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Hedge funds used to be reserved, by SEC regulation, for the rich and very rich. The SEC required hedge fund investors to have a cool $1 million in the bank, earn more than $200,000 a year or have investments worth $5 million.

Those restrictions have relaxed though and now almost anyone can take advantage of hedge fund investment opportunities. There are many types of hedge funds available. In fact they are now nearly as diverse as mutual funds.

Though much the same as mutual funds hedge fund portfolios are drawn from the private sector. They use a pooled fund investment strategy but are more flexible than mutual funds because they are not subject to many of the SEC regulations that govern mutual funds. This flexibility is both good and bad. Return on your investment can be very high but because the fund manager is free to employ risky strategies that a mutual fund manager must stay away from, but your losses can be large as well. Typical investment tactics include investment in short stocks, options and futures and buying on margin, that is, using borrowed money.

Hedge fund managers typically have their own money invested in the fund and they are paid a hefty percentage of fund performance. This means they can generally be relied on to maximize profits on the fund while watching carefully for dangerous situations. But they are also paid a management fee that they get whether the fund performs well or not.

The popularity of hedge funds has resulted in a wide variety of differing types of funds but the strategies they employ generally fall into three broad categories:
Arbitrage Strategies Event-Driven Strategies Directional Strategies

Each of these hedge fund strategies have their own strengths and weaknesses. A wise investor will investigate the pros and cons of each and discuss their relative merits with a qualified investment advisor.

I have heard it said that in a bubble, the price of the hot item affects the economy more than the economy affects the price of the hot item. While this was true during the past two bubbles (internet/technology stocks of the late 1990′s and early 2000 and housing) does this hold up with the current sector shift into commodities? Could we be witnessing the formation of the next bubble?

Before we get ahead of ourselves, it is a good idea to determine what classifies a “bubble.” A bubble can be loosely defined as when excess resources, capital and financing are being poured into a specific hot investment as compared to other capital investments. There are differing types of bubbles, but James Montier did a good job of categorizing them:

Greater fool theory – higher prices are willing to be paid as long as there is someone else to buy it from them – speculative Fundamental analysis – investors err by extrapolating that past returns will continue indefinitely into the future Fads – investors succumb to pressure to conform to the majority’s view (social and psychological factors) Informational – prices deviate from the fundamentals because investors assume they have hidden information that supports higher prices

Additionally, if you take a look at both of the most recent bubbles mentioned above, you can see a consistent pattern emerging from their formation to the eventual bursting:

- Bubbles usually start because of rotational investment shifts; investors seeking “the next big thing” move money into these investments in an attempt to improve returns

- Hype and over-promotion become rampant

- The word “new” is usually always bandied about by the pundits and used by investors to rationalize why this time is different than the past

- Institutional investors are usually leading the charge into the hot investment

- Individual investor follows the institutional money

- The non-investor feels they are being left out and follows the herd, believing they must not miss out

- Speculation follows – leverage and margin are used in excess

- Bubbles seem to be always tied to loose credit policies or easy money

- Bubbles tend to initially fund unsound business, and promote over-investment

- Bubbles invariably start slowly and gradually build over a period of years

- At the peak of a bubble misrepresentation and fraud flourish

- After the peak, prices fall precipitously and then partly recover

- After the recovery there is usually another protracted period when prices stay stagnant or drift lower

- Bubbles are often followed by economic recessions

The inevitable bursting of a bubble can be very painful and has the tendency to redistribute wealth, as the early adopters who cash out take the money from the late arrivers. Sadly, the late investors then usually get saddled with an investment rapidly declining in value that frequently becomes illiquid, and as such they lose out even more. However, even with the associated pain bubbles are good for a free economy. Daniel Gross points out in his book, “Pop,” that bubbles leave behind a new commercial and consumer infrastructure. “The stuff built during infrastructure bubbles – housing and telegraph wire, fiber-optic cable and railroads – don’t get ploughed under when its owners go bankrupt,” he reasons. “It gets reused – and quickly – by entrepreneurs with new business plans, lower cost bases, and better capital structures.

So where does this leave us with our original questions?

As an investment advisor I am in a unique position to be able to see the trends of a bubble develop. I see when institutional money begins its shift into other markets. I see the promotional machine begin and when it ramps up to a furious pace in an attempt to lure investors’ money. I see when clients begin to take abnormal interest in their portfolios and start calling to make sure they have some exposure to the current “hot” investment. Finally, my clients let me know it’s time to take some profits off the table because the phone rings continuously requesting a change in their portfolio to heavily skew it away from a successful, less risk, diversified strategy to one of putting the majority of their eggs in one basket. While the timing may not be spot on, every time we have had bubbles my clients turn out to follow that consistent pattern mentioned above, which is a great forecaster of things to come. So when clients started calling and asking about their exposure to commodities, it raised a red flag for me.

