November 14, 2010

A Good Hedge Beats Leverage

The global financial crisis was fueled by excessive risk-taking, asset managers point out.

The Dow took a 2.2% haircut this past week. Since stocks on average generate returns of 6.5% above the rate of inflation per year, and the current inflation rate is 1.4%, this past week has wiped out more than a quarter of the annual return an investor might expect for the risk he has taken with his investment funds.

With the Fed’s launch of QE2, and this week’s options expirations, the conventional wisdom of late has been to expect a big rally. If you were anticipating a big rally, you might have invested in leveraged funds that double or triple the performance of a market index, and lost 4% or 6% this past week, wiping out half or more of a year’s expected stock gains.

If the market collapse of 2007-2009 demonstrated anything, it is that a sudden and unexpected loss of liquidity has the potential to bring about significant losses on leveraged strategies. The legions of Americans whose real estate investments remain underwater remain well aware of this fact, but stock investors after such a long rally may be starting to forget this fact.

Historical amnesia is an all too common malady. Our awareness of the fact that there are determined enemies out to destroy us and our civilization was heightened in the aftermath of 9/11, but has long since subsided. The decline may have begun when we imposed on airline passengers the indignity of removing shoes because one terrorist used shoes as a terror tactic, and it continues today with our war against printer toner cartridges after the Yemen cargo plot.

In the investment arena, we dare not forget that the crisis was fueled by excessive risk-taking. A new report from the Research Foundation of CFA Institute brings together lessons learned from top-level people in the financial services world, who offer their perspectives anonymously.

For example, an asset manager states: “I cannot believe anyone understood the layers of leverage in collateralized debt obligations squared (CDOs-squared) and collateralized debt obligations cubed (CDOs-cubed).”

For those not hip to the lingo, CDOs “squared” were CDOs whose collateral were tranches of other CDOs, and CDOs “cubed” were CDOs backed by tranches of CDOs and CDOs-squared.

Another asset manager states, in discussing risk: “Never underestimate greed, in the broadest sense of the term; the power of capitalism to reward risk taking is good, but people’s behavior is not necessarily self-moderating. It has led to trouble, to lax lending, and to lax underwriting standards. It makes it easy to make money. When things go wrong, really wrong, just about everyone is complicit.”

Financial advisors can eschew complicity in their clients’ portfolio blow-ups by backing off of leverage, and bulking up on portfolio hedging. In the last crash, it was said that “all correlations went to 1.0” Advisors must think hedge rather than leverage.

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