In Insights

Financial innovation fuels a burgeoning mix of products whose performance characteristics investors often misunderstand. In response to the perennial threat of fee and margin compression, the industry is always looking for the next great strategy to offer customers, and competitors quickly copy new-fangled products as technology eases the delivery of investment services.

This constant innovation does create new ways for investors to reach their goals. But the profusion of choices has also exposed investors to product risks that become apparent only after the latest strategy collapses or the bubble bursts.

Consider, for example, the growing popularity of liquid alternatives. As 40 Act funds increasingly enter the territory once reserved for alternative funds and vehicles, many investors can now access liquid alt strategies––such as long/short, market neutral, and arbitrage––that had previously been available only to the privileged few. But as liquid alts and other complex strategies go mainstream, it’s critical that advisors understand how these products are designed and what can go wrong with them.

To illustrate the pitfalls of financial innovation unaccompanied by greater investor education, consider the following three examples of products that didn’t perform as expected.

Case Study #1: Leveraged ETFs

Leveraged ETFs are designed for short-term traders looking to increase specific exposures, and these ETFs can perform that function very efficiently. Problems arose when long-term retail investors started using leveraged ETF strategies to achieve long-term leveraged returns, an attractive proposition in a bull market.

As these investors discovered, leveraged ETFs are exceptionally complex products, rebalanced daily to provide daily leverage. For reasons beyond the scope of this piece, daily leverage and daily rebalancing do not necessarily lead to long-term leverage; in fact, the opposite can be true.

Thus, an effective tool for short-term traders became a source of disappointment and litigation for long-term investors.

Much of this could have been avoided if issuers, advisors, and investors had done a better job of communication and learning around what specifically leveraged ETFs are designed to do (and as importantly, what they are not designed to do!).

Case Study #2: Securitization

A very popular product leading into 2008 (and arguably a cause of 2008) were securitized bonds such as mortgage-backed securities. This type of product provides borrowers with lower rate financing opportunities than would otherwise be available while providing investors with low-risk lending opportunities.

Securitized bonds are created by assembling a portfolio of loans, and chopping up the incoming loan payments into tranches that are assigned different levels of risk. As risks increase, so do returns in a “waterfall” structure of sequential payments.

Securitization is appealing when the loans in a package are generally independent of each other––failures should be limited and discrete, so the safe portions of the waterfall generally always will have money available to make payments, while the risky portion of the waterfall will suffer periodic stoppages. The concept was so strong that rating agencies would often give the highest credit ratings to the safe portions of the waterfall, presumably thinking what are the odds that many loans would all simultaneously fall?

The answer turned out to be surprisingly high. In practice, many securitizations were built with loans that were fairly similar––e.g., if one loan failed, then there was a good chance of another shortfall. Thus, these products often weren’t designed to deliver the low-risk returns they promised.

It seems clear that the ratings agencies should have evaluated many of these investments differently, and the financial community put a level of faith in agencies (at least prior to 2008) that may have been unwarranted.  Advisors and investors would have been well served by kicking the tires on the underlying loan pools and questioning the assumptions being made by issuers and rating agencies.

Case Study #3: Auction Rate Securities

A good example of a successful product that collapsed under stress are auction rate securities. Simply speaking, investors would lend money to institutions at interest rates that were set in monthly Dutch auctions. For over 20 years, these securities were appreciated for offering attractive yields with easy short-term liquidity, and often marketed as cash equivalents.

A careful investor would have asked what would happen if the auctions failed. The answer he or she would have received is that the products all had, somewhere in their prospectus, language covering this possibility. But it appears few in the financial community gave that language much thought. That is, until the auctions began failing in 2008.

Investors discovered that there were no standard consequences from one failed auction rate security to the next. Some securities were structured to pay very high interest rates if auctions failed, while others were designed to pay very low rates. Investors did extremely well in some failed auctions, while others found themselves stuck with a product that was long-term, illiquid and very low paying. Some issuers created liquid markets because they wanted to redeem their failed auction rate securities, whereas others had no requirement or incentive to do so.

Inconsistent product design meant that hundreds of billions of dollars’ worth of auction rate securities behaved unpredictably when markets were highly stressed. Not surprisingly, this resulted in tremendous investor dissatisfaction, many lawsuits and a black eye for the investment community. On the flip side, investors careful enough to ask what could go wrong either stayed away or chose those securities which rewarded them handsomely when the auctions did fail.

Forewarned is Forearmed

With these illustrations in mind, financial advisors considering liquid alts or hedge-fund-like strategies should conduct thorough research to answer the following questions:

• What is this product designed to do? For example: Who is it designed for? Is there an alignment between the product’s goals and my needs? Are there superior solutions for meeting my needs?

• How confident are you in the product design and issuer? For example: Have you read the prospectus and “kicked the tires” of the strategy? Do you know who is issuing the liquid alt and whether they have done this before? Since liquid alts can earn higher fees on the private side, why is this strategy and manager being offered in this form?

• How will the product perform if the world changes? For example: How will the product weather different market conditions? Has the manager explained satisfactorily what he or she expects will happen in negative market environments?

Innovation in finance will continue to challenge investors to conduct deeper due diligence. Especially with new products, a fuller understanding of the product’s performance characteristics is an essential risk mitigation strategy.

Lawrence Solomon is COO of Exceed Investments, a New York-based boutique financial services firm that provides defined outcomes indexes and investment products that balance protection and upside performance for investors.



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