When the gap between Wall Street and main-street economic performance gets ever starker, learn why these are the 7 asset classes to beware of.
Introduction
US stocks set a new record earlier this week, according to the Financial Times. The benchmark US stock index S&P500 “rallied more than 50 per cent from the darkest days of the coronavirus crisis”. From 2020 Apr to July, the number of unemployed in US stayed above 16 million. The peak of more than 23 million occurred in April. During the darkest days of the Global Financial Crisis, this number hovered at around 15 million.
This cartoon from the Economist captures nicely the stark discrepancy between the performance of the stock market and that of the livelihood of the average person.
In this strangest of times, it is critical that we keep our heads and avoid potential financial pitfalls. I previously I wrote about 7 asset classes retail investors should beware of when they sign up to financial contracts with insurers or invest in mutual funds. These are:
- Hedge funds;
- Private equity funds;
- Collateralized Loan Obligations (CLOs);
- Structured products;
- Subordinated bonds;
- Derivatives; and
- Capital securities.
In this first of two posts, I will explain why you might already be exposed, what the above asset classes are, and why you should beware of them.
You might already be exposed
Unlike a typical mutual fund, hedge funds, PE funds etc. are lightly regulated. They are specifically exempt from the disclosure requirements of the US Investment Company Act of 1940 through one of two exemptions, or safe harbours. These are available to funds not advertised or offered to the general public. The funds are only offered to accredited investors.
You might think, “I’m just an average Jane. The companies selling these securities can’t offer them to me. So I’m safe.” Here’s why you should think again. If you have a life insurance or annuities contract, your insurer might be using your funds to make such investments. Here’s from a recent industry review by AM Best:
Schedule BA is a “catch-all” schedule for non-traditional asset classes, including private equity, hedge funds and unsecured loans. Many of these are on my list of 7 asset classes to beware of. From AM Best’s report, insurers’ allocation to these has increased to 7.6% by 2019 Sep 30th.
You might also think that your insurance policy is between yourself and the insurer, and they have an obligation to deliver their promise to you. You would be partly right: the insurer’s promise to you would typically be very low on guarantees if any is offered. Given the way regulators calculate insurers’ capital requirements, most insurers would stick to the principles of asset-liability matching. They would mostly back guarantees with fixed income assets. The other assets, including Schedule BA assets, would be matching non-guaranteed liabilities. This keeps the insurers’ capital requirements in holding such risky assets low. This is possible because policyholders, yourself included, are the loss-absorbing capacity.
So it is crucial for you to see what type of insurance and annuity contracts you have. If you do not yet know, it is time to check if your contract allows for such assets.
Hedge funds
The term “hedge fund” originated in 1949 with the establishment of A.W.Jones & Co. The firm operated in relative obscurity until a Fortune magazine article spotlighted its founder Alfred Winslow Jones in 1966 April. Since then, the fortune of the industry has waxed and waned with the market cycle.
Why you should beware of hedge funds
There are three reasons you want to steer clear of hedge funds as a retail investor.
- disclosure: earlier in this post, I mentioned that hedge funds have much lesser disclosure requirements than typical mutual funds. If you have exposures to them via either a life insurance or annuity contract or other retail funds, I am certain you will not know how your indirect hedge fund investment is doing. That is despite you paying their fees.
- fees: you can invest in ETFs and pay as little as 0.09% or 9 basis points per year, and the more expensive mutual funds might set you back 1.5% per year. Hedge funds typically go by 2-and-20. That is, they charge you (a) 2% per year, and (b) of the profits they make above a certain threshold, the fund managers take another 20%. If your insurance or annuity fund invest in hedge funds, you are paying this fee. Further, you also pay your insurance company an additional fee for this privilege.
- leverage: due to its lax regulations, hedge funds can very much do what they like, including borrowing money to place high-conviction bets. Long Term Capital Management collapsed due to use of excessive leverage in 1998. More than 20 years later, regulators have yet to regulate the use of leverage by such funds. In fact, it was only earlier this year that The European Securities and Markets Authority (ESMA) launched a public consultation on a draft guidance to address leverage risks in the Alternative Investment Fund (AIF) sector.
Private equity funds
Private equity is probably the oldest form of financing there is. The first stock exchange where equities are publicly traded only started in Holland in the 15th century. These days, many high growth companies are still private. When Amazon went public in 1997 May, when it was barely 3 years old. AirBnB filed for an IPO earlier this week, 12 years after its founding in 2008.
