Don’t Understand? Don’t Invest!

Robert Keavney

One of the defining elements of the modern financial era is the development of financial engineering and product structuring.

Once upon a time, long ago, investing was simple. People invested in things, and they received the return that those things produced. The progressive development of derivatives’ markets brought more complexity, with different opportunities and risks.

Today, these different tools, and others, are packaged together in combinations, creating ever more complex assets. Leverage is the most common tool. Borrowing has long been used to ‘gear up’ exposure to a market, however, it now has other uses.

For example, take an infrastructure fund developing a toll road. Without any financial engineering, investors would receive no yield for the period of construction, followed by growing income as traffic started to flow.

However, the promoters of this fund could offer it with a 5 per cent yield from the first day, the initial distributions being funded by the simple process of borrowing the money and paying it out.

On one hand, this puts cash in investors’ pockets. On the other, it adds a corresponding debt to the assets in their fund. At first glance, this might seem a pointless exercise, like borrowing a dollar to pay to yourself. You’d certainly take no pleasure in a ‘salary’ increase funded by your own borrowing.

However, it is understandable that there could be appeal for investors in receiving reliable cash flow from day one. In fact, many listed property trusts have been ‘enhancing their yield’ in this way, contributing to their increased level of debt.

It is necessary to understand that such engineering doesn’t actually change the nature or add to the long-term profitability of the underlying assets — it merely manipulates the cash flow. The decision to recommend such a product must be based primarily on an analysis of the underlying assets, the underlying cash flow and so on.

This is key to understanding engineered or structured products.

Packaging together various things doesn’t give you more than a package of those things. (Sometimes it does generate something extra — higher fees. Investors seem more willing to pay more for products they don’t understand, than they would to buy all the separate underlying components that make it up … sort of paying a premium for mystery.)

CDOs

With this background we can turn to the subject currently making headlines: collateralised debt obligations (CDOs).

At the time of writing, two hedge funds promoted by US investment bank Bear Stearns (Bear) are reported to have lost 100 per cent and the other 91 per cent. At one time they held $23 billion in assets.

You can’t fail to appreciate the name of one of these funds: High-Grade Structured Credit Strategies Enhanced Leveraged Fund. We won’t attempt to understand the meaning of ‘high-grade’ in this context, but we do know what ‘leveraged’ means. The fund had $10 of borrowing for every $1 of capital.

When it first became apparent that the Bear funds were in trouble, but before the extent of the losses were known, executives at other Wall Street firms made statements implying that investors should be able to expect the promoter of such funds to support them in a crisis. One stated: “Investors know that they are backed by the financial muscle of a large institution that has a big interest in safeguarding its reputation.”

That sounds reassuring, perhaps as reassuring as the term ‘high-grade’, but you will notice it fell short of saying they provide a guarantee for their funds. If an institution suggests it will protect their clients’ funds, but not to the extent of actually guaranteeing it, then planners should have confidence in them, but not to the extent that we actually stop laughing.

Bear’s losses arose from the slump in certain CDO prices.

Gone are the days when banks lent people money on their properties, took a mortgage, and earned the interest.

Now, the bank bundles these loans into packages and sells them as a mortgage based interest-bearing product called a CDO.

Some CDOs are composed of well-secured mortgages over properties owned by low risk borrowers.

Others consist of poorly secured loans to high-risk borrowers (that is, sub-prime mortgages).

The Bear funds were exposed to sub-prime CDOs.

How could an organisation as sophisticated as a Wall Street investment bank so badly misunderstand these risks?

They were in very good company, as leading ratings organisations gave investment grade ratings to CDOs in which underlying mortgages were of low grade.

If you invest in a large pool of low quality mortgages, your return will reflect the average of the pool. You spread your risk, but you don’t improve the quality of the underlying assets.

Yet, somehow, many non-prime mortgage pools attained a grade as high as triple A. This is akin to believing you can turn sand into topsoil by piling a lot of it in one place.

Now, large scale downgrading of the ratings of lower quality CDOs is taking place in parallel with tumbling market prices.

