Brent Sheather: Who pays for the free lunch?

One of the defining features of the personal investment market during the past 20 years has been the increasing number and complexity of products available.

Before 1984, it was difficult even to invest overseas but today mum and dad are as likely to have hedge funds and collateralised debt obligations (CDOs) in their portfolios as individual New Zealand shares.

In the present benign economic environment, it is not obligatory to know just how a CDO works or indeed even that they comprise a major part of your portfolio.

Many investors appear to be happy just as long as the income stream continues to flow and the quarterly reports look OK.

The wider investment universe available to mum and dad has certainly been good for the financial planning industry - sustaining wide margins and high annual fees. Indeed, one can't help but wonder whether some of the more esoteric instruments are being made available to retail investors more as a result of demand from advisers for high-margin products capable of sustaining hefty annual fees in a more general low-return environment rather than any genuine need from mum and dad.

Besides the fee bonanza, the other feature of many of the new products is risk and whether, in a less friendly environment, it is controlled or not.

Usually risk is measured in terms of the variability of returns or standard deviation. Indeed, much of the excitement for hedge funds is the fact that they can achieve reasonable returns at low levels of risk, where risk is defined as the standard deviation of returns.

Herein lies a potential problem. Harry Kat, professor of risk management at the Cass Business School in London, says "risk is one word but not one number". In a recent paper in the Financial Times, Kat outlines the basics of portfolio risk management - that if one invests in two different shares the volatility of that portfolio is likely to be less than that of a single-stock portfolio.

Thus one of the key aspects of successful diversification is to combine assets or asset classes which are not strongly related. Traditionally, this has meant bonds which are nominal assets combined with equities which are real assets.

Today, however, returns from many bonds are low; too low to sustain a decent annual fee. Investors are thus being told that they can get similar diversification benefits to bonds from combining hedge funds with their share portfolios while earning a better return than from bonds.

Kat says fair enough but that isn't the whole story. While the standard deviation of a share portfolio will be lowered by the addition of hedge funds there can be other unpleasant side effects: little known statistics by the names of kurtosis and skewness. Skewness measures whether there is a relatively high probability of a nasty or pleasant surprise while kurtosis measures the probability of an extreme outcome, either positive or negative.

Kat says: "Since, for long-term investors, compounding effects are extremely important, they will want to avoid big intermediate losses. Most investors will, therefore, want skewness to be as high [positive] and kurtosis to be as low as possible."

Kat warns that the effect of adding hedge funds to portfolios may be to reduce standard deviation but, sometimes at the same time, skewness falls and kurtosis increases. "In that case, there is no true free lunch as the investor pays for a lower standard deviation by accepting less appealing skewness and/or kurtosis characteristics." Are mum and dad ready for an extreme outcome?

The possibility of extreme financial outcomes actually happening has been exercising the minds of many of the world's financial luminaries including Alan Greenspan and Bill Gross, bond guru of Pimco. The potential for disaster has rarely been greater: The derivatives market, of which CDOs are a small part, apparently has a worth 22x that of US gross domestic product. Part of CDOs' attractions is that they pay high interest rates and return your capital providing there are no "extreme credit events". If, however, things do turn nasty and five or so stocks out of a 100 company-CDO portfolio go bust, bingo you can lose everything. That's rather extreme.

Options trader and writer Nassim Taleb makes a living from exploiting the tendency of investors to underestimate the incidence of extreme events and he has written a book Fooled By Randomness. He calls these unlikely events black swans: Most swans are white but, once in a while, a black one turns up and because their incidence is apparently random they are impossible to predict.

Faced with uncertainty on this scale, "the market" simply doesn't price the event. For long periods of time, a product or strategy produces high returns while exhibiting "normal" volatility thus encouraging investors to commit more funds.

Then out of the blue, the product suddenly blows up. There have been several high-profile international examples of black swans, including the demise of giant hedge fund Long Term Credit Management a few years ago.

Local investors have also incurred substantial losses due to black-swan type events. Back in the early 90s, a US-based hedge fund was promoted to Kiwi investors as generating equity-like returns with bond-like levels of risk. The managers had numerous university degrees and looked sensible. All went well for a couple of years then, suddenly, the wheels fell off the product and investors lost virtually everything.

Warren Buffet has famously stated that he doesn't invest in anything he doesn't fully understand. Good advice for investors and their advisers.

* Brent Sheather is a Whakatane-based investment adviser