Top five failings of financial products

Putting together a list of the most common faults I have encountered in more than five years reviewing financial products for Eureka Report took much less time than I had anticipated: For one simple reason…’short gamma’.

Now ‘short gamma’ may sound a little esoteric but it’s an academic word for the business of selling things at the wrong time or to put it into the context of this exercise a financial institutions selling investments on your behalf at a bad time, invariably driven by some technicality or self-imposed regulation.

Of course selling assets just because the price is falling doesn’t make sense if you are a long term investor, and the ongoing fundamentals of the investment stack up. You’d probably never initiate such wasteful behaviour on ‘your own account’ but it happens all the time in institutional markets…in fact ‘short gamma’ is the core issue in the first three of the five common failings I have identified. (You can see Eureka Report Managing Editor James Kirby and myself discussing these issues in the video above).

 As you’ll see in every instance, financial products offer the privilege of a service for which you may spend way too much: The question for you to ask can only be… is it worth paying these prices for such services? Here are my answers:

Expensive Leverage

This failing is most perfectly typified by margin lending. With typical “loan to value ratios” of around 70%, investors must provide $30 from their own funds to supplement the $70 a margin lender will advance against the security of a share with a current price of $100. The margin lender needs this LVR to be maintained, so when the share price falls, the borrower is required to provide additional cash collateral; failing which, the margin lender will sell down some of the shares, typically at a loss compared to their initial purchase price. Debacles like Storm Financial show the severe risk of financial loss that margin lending creates – especially since borrower’s personal assets will also be taken as security for access in the event of unmet losses being incurred.

Expensive Protection

Security is always expensive… but it’s often very high when it comes to capital protected or ‘CPPI Structured’ products. Popular before the GFC, these capital protected products use technology known as “constant proportion portfolio insurance” (“CPPI”) which is pure “short gamma” – the products are forced to sell underlying assets when markets fall, placing the sale proceeds into a zero coupon bond which will grow in value to be equal to the protected value of the structured product at its maturity date.

When markets fall hard as they did in the GFC, these CPPI products are forced sellers of their whole portfolio, setting up what is known as “cash lock” – where all the value of the product is locked up in the zero coupon bond which is now being relied upon to provide capital protection at maturity.

 As a result, all dividends or other income from the initial portfolio ceases, and the product can no longer participate in capital growth if the markets subsequently recover. This loss of income and capital growth proved devastating for many structured product investors after the GFC, especially those using borrowed funds with ongoing interest servicing costs.

Expensive trading

Traditional actively managed funds. As we described above, actively managed “benchmark aware” funds are “short gamma,” and this can be measured in the high levels of turnover experienced by traditional funds. Towers Watson has reported that the average turnover of a traditional Australian actively managed share fund can be as high as 80% pa, as funds sell down and buy-in to their portfolio. This high turnover generates high levels of tax inefficiency compared to a concentrated, “buy and hold” style portfolio. The tax drag of the traditional active fund is around 0.60% pa – ie, the high turnover fund needs to add 0.60% pa just to break even with the returns from the same portfolio held within a low turnover fund.

 Expensive Sectoral Bias

 “Benchmark aware” managed funds or structured products can hold assets which may from time to time not be of “investable quality.” Often this is in the name of adding diversification, such as with traditional international share funds. These invest across a wide range of markets in line with the representation each market has to the overall global market. The most common benchmark for international share funds, known as the MSCI index, is compiled by measuring the total market capitalization of a specific country’s sharemarket (eg the USA) and pro-rating that against total global sharemarket capitalization. Traditional international funds which are benchmarked against the MSCI index are forced to invest in these markets even when their prospects are negative or weak. It’s obvious for example that investing into currently weak European markets is a poor use of investment capital – far better to wait to invest when those markets begin to improve. Structured products with exposure to exotic assets or markets – wrapped in the security of a capital guarantee – similarly can be an inefficient form of investment if the assets or market don’t perform well.

Expensive Diversification

“Strategic asset allocation” used to be seen as the best way to build a portfolio, relying on the idea that diversification can help protect a portfolio when some asset classes fall in value (the idea being that uncorrelated assets shouldn’t all fall in value at the same time). The GFC showed that SAA doesn’t work in times of financial distress – and diversified managed funds or portfolios built using this traditional method failed to deliver the capital preservation that was expected. This failing has led to the observation of the problems with “sequencing risk” by commentators like Ken Henry – the idea that sharp falls in asset prices expose older investors to more significant risks than earlier stage investors. In fact, the problems with SAA have prompted a profound search within the investment management industry for more robust alternatives, including concepts such as “Dynamic Asset Allocation” (typified by the slogan “risk on/risk off”) which are starting to emerge as product providers innovate.

It’s interesting to note that many SMSF investors avoid some or all of these typical failings of financial products, by investing in fundamentally sound assets and holding them for the longer term. Research of these investors’ attitudes show they are focused on capital growth and income, both of which can be enjoyed by buying well and holding unless and until the fundamentals of the investment become impaired.

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services. He is also a portfolio construction manager for BetaShares.