Basis Capital

Closer to home, Basis Capital, an Australian-based hedge fund manager that operated in CDO markets, appears to be facing challenges.

At the time of writing, the situation worsened from the initial announcement of 9 per cent and 14 per cent declines in June. It is reported that one fund has lost more than half its value.

One can only wish the managers well as they attempt to salvage value for investors.

The blame has been attributed to “indiscriminate mark-to-market pricing by dealers” for its losses.

An analysis of this statement can reveal a lot about the nature of the CDOs and many other structured products that operate in illiquid markets (that is, those where the assets are not frequently traded).

Ready liquidity means a ready price, thus current value can always be accurately known.

In illiquid markets, estimates of value often lack precision, as there may be no comparable recent sale on which to base a view.

Further, many CDOs aren’t required to mark their assets to market (that is, they may make no attempt to reflect the prevailing price of their assets in their accounts).

Hence, even a fund’s promoter may not actually know what the illiquid assets it owns are worth.

Consequently, the performance of such funds may involve mere estimates. (Sceptics might wonder whether product managers may be tempted to estimate high when performance fees are at stake, though I do not suggest this was the case for Basis.)

Complaining about ‘mark-to-market pricing’ is complaining about attempting to work out what an asset is actually worth.

Bloomberg commentator Mark Gilbert has described pricing in illiquid markets as “mostly generated by a confidence trick. As long as all of the participants keep a straight face when agreeing on a particular value for a security, that’s the price. As soon as someone starts giggling, however, the jig is up, and the bookkeepers might have to confess to a new, lower price.”

This is too cynical, but it leads to an important point. Sharp changes in price in such markets, and the products that invest in them, should not come as a shock. There is no daily pricing to provide continuous feedback about changes in market conditions, so there should be no shock when the unexpected occurs.

Adding to this, most hedge funds readily acknowledge that they lack transparency.

Researchers need to acknowledge that the inability to monitor processes and developments within non-transparent funds and illiquid markets limit the degree of conviction they can have in their own assessments. For this reason, Centric avoids most non-transparent products.

It appears a number of research houses did not share this uncertainty, as they granted their highest rating to Basis products.

It has been claimed that hedge funds are products for all seasons, which offer strong returns with limited downside. The reality is that some feature careful risk controls, some gear aggressively into risky assets and others follow a broad range of other strategies. Few generalisations apply to all hedge funds.

The only way to understand a hedge fund, or any structured product, is to look into the underlying components — assuming it is transparent enough to allow this. In the case of Basis and Bear, the underlying elements included borrowing to buy risky mortgages.

It has been claimed that hedge funds are the way of the future. The same has been claimed of commodity funds, and more recently private equity.

With the share of portfolios being argued for by the promoters of all these alternatives, there might soon be no room for the conventional asset classes of listed shares, property and interest. My view is that these three remain the core of most sound portfolios, though certain alternatives can play a supplementary role.

Unusually, the sub-prime mortgage problems have emerged in the midst of a healthy American economy, with strong employment and non-punitive interest rates.

At the same time, Australia is seeing a string of losses from property-based lending businesses (Westpoint, and so on) in the midst of a strong economy (though with considerable variations between states). It is hard to think of a precedent.

Equally, unusual timing is the promise to bring a new broom to a tired management boom as a rationale for the flood of private equity taking over listed businesses.

Companies are at record margins of profitability and share prices are around record levels and have been rising strongly for years, yet private equity is going to make great improvements in management.

The key for planners in understanding the unfolding range of new products is to recognise that their underlying assets and strategies are components with which they are familiar.

Sticking them in a product structure, talking a lot of jargon, and adding a fat fee structure, doesn’t magically reduce the risks or increase the profitability of the underlying elements.

If planners can’t really understand a product they don’t have a reasonable basis (pun unintentional) for recommending it.

Even a high research rating doesn’t justify entrusting clients’ funds to something you don’t understand.

Robert Keavney CFP BA is the chief investment strategist at Centric Wealth Advisory .