Buy-out funds
There are broadly two types of private equity funds: buy-out funds and venture capital funds. Buy-out funds acquire public companies, converting them into private companies before listing them again or selling them on to other PE funds. The better publicized of these are KKR, Apollo and Blackstone. In 2007, KKR led the largest buyout ever, at US$48 billion, of TXU, a Texas utility company. Warren Buffett joined the party, buying US$2 billion of debt of the debt issued to fund the deal. The newly formed company was Energy Future Holdings. In 2014, the company filed for bankruptcy. Buffett’s Berkshire Hathaway took a write-down of almost US$900 million, according to p17 of the 2013 Shareholder Letter.
Venture capital funds
Venture capital funds provide financing to start-up companies. Even Apple, the reigning largest publicly listed company with a market cap of US$2 trillion, raised funds from VC during its early days. Surely it must be good to invest in VC to spur innovation and entrepreneurial spirit? The truth is more nuanced, according to a Harvard study:
Behind the anecdotes about Apple, Facebook, and Google are numbers showing that many more venture-backed start-ups fail than succeed. And VCs themselves aren’t much better at generating returns. For more than a decade the stock markets have outperformed most of them, and since 1999 VC funds on average have barely broken even.
Diane Mulcahy, HBR 2013 May: Six Myths About Venture Capitalists
Why you should beware of PE funds
The reasons PE funds is on the list of 7 asset classes to beware of are very similar to that for hedge funds: disclosure, fees and leverage. The main issue, from the perspective of an investor, is returns. The PE industry is one that argues for the use of the Internal Rate of Returns (IRR) as its performance measure. As the Oxford don Ludovic Phalippou pointed out in this paper, this measure is seriously flawed as it gives unduly significance to early years cashflows. Consequently, the older funds typically give very consistently high IRRs year after year. This turns many PE founders into billionaires but does not do much for the investors.
Richard Ennis, a money manager and institutional investment consultant, argues similarly in a recent article published in April in the Journal of Portfolio Management:
“alternative investments proved to be a serious drag on institutional fund performance during the study period.”
Richard M Ennis, 2020 April: Institutional Investment Strategy and Manager Choice: A Critique
If the before-fee returns of PE funds are not much better than that for listed equities, you can be sure that after paying the fees to the PE funds managers and your insurance managers, your return will be lower than that for listed equities. If your insurance or annuity managers invest via a secondary PE fund, you would be paying three levels of fees. And that’s after you took on the additional risks of investing in this asset class, such as lack of liquidity and transparency.
Collateralized Loan Obligations (CLOs)
These are very similar to the Collateralized Debt Obligations that caused so much havoc during the Global Financial Crisis in 2008-2009. Both are examples of a broader asset class known as Asset-backed securities. Essentially, investment banks (1) buy a whole bundle of bank loans from commercial banks, and (2) issue different tranches of fixed income securities to fund that purchase, using the payments from these loans as collateral. The difference between CLO and CDO is that CDO during GFC involves mostly mortgage loans, especially the subprime type. CLOs can involve a whole lot more different types of non-investment-grade loans to different industries.
Despite industry talk that the current industry standards for CLOs (CLO 2.0 or even CLO 3.0) is very different from the CLO 1.0 during the GFC, you can still find threads of commonalities.
Why you should beware of CLOs
The first is moral hazard or the loan originator’s skin in the game. One of the root causes of the collapse in CDO’s is that originator banks became nonchalant about the quality of the borrowers they make mortgage loans to. This is to be expected, as the bank can sell the risks of these to investment banks in a matter of months. Since then, regulators have required loan issuers to retain skin in the game, in the form of a 5% risk retention. The problem with this level is that, the impairment rate of AAA-rated CDOs during GFC was more than 50% – see p229 of the Financial Crisis Inquiry report.
The second reason to be wary about CLOs is the revolving nature of both structures. That is, CLO managers can buy new loans upon the maturing of existing loans. Managers, who are paid based on the size of managed assets, do this to keep the asset size of the CLOs steady. This gives rise to a potential slide down the risk curve. When credit markets are hot, lenders compete with each other by relaxing loan covenants. In fact, Janet Yellen, former FED Chairman, warned about declining loan standards in 2018 October. Managers would argue that credit rating agencies rate and review CLOs. My retort is that so were CDOs. I would also hazard a guess that the frequency of reviews by credit rating agencies is much less than that of CLOs managers revolving their assets.
Summary – Part 1
In Part 1 of this 2-part series, I listed the 7 asset classes to beware of. I also explained why you might already be exposed to these asset classes. This is even if you are not an accredited investor. I also explained in layman terms what each of the following asset classes is, and why I think you should avoid them:
- Hedge funds;
- Private equity funds;
- Collateralized Loan Obligations (CLOs);
Please tune in next week for Part 2, where I will cover the remaining four asset classes.
