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.
Recap of Part 1
In Part 1 of this 2-part series, I explained why you might already be exposed to the 7 asset classes to beware of. This is even if you are not an accredited investor. I also explained in layman terms three of these asset classes, and why I think you should avoid them:
- Hedge funds;
- Private equity funds;
- Collateralized Loan Obligations (CLOs);
In Part 2 this week, I will cover the remaining four asset classes, reordering them slightly:
- Structured products;
- Derivatives;
- Subordinated bonds; and
- Capital securities.
Structured products
What they are
You can think of structured products as a super-category comprising asset-backed securities, such as the CDOs and CLOs mentioned last week. It also includes other structures involving the use of some form of derivatives. These include credit default swaps (CDS), CDS index products, and equity-linked structured products.
Structuring, in the context of investment, is the process of engineering new financial instrument from existing assets. Structured finance practitioners l had encountered take pride in their value-add in diversifying risks. They do this by splitting asset and liabilities cash flows and layering of one instrument on top of another. Through such machinations, these practitioners argue they greatly reduce the overall financial risks of the original assets and liabilities.
Why you should be wary
In an interview with The Atlantic in 2009, Paul Samuelson, the first American to win a Nobel prize in economics, reportedly said the following:
MIT and Wharton and University of Chicago created the financial engineering instruments, which, like Samson and Delilah, blinded every CEO — they didn’t realize the kind of leverage they were doing and they didn’t understand when they were really creating a real profit or a fictitious one.
Paul Samuelson, in The Atlantic, 2009 Jun 18: An Interview With Paul Samuelson, Part Two
Walter Isaacson is an American history professor and author. Amongst his published works are biographies of Einstein and Steve Jobs, and other books on innovators. One of these is The Innovators: How a Group of Inventors, Hackers, Geniuses, and Geeks Created the Digital Revolution. Isaacson’s opinion about financial engineering, given his work trying to understand how innovators and innovations work, is:
I think one problem we’ve had is that people who are smart and creative and innovative as engineers went into financial engineering.
Walter Isaacson, historian on innovators and innovation
Personal experience
As one who had been through the fall of Long Term Capital Management in 1998, and then the havoc caused by subprime mortgage and other forms of financial engineering in 2008 and 2009, I could not agree more with Samuelson and Isaacson. I have seen financial structuring people at work up-close and personal. They totally understand it is their employers who are paying them to reduce risks. They do not owe anyone else this service. Systemic risk is the least of their concerns, if at all. Once the risk gets out the door, what happens next to the guy on the street is none of their responsibility. That’s even if that guy is still on the company’s book as a retail customer. After all, the retail guy has next to no leverage against financial firms with resources that are orders of magnitude greater.
Being a retail person, you do not want to deal with these companies.
Derivatives
As its name implies, derivatives are a type of financial instrument which price is derived from another financial asset. A commonly known instrument is during falling equities market is the put option. This allows investors to sell (i.e. put) a certain amount of stock to the put-writer at a pre-specified price. This is a common instrument to execute a short trade. For example, the shorts in Wirecard made US$2.6 billion from the collapse of the German company’s share price.
Other than options, there is a whole cornucopia of derivatives out there. BIS tracks the major types of derivatives report here.
Why you should be wary
Options are not as cost-effective as some textbooks may have you believe. For a start, option premiums are calculated based on the stock’s volatility. As such, premiums can run to a few percent to low double-digit percentage of the stock’s price every year. From the Wirecard article, it sounded like the funds which shorted for years had a pyrrhic victory, if they did not go bust. Further, based on the article, short-sellers face regulatory risks. The regulator can ban such practice, meaning the writer does not have to honor the trade when its in the short seller’s favor.
Crises prone
Since the previously mentioned GFC 2008 and LTCM 1998, more recent derivatives related crises include:
- the oil ETF USO collapse: USO is an ETF based on US oil futures, a type of derivatives. Its price was down more than 80% for the year-to-date in 2020 May as oil prices collapsed;
- In 2018 Feb, Credit Suisse announced the closure of VelocityShares Daily Inverse VIX Short-Term exchange-traded note (XIV), after prices collapsed 80% in a single day. This was based on another type of derivative linked to the Chicago Board of Trade’s so-called fear index, VIX.
In all the above cases, professional managers made a living trading the derivatives. If there are losses, these were democratized to ordinary Joes, either directly or indirectly via taxation.
