The scandal around the so called investment guru Madoff is the second big case in this year as masses of people have lost their fortune. The first case was the bankruptcy of Lehman Brothers. Many people are lured to invest their money in financial market instruments that promise attractive yields. These instruments are, however, as opaque as black boxes.
Hedge funds as black holes
Hedge funds bet with complex structures of derivatives. Most of them lack the transparency. The common investors do not understand how they work. Institutional investors usually invest in funds of hedge funds. Their managers claim to be capable of picking the promising funds. Funds of funds absorb a cascade of fees that have to be subtracted from the yield.
There is a wide variety of investment styles among the hedge funds. It seems that the general lack of transparency of the hedge funds industry has made it possible that the Madoff Ponzi could remain undetected for such a long time. The Madoff scandal demonstrates also a failure of the SEC as well as of the involved audit firms.
Hedge funds should correlate with other asset classes, e.g. stocks or bonds, according to the theory. The fact is: Hedge funds have badly performed during the actual financial crisis. The global hedge-fund industry lost $64 billion of assets in November 2008 says Bloomberg.
Structured products as another black hole
Masses of people have lost their savings with structured products that have been issued by the bankrupt Lehman Brothers. People who have been badly advised to invest their money in a Lehman Brothers productS. They were persuaded to invest in products that they did not really understand. Structured products are a combination of a traditional investment (e.g. shares, bonds, foreign currency, commodities) and a derivative financial instrument.
There are several types of structured products. The most popular ones are those that promise full or partial protection of the capital. The people trust the word “capital protection” on the label, but they forget the issuer as a risk factor. Lehman Brother was an issuer that went bankrupt and thus was not able to fulfill its obligation.
Keep It Smart and Simple
What is the lesson learned from Lehman Brother bankruptcy and the Madoff scandal? Structured products and hedge funds are complex and difficult to understand. They can behave like black holes and absorb the investors’ fortune. Even professional and institutional investors did or could not look through it in the case of the Madoff scandal.
The best way to protect the money is to invest in assets that are transparent and easily understandable for everybody. People are well off who live in their own flat or house. Residential buildings are the best and safest investment for individuals and institutional investors. Another safe investment class are investments in government bonds. Gold is a volatile asset, but gold performs well during times of crisis and war. Other kinds of investments should be scrutinized cautiously by individuals. The thumb of rule is: high yield – high risk.