(James Saft is a Reuters columnist. The opinions expressed are his own)
By James Saft
May 28 (Reuters) - Investors appear to have forgotten two prime lessons of the last crisis: complexity is expensive and leverage is dangerous.
Not that you have to look far, but two recent trends - funds which mimic hedge fund strategies and leveraged exchange-traded funds - exemplify the extent to which five years of market gains and easy central bank money have lulled investors.
It is almost as if the financial crisis never happened.
First, let’s look at leveraged ETFs - exchange traded vehicles which use derivatives or other means to create leverage and amplify gains and losses - which have multiplied and come in for increasing criticism.
“We’d never do one (a leveraged ETF),” BlackRock Inc Chief Executive Larry Fink said on Wednesday. “They have a structural problem that could blow up the whole industry one day.”
Not only are they typically engineered to achieve their objectives over short periods, as opposed to being long-term holding products, the search for something to appeal to risk-hungry investors is taking them into ever-more arcane areas of the financial markets.
Take, for example, the proposed AdvisorShares Pacific Asset Enhanced Floating Rate ETF, currently awaiting approval from the Securities and Exchange Commission. (here) It will use derivatives to magnify bets on floating-rate, high yield bonds, stuff safely classified as junk.
Dissatisfied with the tiny yields on offer if you take credit risk on companies which themselves are often already highly leveraged?
Just borrow money to make those returns bigger.
Of course you ought to remember that not only is your return going to be magnified, so are your losses. And note too that this is a difficult part of the market in which to transact if ever things get hairy.
“Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time,” James Montier of fund manager GMO wrote last year.
Now to be sure, leveraged ETFs are only 1.2 percent or so of the $2.5 trillion global ETF market, but this is not the only sign that a long bull market with low volatility has lulled investors into taking on more risk.
While margin lending is now down from all-time peaks hit earlier this year, there is anecdotal evidence that brokerages are doing more lending against portfolios for purchasing things other than securities.
These loans, which are secured by investments held with the broker, allow clients to borrow as much as 95 percent of the value of their holdings and then use the funds elsewhere, often to buy vacation or rental housing. The problem, of course, is that your holding can get sold out from under you, at exactly the wrong time, if the market takes a tumble and the margin clerk gets nervous.
While the dangers of leverage are easy and instinctual to understand, perhaps the real enemy of the average investor is complexity, another thing which is making a roaring comeback.
Complexity is expensive for at least two reasons. Every bit of fancy footwork, be it a derivative bet or a complex hedging technique, costs money, money which is a sure thing while the supposed benefits are only speculative. Complexity is also the great friend of the intermediary, making it easier to load up unsuspecting investors with costs.
Look, for example, at the newly burgeoning market for so-called liquid-alternative funds, recently highlighted by the Wall Street Journal and, particularly amusingly, by Joshua Brown, an investment advisor for high net worth clients. (here) (here)
Available to run-of-the-mill clients, these funds, like the hedge funds they mimic, follow a myriad of alternative strategies and generally sell themselves as offering a hedge against long-only investment.
Such funds accounted for almost half of net fund sales at broker-dealer houses in 2013, according to a study done for the Money Management Institute. (here)
Little wonder, Morningstar puts the costs of these funds at almost 2.5 times those of an index fund, and nearly half again as much as a traditional active mutual fund.
That brokers like to sell complex, high-costs funds isn’t new. That investors are increasingly willing to go along for the ride is.
Like the increased use of leverage, this rise in complex investments could go along for quite some time, but has historically been a warning sign for the market as a whole. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)