For the better part of this year investment markets have been largely trendless. There have been many ups and downs but no clear breakout to either the down-side or the up-side. The current state of things, a slowing and fragile economy in Europe as well as issues with sovereign debt, better economic data in the US, and perhaps a more stable outlook in Asia with lower inflation and still good growth, support the view that we may be in for an extended period of up and down investment market performance. In such a market, and especially given the difficult investment market we recently suffered in 2008-2009, there is a tendency for investors to give up on mainstream investments such as stocks and bonds and to seek better investment returns in more exotic vehicles, or by employing more exotic investment strategies. These products and strategies are often poorly understood by the average investor and heavily sold by certain investment sales people because commissions to the advisor are usually quite high.I can’t get into all of the various investment products of which investors should beware here, but I will highlight a few.
Life-settlement contracts (also known as "viaticals"): Sponsors of these programs approach certain individuals offering to purchase their life insurance policies at a discount. The sellers of life insurance may be people who are terminally ill and would like to realize a cash value from their insurance policies before they die, or they may be people who no longer require life insurance and would like to “cash in” their policies. In certain cases the sponsor enters into a contract with at-risk people without life insurance to purchase a high-value policy in return for a cash payment. The sponsor pays the premiums until death in return for most of the proceeds at death. This pool of insurance contracts is made available to investors and usually sold as an asset that is uncorrelated to mainstream investment markets. The profitability of this investment depends on realizing the value of the life insurance contracts in a reasonable amount of time. The gain is the difference between the price paid for each insurance contract and the value of the contract when realized (less commissions, premiums, and other costs of course).
The little-understood risks of this investment include the following:
– The investment may not be well-diversified: Some life-settlement funds may have as few as 20 contracts underlying them. Given the difficulty of gauging a person’s life-span, even amongst the terminally ill, a poorly diversified portfolio carries substantial risks and is heavily dependent upon the skills of the sponsor.
– The sponsor may not have much skin in the game: Often the sponsor makes its money from fees paid by investors, not from realizing a gain on the underlying insurance contracts – so the motivation is to get investors, not to make sure the investment pans out.
– Legal risk: In the United States and many other countries, the beneficiary of a life insurance contract has to have what is called an “insurable interest” in the insured – meaning that the beneficiary would suffer financial harm if the insured died. Even if the sponsor figures a way around this provision, there may be the issue of fraud if the amount of insurance sold on a life is much greater than the person’s net worth. Recent cases in the US have voided life-settlement contracts and not allowed return of premiums where the amount of insurance was excessive – a losing proposition for life-settlement investors.
Privately-traded investment products: These investments can take a number of forms: Equity or debt of non-publicly traded companies, real estate, natural resource rights to oil, gas, timber, or other assets, to name a few. The common denominator is that these are investments that are not traded on the public markets. Often these investments are sold as a diversifier to a portfolio of mainstream investments under the premise that private investments are less volatile and not well-correlated to public markets. In fact the diversification benefits are often overstated and stem from the fact that it is more difficult to value privately-held property. Such investments are often only valued once per quarter, or even once per year. If you valued the stock market only once per quarter or once per year it would also be much less volatile and not as well correlated to the same market valued continuously. Privately-traded investments are heavily dependent upon the skills of the investment manager (as compared to publicly-traded investments that owe their returns to demand for the investment itself in addition to the manager’s skill).
Hidden risks include:
– Illiquidity: There may be a substantial lockup period when the investor cannot redeem his stake.
– Exorbitant fees and commissions: These eat into investor returns and are often not clearly spelled out or not transparently calculated.
– Opaque investments: Often the manager has a broad mandate as to how he can invest his clients’ money. While this may be desirable for a skilled manager, it makes it more difficult to position the investment within the context of a broader portfolio and to understand the asset class exposure. This last point is most important because often these types of investments are sold on the basis of the dividends they are expected to generate. Many privately held real estate funds lured investors in with dividends in the 7% to 10% range earlier last decade but stopped paying these dividends during the real estate crisis of 2008-2009. Investors were locked into a declining asset with maybe only quarterly or even annual redemptions possible and no dividends.
– Tax risk: Certain privately-held investments are sold for the tax benefits. This is often the case in the United States with interests in natural resource properties where tax breaks can be realized from depletion and operating costs. While the tax breaks are often genuine, the risk is that the tax laws may change (as happened in the mid-80’s with real estate limited partnerships), or that the investor must accept unlimited liability in order to realize some tax breaks (as in the case of general partnership interests in oil wells). Another tax issue could be that the investor might only be able to use tax losses generated from the investment against similar types of investments rather than against other income – in the case where the investor does not have offsetting gains in similar investments, the tax loss may not be realizable.
Exotic derivatives strategies: This is a very broad category but usually the strategy is sold as a less volatile investment which still has potential for upside if markets do well. A very simple example is a covered call strategy where the investor owns shares in a company and sells call options on these shares. A profit is realized from the sale of the calls, which mitigates some of the downside if the underlying shares fall in value. If the shares go up in price by less than the value of the calls sold then the investor still has a profit, but if the shares increase in value by more than the call value then the investor has a loss on the strategy as compared to not having sold the calls. While many such strategies do indeed mitigate volatility, it is important to consider whether this form of risk control is any better than, say, just holding more cash in a portfolio.
Hidden risks are mostly in the form of poorly-understood costs. For example, while the actual cost of buying or selling an option or other derivative may be minimal, the spread between the option purchase price and sale price (bid and ask) could be substantial – which would be important for a strategy that includes both a purchase/sale and subsequent sale/re-purchase of the same security. Furthermore, management fees for such strategies are often quite high; perhaps a base fee plus a performance fee. The investor may be better served by a simpler strategy that does not involve having to hire a high priced manager. Having said all that, a skilled investment manager could potentially add considerable value in certain circumstances by employing such strategies. For example, in the case where an investor has a large concentrated stock position, a good hedging program can help not only to mitigate downside but also to minimize the tax consequences of hedging the portfolio.
As with all investments; make sure you understand what it is you are buying and how and when you can get out of the investment before you jump in.