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return and derivatives

Some thoughts on risk,
return and derivatives

By now you have read about some of the horror stories related to derivatives. Orange County, Calif., is bankrupt; Barings PLC, Britain’s oldest merchant bank, was sold to a Dutch bank just before it was about to go bankrupt; and the Milwaukee Philharmonic lost a good portion of its endowment fund. Robert Citron, the chief financial officer of Orange County, lost $2 billion at last count. Nicholas Leeson, the 28-year-old Barings trader, bet $29 billion and managed to lose $1 billion. Piper Jaffray Inc., a leading regional brokerage firm in Minneapolis, lost more than $5 million for the orchestra and had significant losses in other major accounts.
What are derivatives and how could this happen?
A derivative by definition is an indirect investment whose price is determined by other prices, for example interest rates on U.S. treasury bonds, the Nikkei index or commodities prices. For example, if you buy a share of stock in General Motors Corp. you are making a direct investment in a corporation. If you buy a created security that goes up or down based on the overall performance of the Japanese stock market, or the U.S. treasury bond market, then you have just bought a derivative.
A group of mathematical misfits on Wall Street have taken this concept and created a series of extremely complex investment vehicles. Some of them are so complex that I’m convinced even the people who created them really don’t understand them.
The traditional stock and bond markets have been analyzed for over a hundred years in terms of the potential risk and return to investors. If you decide to invest in the stock market, an investment adviser is capable of telling you what the expected return and expected risk of such an investment would be. For example, the stock market in the United States has had an average return in the 10 percent range for a long period of time, and the risk is very identifiable through the computation of measures such as the standard deviation or the beta of the stock market. This doesn’t mean that the return in any given year of a diversified investment in the New York Stock Exchange will be 10 percent, or that the risk will be exactly as measured over the last 100 years, but it does give the investor a series of parameters from which they can make decisions. If you stay in the market long enough, you will probably be close to the long-term average.
The problem with derivatives was that because they are newly created products there is no way to measure the real risk and return of these investments. It would be similar to going to Las Vegas and shooting craps with no idea of what the odds might be of rolling a seven.
So individual investors and investment managers have placed bets on derivative products without really understanding the odds of the game.
The mathematical geniuses behind these products created programs that made them look less risky than they really were. There is a tendency to do this when you are trying to sell something. That is another thing to think about in this entire equation. Commissions on regular stock trades and mutual fund sales have been declining for years and Wall Street firms have been looking for ways to augment earnings. One advantage of derivatives is that they are so complex that in some cases it is almost impossible to determine the fees. If you buy 100 shares of stock or a mutual fund, you are absolutely aware of the brokerage commission. I am convinced that many of the buyers of derivatives not only didn’t understand the risks they were taking, but they had no idea of the level of fees.
My experience with derivatives is limited, but educational. Several firms approached Essex with various products of this type and wanted us to sell them to some of our largest clients. During several meetings we were mystified by the complexity of the products and concerned about our difficulty in understanding them. I was a math major in college, have been in the business for 25 years, and I had no idea what they were talking about.
The use of derivatives is more widespread than you may think. A study by the Investment Company Institute indicates that at least 18 percent of the stock mutual funds have said they use derivatives. The derivative of choice in a stock fund seems to be a forward currency contract. Also, it is estimated that more than 25 percent of bond funds use derivatives.
To be fair about this, I should say that in many cases the derivatives purchased by these funds are actually used to reduce portfolio risk and in many cases they effectively do that. I should also mention that not all derivative investments have lost money. For every loss there is some person or investing entity on the other side of the transaction making money.
My only question is, did the people on both sides of the transaction understand exactly what kind of risk they were taking?
I have a rule of thumb that in a general way deals with derivatives, real estate, December Maine potatoes and even Hillary’s cattle futures: Don’t ever make an investment unless you fully understand the risk and return characteristics. It may be very reasonable in certain circumstances to take more risk, as long as you understand how much you are taking and as long as the potential return is that much higher. Mr. Citron in Orange County, Mr. Leeson of Barings PLC and Piper Jaffray in Minneapolis did not follow this rule. Maybe they decided not to be concerned because it wasn’t their money. I would suggest that it is always up to us to analyze potential risks, because what we are talking about here is our money.
(John Mooney is president of Essex Investment Group Inc., a diversified financial services firm and real estate developer.)

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