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.
- Consistent with the motive to reduce transactions costs, funds are more likely to initiate complex instrument positions after they experience outflows.
- The use of complex instruments is associated with higher fees—0.07% higher annual fees relative to funds that choose not to use complex instruments, and 0.19% higher for funds that are not allowed to use complex instruments. Specifically, funds that use short sales have fees that are 0.14% higher, and funds that use options have fees that are 0.10% higher.
- Consistent with return distribution manipulation, funds are more likely to initiate complex instrument positions after poor performance and after experiencing high levels of risk—consistent with poorly performing funds trying to increase risk to catch up.
- The use of complex instruments is more likely to be initiated in funds with low levels of institutional ownership, which are likely to be less monitored and experience more intense agency problems.
- The use of complex instruments is associated with economically and statistically significant lower excess returns and four-factor alphas relative to funds that choose not to use them. Leverage, short sales and options were all associated with lower returns and lower alphas. “Specifically, the composite measure is associated with 0.59% lower annual excess return and 0.46% lower annual four-factor alpha.” And heavy users have significantly worse performance than light users.
- Negative excess returns are driven by all three types of instruments, but the negative alpha is most strongly associated with leverage use and bought options.
- While having no effect on standard deviation, complex instrument use is associated with undesirable outcomes—more idiosyncratic volatility, left skewness and higher kurtosis. However, market beta exposure is reduced, consistent with a hedging motive.
- Leverage is, of course, associated with greater risk, while short sales and option use are associated with lower standard deviation and beta exposure but more idiosyncratic volatility, left skewness and higher kurtosis. These negative effects are greatest among heavy users.
- Funds that use complex instruments have higher risk in their equity holdings than funds that choose not to use these instruments.
- Contrary to the expectation that funds would use leverage to exploit the low beta anomaly (low-beta stocks outperform high-beta stocks), funds that use leverage actually buy higher-beta stocks than funds that choose not to use leverage.
Shifting Of Risks
Calluzzo, Moneta and Topaloglu concluded that “funds that use these instruments decrease systematic risk but increase unsystematic risk.” This shifting of risks is not good for investors, as it decreases exposure to risks that are rewarded (systematic risks) and increases exposure to risks that are not (the market doesn’t reward investors with higher returns for taking risks that can be diversified away).
They also concluded: “The only setting where the use of complex instruments is not associated with negative shareholder outcomes is when funds use complex instruments in the presence of high levels of institutional ownership.”
In other words, institutional ownership likely constrains fund managers to limit the use of complex instruments to achieve positive outcomes, such as reducing transaction costs in the presence of fund flows.
The authors also note that their “results provide evidence that investors pay to access funds that use complex instruments. This result is unsurprising and aligns with the intuition that the more complex the product, the more it will cost.”
Unfortunately, their results also showed that investors were not getting value for the higher fees. In fact, they were paying higher fees while outcomes were worse. The only winners were the purveyors.
That said, it’s important to not “throw the baby out with the bathwater.” Complex instruments and the use of leverage can be used in ways that add value. One example, as mentioned above, is to reduce costs associated with fund flows, mitigating the harmful effects of liquidity demands created by outflows.
Also, leverage can be used to bet against beta and to create risk-parity-type portfolios, leveraging up low-risk assets to provide the same return as high-risk assets while providing diversification benefits.
AQR Style Premia Alternative Fund Class R6 (QSPRX) is a good example of a mutual fund that systematically provides exposure to well-documented factors that have provided premiums (value, momentum, defensive and carry). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR Capital Management funds in constructing client portfolios.)
The paper provides a simple way for investors to differentiate funds that use complex instruments in a positive way—screen for those with high institutional ownership.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.