The Investment Scientist

The investment risks you don’t see

Posted on: February 8, 2010

When talking to a prospect about my advisor services, I would ask him his philosophy about risk. The conversation would usually go like this:

Prospect: “I don’t like losing money.”
Me: “What do you mean? Can you be more specific?”
Prospect: “I don’t mind giving up a little upside; I just don’t want to lose too much on the downside.”
Me: “So you are concerned about volatility risk?”
Prospect: “That’s it.”
Me: “Other than that, are there risks you are concerned about?”
.. (long pause)
Prospect: “Not that I can think of.”

It is not surprising that most investors equate investment risk to volatility; they see assets prices (and their portfolio values) fluctuate every day. But there is much more to investment risk than what meets the eye. And what investors don’t see usually is far more insidious. For example:

Asymmetric information risk

To reduce portfolio volatility, some high-net-worth investors are big into the so-called non-correlated asset classes like absolute return hedge funds and managed futures. (In fact, they are not even asset classes, but that’s the subject for another post.)

During college, I bought a used Honda. It ran fine for two weeks, then the engine just died. To this day, I still remember vividly how the seller touted Honda’s stellar quality; she just didn’t mention there was a serious problem with the engine.

Hedge funds and managed futures are not unlike the used-car sales business in that disclosures are voluntary. You can be sure that all information that is disclosed is good; you just don’t know what skeleton is in the closet. Yet, despite numerous academic studies that show hedge funds and managed futures on average destroy value, high-net-worth investors still flock to them like sheep to the slaughterhouse.

Agency risk

Many investors invest through funds of funds-the type of funds that, according to their glossy brochures, would do the due diligence for you and invest your money in multiple hedge funds to achieve optimal diversification. Little do investors know, the main objective of funds of funds is not to do due diligence for investors, but to gather assets from them for less-than-stellar hedge funds. No wonder David Swensen called them “cancer” of the institutional investment world.

Over the years, many funds of funds channeled money to Bernie Madoff; none found out that Bernie Madoff Investment Securities LLC’s accounting was done by a hole in the wall in upstate New York. As far as due diligence goes, these funds of funds didn’t even do the bare minimum.

Investing through funds of funds is like hiring a seller’s agent to buy your house. You might think he works for you, but he certainly does not.

(Repost from my Morningstar Advisor column.)

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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