Given the frequency of derivatives related crises, it is no surprise that Bloomberg ran an article in 2019 April titled Derivatives are still too dangerous. The argument is that despite trying to organize derivatives activities around the clearinghouse, regulators had not ensured that these can stand up to stresses.
Subordinated bonds
Subordinated bonds, or more broadly subordinated debt, are a type of debt securities which rank below other more senior or secured securities. When the issuing company has insufficient earnings to pay all debt interests, subordinated bondholders only get paid after the senior bonds receive their full share. When a company defaults, subordinated bondholders only get a share of any remaining assets after the senior guys get their full share. Often, this means subordinated debt owners get nothing. As such subordinated debt are also called junior securities.
Why managers invest in subordinated bonds
So why would managers in asset houses and insurance companies invest in these instruments? There are two main reasons. The first is the one that investment managers would tell you. It is this:
“The current interest rate environment is what is called ZIRP. This stands for zero interest rate policy. All over the world, central banks policy rates are at record lows, many at zero (Euro area, Sweden) or even negative (Switzerland, Japan). As debt instruments are priced at a spread to these rates, many of these now pay meagre returns too. In order to generate higher returns with the clients’money, managers will have to take higher risks. This means going down the credit curve, by taking on lower-quality debt, even non-investment grade debt and junior debt. The historical performance of these instruments shows that, while there might be losses on specific issues, the overall portfolio would still deliver good returns. We are professionals, and we know how to avoid those bad issues.”
investment managers’ rationale for investing in subordinated bonds
Why managers really invest in subordinated bonds
There are some truth to the above. For a better idea of the motivation, however, you need to understand the second reason. This has to do with the term asymmetric risk-return. This refers to the uneven allocation of risk and return between retail investors and professional money managers. When the managers tilt towards riskier assets, they do so with these in mind:
- Should the bet turn out to be a winner, managers will receive a meaningful bonus for they had kept the retail investors happy. Hence, Heads – Managers win.
- Should the bet turn sour and retail clients lose money, the managers’ personal bank account will not suffer losses. At worse, they receive a lower bonus. If they are able to make less losses then their peers, they might even look forward to an above-market bonus. Hence, Tail – Managers don’t lose.
In fact, the asymmetric risk-return profile of the professional investment managers is a common theme across the 7 asset classes to beware of. Professional managers invest in risky assets on your behalf where they would not touch with a ten foot pole with their own money.
Capital securities
Capital securities are closely related to subordinated debt. They are core to how bank regulators attempt to shape the capital structure of banks following financial crises of the past few decades.
In 2003, BIS publishes the following paper on the use of bank subordinated debt in member countries. It found that over 50% of the banking assets in member countries were accounted for by subordinated debt. In fact, the BIS argued that such securities had the potential to promote indirect or secondary “market discipline”.
The GFC experience
The regulatory efforts, together with favourable market conditions prior to the GFC, led to the popularity of bank subordinated debt amongst institutional fixed-income investors. That was during a period of exceptionally low credit spreads, and these subordinated bonds over a yield pick-up over senior bonds.
During the GFC, however, the prices of bank subordinated debt collapsed. Some banks’ equity value was completely wiped out and holders of more senior securities faced significant uncertainties.
If at first, you don’t succeed
After the GFC, bank regulators regrouped and came up with the Basel III accord to avoid another GFC. To help banks meet Basel III capital requirements, a new capital instrument came on the scene in 2014: contingent convertibles for European banks, or CoCos for short. In US, regulators forbid the use of Cocos, but had preferred equity instead. Investors in such instruments risk being required to convert their securities into bank’s commons equity at a time of falling equity price. This would mean losses at two different levels. First, investors lose the higher yield. Next, they lose on the principal amount on the conversion of bonds to equity. Nevertheless, the popularity of these grew, “in a world of safer, lower-yielding products”. Sound familiar?
Conclusion
So there you have it, all 7 asset classes to beware of:
- Hedge funds;
- Private equity funds;
- Collateralized Loan Obligations (CLOs);
- Structured products;
- Derivatives;
- Subordinated bonds; and
- Capital securities.
Until we solve the problem of asymmetric risk-return for the retail investor versus investment managers, excess risks will always fall on those who can least bear it. You might not be able to avoid having your tax money fund the rescue of banks, insurance firms or asset management companies should they collapse. However, with the knowledge you learnt in these two posts, you will be well-equipped to avoid having to bear direct losses in the 7 asset classes to beware of.