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.