualized yield of 1.5%
7) Which of those numbers do you think is heavily advertised and which is buried in the disclosures?
This is not a fringe thing going on in the asset management landscape. There are tens of billions of dollars invested in these strategies. Perhaps some folks experience psychological benefits receiving astronomical “yield” from their portfolios. Maybe the emotional benefit of a 50% “yield” composed primarily of a return of their own capital is worth the fee.
Also maybe some people never read the disclosures?
Two things we believe:
All men are created equal.
All yields are not.
Sean Cawley, CFP®
Neither asset allocation nor diversification guarantee against investment loss. All investments and investment strategies involve risk, including loss of principal.
Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.
This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.