What do Bradford & Bingley, AIG, Wachovia and Lehman Brothers all have in common – apart from the small matter of their role in the global financial crisis? The answer is that their fates underline the importance of two often overlooked types of investment risk: “fat tail risk” and “counterparty risk”.
Private investors need to understand the havoc they can wreak on portfolios – especially those who, like me, have bought exchange traded funds (ETFs) and structured products.
A reader wrote to me complaining – rightly, I concede – that in previous columns on ETFs and listed structured products, I didn’t mention them overtly. So let me explain them now.
Fat-tail risk is a slightly bizarre description of a simple concept. Statisticians state that phenomena such as height, exam results, as well as share price returns, tend to form a simple bell curve. The freaky, extreme events occur at very low levels – as “outliers” on a graph of outcomes. But quantitative financial engineers love to talk about the fat tail – which suggests that the chance of really nasty, extreme events is not that unlikely. At a recent conference, I met some analysts from a firm called FinAnalytica with some amazing graphs that suggested big events happen on average every 233 days! So the chances of what we regard as a “freaky” event – such as a 50 per cent share price fall – are much higher than we imagine.
Therefore, this fat tail matters to structured products offering capital protection only if an index doesn’t fall through a barrier level – for example, 50 per cent below its starting point.
Many, if not most, fat tail events end up hitting the banks that tend to be on the wrong end of the trades. And this can give rise to counterparty risk.
Counterparty risk is the risk that the institution on the other side of a trade you’re exposed to defaults or goes bankrupt. So it also matters to adventurous types who hold ETFs and structured products.
Some structured product providers have been reluctant to admit that they used Lehman as counterparty on their offerings to retail investors. But the bush telegraph suggests that plenty did. And a number of Merrill Lynch’s listed structured products involve senior debt with Bradford & Bingley.
These risks need to be understood in the ETF sector, too. Some of the ETF providers, such as iShares, use a method of tracking the market called “full replication”. It is used by the big unit trust tracker funds, such as Fidelity. This means buying or sampling the market by holding its constituent shares in a segregated account to offset possible manager failure. However, other ETF providers use a different system called “synthetic replication”, in which up to 10 per cent of the underlying portfolio is invested in “swaps”.
These swaps are issued by big financial institutions and other third parties that guarantee to pay out the “tracked” index return via derivatives contracts.
Before you scream at your stockbroker to sell all ETFs, this doesn’t mean it’s a bad concept. These swaps keep tracking error to a minimum and trading costs low and they allow investors to invest in difficult to access and illiquid markets.
Still, there are some additional risks that the financial crisis has brought to light. Paul Amery, European editor of the Index Universe website, notes: “Investors should be aware that the collateral held to back the swap may have nothing to do with the market being tracked. There’s nothing inherently wrong with this, but it means that, in the case of default, the investor may acquire something a bit unexpected.”
Admittedly, you don’t get big returns without risk. But, I agree with Amery’s view that “this whole area of counterparty risk is one that was not well-explained by product providers and now it will have to be.” That’s no bad thing.
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