Swedroe: Complexity In Funds Will Cost You

May 30, 2017

NASCAR racing automobiles are very sophisticated and complex automobiles. In the hands of a Mario Andretti, they are capable of great feats. The same machine in the hands of a drunk driver, however, is a very dangerous vehicle.

Complex financial strategies and instruments such as short selling, derivatives (such as options) and the use of leverage are the financial equivalents of racing cars—they are dual natured, with the ability to either lead funds to safety or to greater risk-taking.

The past 15 years has seen a dramatic increase in the complexity of mutual funds as more funds are given the authority to use leverage, short sales and options—more than 40% of domestic equity funds have reported using at least one of these instruments over this period. And the percentage of equity mutual funds that can use all three (leverage, short sales and options) increased from 26% in 1999 to 63% in 2015.

‘Betting Against Beta’

In theory, these complex investment strategies should enable sophisticated investors to more efficiently exploit profitable trading opportunities. The reason is, as my co-author Andrew Berkin and I explain in our new book, “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today,” there’s strong evidence that leverage and margin constraints drive up prices on high-beta stocks relative to low-beta stocks.

This effect leads to a profitable “betting against beta” strategy for unconstrained investors with access to complex instruments. In addition, mutual funds can also use complex instruments to manage and hedge risk as well as to reduce transaction costs and costs associated with fund flows.

Paul Calluzzo, Fabio Moneta and Selim Topaloglu, authors of the March 2017 study “Use of Leverage, Short Sales, and Options by Mutual Funds,” contribute to the literature by examining the question: “Does complex instrument use by mutual funds benefit or harm fund shareholders?”

They note: “Open-end funds can use leverage as long as they maintain the asset coverage requirement of at least 300% (i.e., the fund’s net assets plus market value of the written options and/or the securities sold short divided by market value of the written options and/or the securities sold short is at least 300%).” Their study covers the period 1999 through 2015, and their data set includes almost 4,800 funds.

 

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