Without question, commodities could be the next technology or housing bubble. Many of the patterns seen in past bubbles are present today. Based upon my clients’ activity level I would put us mid-stream into the bubble. From a fundamental standpoint as well it seems only mid-stream because some of the imbalance in commodity prices is due to the current imbalance in supply and demand and is therefore justified. Upward price adjustments can also partially be contributed to the weakening US dollar (e.g. oil’s mercurial rise – the largest component of a commodity index – which is pegged to the US dollar). With the dollar continuing to fall, some of the price increase is exacerbated. The rest is due to world economic expansion and, my cause for concern, speculation. Because the majority of the rise is not speculative, at this time it is a little different than previous bubbles and therefore makes it harder to gauge. Of course, the greater the speculation, the closer we approach a true bubble.

When it comes to bubbles recognition is only half the challenge. The other half is what to do and when to do it with regards to your investments. It is recommended that investors manage their risk exposure by never investing more than 5-10% of their assets into any one sector. This approach always limits potential losses so if a bubble does occur, while you may have some minor pain (a 10% loss) you have not been wiped out. Another prudent practice is to regularly review your asset allocation and rebalance your portfolio to insure that any investments that have become out-of-balance are readjusted (i.e. partially sold off) to within the risk tolerance you have set for your portfolio. The advantage of this is that during bubbles, those investments will rise, and regular rebalancing will bring this investment back to an acceptable risk level, thereby reducing exposure and locking in some profits. While this may not maximize gains it unmistakably minimizes losses, which are a major concern if the potential for a bubble exists.

As the hype surrounding commodities continues to build, the chances are increasing that we are moving closer to a true bubble, which is terrible news considering we have yet to recover from the previous one. The effects of another bubble so soon after the last could be devastating to the US economy. However, the good news is that it’s not too late to turn it around. Even with the excess capital flow into commodities continuing unabated, I feel we are still months, if not a few years, away from this situation turning into a full-fledged bubble. This gives the forces that could slow it down or reverse the trend a chance to take hold. In the meantime, be aware that the signs are there, because you don’t want to end up as one of the late arriver’s.

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Synopsis of Content:

Solin does it again – taking complex and difficult investment information and reducing it to a simple discussion that anyone can understand. Solin teaches the reader at a very fundamental level what to do and what not to do when investing in stocks and bonds as well as how to manage cash and other securities both in preparation for retirement and during retirement. He add a chapter on stretching your money and other tips on how to survive financially if things get tight.

His explanations of social security, pensions, annuities and other retirement devices are right on point and again easy to understand. Each chapter ends with a simple single sentence that sums it all up. The chapters are short and well organized touching on only one major subject.

In the last chapters he warns about people scamming elders, long term care costs and insurance, and some tips on how to set up one’s estate. Finally he provides his Ten Golden Rules which summarize the book and then a good bibliography for further reading.

This book is a hit. It is easy to understand whether you are a sophisticated investor or a total novice. It is a great book for anyone whether you are preparing for retirement, contemplating it soon or in retirement itself.

Readability/Writing Quality:

This is easy to read. It is well organized. Each chapter ends with a “What’s The Point” summary in one sentence. Chapters focus on only one subject making them easy to understand.

Notes on Author:

Daniel R. Solin is a leading securities arbitration lawyer and a registered Investment Advisor. He has testified before Congress and appeared on major television business news magazines. He has written two previous and equally good books that are friendly to the unsophisticated investor: Does Your Broker Owe You Money and The Smartest Investment Book You’ll Ever Read. He has also published a book called The Smartest 401(k) Book You’ll Ever Read. Solin is financial columnist for AOL. He is a financial blogger on the Huffington Post.

Three Great Ideas You Can Use:

1. If you have an account with a brokerage firm, close it. Use a fiduciary instead.
2. Never buy individual stocks or bonds except for T Bills.
3. Keep funds sufficient to meet two years of living expenses in an FDIC-insured savings account, certificate of deposit, Treasury bills, or a money market fund from a major fund family.

If you want to read Golden Rules 3-8 and 10 get the book – they were worth it.

Publication Information:
The Smartest Retirement Book You’ll Ever Read by Daniel R. Solin

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