Opinion

James Saft

Leverage, complexity and amnesia

May 28, 2014

May 28 (Reuters) – Investors appear to have forgotten two
prime lessons of the last crisis: complexity is expensive and
leverage is dangerous.

Not that you have to look far, but two recent trends – funds
which mimic hedge fund strategies and leveraged exchange-traded
funds – exemplify the extent to which five years of market gains
and easy central bank money have lulled investors.

It is almost as if the financial crisis never happened.

First, let’s look at leveraged ETFs – exchange traded
vehicles which use derivatives or other means to create leverage
and amplify gains and losses – which have multiplied and come
in for increasing criticism.

“We’d never do one (a leveraged ETF),” BlackRock Inc Chief
Executive Larry Fink said on Wednesday. “They have a structural
problem that could blow up the whole industry one day.”

Not only are they typically engineered to achieve their
objectives over short periods, as opposed to being long-term
holding products, the search for something to appeal to
risk-hungry investors is taking them into ever-more arcane areas
of the financial markets.

Take, for example, the proposed AdvisorShares Pacific Asset
Enhanced Floating Rate ETF, currently awaiting approval from the
Securities and Exchange Commission. (here)
It will use derivatives to magnify bets on floating-rate, high
yield bonds, stuff safely classified as junk.

Dissatisfied with the tiny yields on offer if you take
credit risk on companies which themselves are often already
highly leveraged?

Just borrow money to make those returns bigger.

Of course you ought to remember that not only is your return
going to be magnified, so are your losses. And note too that
this is a difficult part of the market in which to transact if
ever things get hairy.

“Leverage can never turn a bad investment into a good one,
but it can turn a good investment into a bad one by transforming
the temporary impairment of capital (price volatility) into the
permanent impairment of capital by forcing you to sell at just
the wrong time,” James Montier of fund manager GMO wrote last
year.

Now to be sure, leveraged ETFs are only 1.2 percent or so of
the $2.5 trillion global ETF market, but this is not the only
sign that a long bull market with low volatility has lulled
investors into taking on more risk.

While margin lending is now down from all-time peaks hit
earlier this year, there is anecdotal evidence that brokerages
are doing more lending against portfolios for purchasing things
other than securities.

These loans, which are secured by investments held with the
broker, allow clients to borrow as much as 95 percent of the
value of their holdings and then use the funds elsewhere, often
to buy vacation or rental housing. The problem, of course, is
that your holding can get sold out from under you, at exactly
the wrong time, if the market takes a tumble and the margin
clerk gets nervous.

COMPLEXITY IS NOT YOUR NEW BEST FRIEND

While the dangers of leverage are easy and instinctual to
understand, perhaps the real enemy of the average investor is
complexity, another thing which is making a roaring comeback.

Complexity is expensive for at least two reasons. Every bit
of fancy footwork, be it a derivative bet or a complex hedging
technique, costs money, money which is a sure thing while the
supposed benefits are only speculative. Complexity is also the
great friend of the intermediary, making it easier to load up
unsuspecting investors with costs.

Look, for example, at the newly burgeoning market for
so-called liquid-alternative funds, recently highlighted by the
Wall Street Journal and, particularly amusingly, by Joshua
Brown, an investment advisor for high net worth clients.
(here)
(here)

Available to run-of-the-mill clients, these funds, like the
hedge funds they mimic, follow a myriad of alternative
strategies and generally sell themselves as offering a hedge
against long-only investment.

Such funds accounted for almost half of net fund sales at
broker-dealer houses in 2013, according to a study done for the
Money Management Institute. (here)

Little wonder, Morningstar puts the costs of these funds at
almost 2.5 times those of an index fund, and nearly half again
as much as a traditional active mutual fund.

That brokers like to sell complex, high-costs funds isn’t
new. That investors are increasingly willing to go along for the
ride is.

Like the increased use of leverage, this rise in complex
investments could go along for quite some time, but has
historically been a warning sign for the market as a whole.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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