The mosquito in passive investing

Posted by Peter McGahan

Don't get caught out by not checking the details on 'safe bet' investments. Invest in what you understand, and what is understandable by you, or your advisers. Peter McGahan explains.

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I remember the Virgin tracker fund launched back in the mid 90’s. This was supposed to be a low-cost way for investors to grow their money by avoiding expensive managers. From memory, the annual fee was, however c1%.

Since then, those fees have plummeted, and investors can access one tracker today for an ongoing charge figure of just 0.02%.

The benefit of passive investing (trackers, exchange-traded funds) is well documented, but some investors appear not to be aware of a few of the risks.

Over the last 31 years I have been asked to review many investment products sold or promoted as ‘simple’ or a ‘small risk’. Mosquitoes are small.

One such example was zero dividend preference shares. When measured by basic risk parameters, they appeared as low risk as cash. There was little or no movement in their prices at all, so everything appeared rosy. In fact, many of those purchased had a negative hurdle rate, meaning the assets could fall in value by say 10% per year, but the fund would pay out in full.

What could go wrong? Well…everything.

What was a ‘safe as houses’ marketed plan had intricacies most financial advisers didn’t understand, let alone the layman.

Managers chasing and squeezing extra returns here and there, borrowed and bought riskier shares and junk bonds. When the markets tumbled, managers were forced to renegotiate bank debts, started buying shares in each other’s funds, and the pyramid Jenga pile collapsed, with investors receiving valuations in pennies from their £100,000 ‘safe’ investment.

If investors knew such a scheme was so complicated would they have invested?

The key is to invest in what you understand, and what is understandable by you, or your advisers.

And that is where stock, or securities lending comes into play inside passive investing. Bear with me on the technicalities, but to explain:

Large institutional investors swap equities, bonds and cash with each other, a practice that has been going on for some time. This naturally carries risks. What are you swapping with and who?

Hedge funds make money in many ways, but one of those is to bet on a stock falling in price (shorting). When they want to do that bet, they can borrow money from a passive fund for a fee, and they then offer collateral to the passive in the form of cash, stocks or bonds. The hedge fund then sells the stock it wants to short, and buys it back when it has fallen, making money on the gap in the new price and the short bet. The upside for the passive is the extra fees it can generate for lending.

The risk comes where the collateral offered is not of the same value/safety as that which is loaned. There are examples of passives where most of their securities are held out on loan and where the security is a complete mismatch i.e. bonds and equities being swapped.

Where cash is given as collateral, the passive manager is then forced to invest that cash to receive a return, thereby putting further risk into the passive.

For example, managers in U.S. passives bought what they were thought were low risk bonds in 2008, only for them to tank. In the U.S., cash is often given as collateral which escalates the risk significantly.

The correct process is for the passive to have a policy in place that limits downsides to investors, and for all securities and stock lending to be publicised so your financial adviser can make that decision for you. These rules are already in place by the EU to ensure transparency.

Added to this, many passives have a policy of indemnifying you if the counterparty goes belly up.

Synthetic passives are a slightly different mosquito, where managers use derivatives to replicate performance. These agreements are with counterparties who can simply not meet their obligations. Whilst they have died off in popularity, they are still around.

So have a check what you have, and be sure to take any mosquitos out of your net so you sleep well.

About the author

Peter McGahan is Chief Executive of Independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. 

If you would like your passive investments reviewed, please call 01872 222422, email info@wwfp.net or visit us on www.wwfp.net.

 

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