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.