Modern Investing

by David Schneider

  I wish I could save you from studying this topic. It is complex and goes beyond any 101 class on investing. In fact, it is reserved for only the most serious gamblers and financial professionals—and perhaps lawmakers. But because these products in aggregate have become the largest market that has ever existed, we need to be aware of these instruments. I will try to be as brief and as entertaining as one can be when writing about financial WMDs.

  According to the Bank for International Settlements, the global derivatives market is now $1.2 quadrillion or $1,200 trillion. Compare this to the entire global equity market, which was estimated at US$69 trillion at the end of 2014. It represents less than 5% of the derivative’s market pie.

  Standard derivatives have been around for decades and are highly regulated. It is a controlled but leveraged, a side bet on other games such as stocks, bonds, and commodities. There are financial futures, forwards, options, warrants, etc. All simple forms of derivatives based on these broad asset classes are traded on exchanges or in private transactions over the counter (OTC). The most common and oldest forms of financial derivatives are commodity products such as corn, rice, or wheat. Farmers, who were unsure of their commodity prices at the end of a farming season, were able to fix their prices in advance, hence avoiding any negative price surprises in the future. They could still lose money if prices rose higher than they had expected, but they were able to plan ahead. For this kind of trade to function, a counterparty was necessary to guarantee these prices. These were the gamblers who speculated on either falling or rising prices. They were vital for this system to work.

  According to Investopedia’s definition: “A derivative is a security with a price that is dependent upon or derived from one or more underlying assets.“ But, the real cunning aspects of derivative contracts is that it introduces the factor of short-time periods and leverage to the equation, making derivatives much more complicated and suitable for gambling and betting on all possible future outcomes.

  When we consider the classic underlying instruments of standard derivatives, such as stocks, bonds or commodities, the element of time plays a secondary role. In the case of stocks, there aren't any time limits at all. Derivatives, however, include the aspect of financial options. They deal with much shorter periods. They contain the elements of financial leverage, as these products are purchased at a fraction of their actual contract size. Academia has published groundbreaking research on how to price these standard derivative products, and they have become part of any international stock exchange. But when we talk about modern derivatives, those that can be considered financial Weapons of Mass Destructions (WMDs) are a different kind of bread—a more evolved beast.

  The real innovation and magic of financial derivatives rose to the surface when a few clever investment bankers started experimenting and combining standard derivatives with aspects of several other financial securities. It probably all started with the mortgage bonds department, headed by Lew Ranieri of Salomon Brothers, who has been credited with developing a multi-trillion-dollar debt-securitization market that transformed the face of finance. Everything from mortgages to car and credit card loans to purchases from banks could be sliced into pieces, repackaged, combined with other financial products, and then sold to investors around the world. From then on, it was possible to create all sorts of new cash flow payout scenarios, when an underlying base financial product moved. A new, more potent, form of side bets was created. In many cases, sides bets on the first layer of side bets and so on. Increased financial leverage grew exponentially as each layer of a side bet was just one intentionally created side-effect.

  Like in a chemical laboratory where some mad scientists in white lab coats performed gene mutations and cross-breeding, new financial products were created by combining simple bond cash flow structures or simple interest rate structures (interest rate swaps) with the character of optionality and massive financial leverage. Different types of cash flows were engineered together, and a new breed of giant financial securities emerged with some fascinating results.

  Because we are not talking about principal investments, only imaginary cash flow payments far into the future, we can say that they add a huge swoosh of financial leverage into the mix. If you pay for derivatives contracts, you usually only pay for just a portion of the entire nominal derivative contract, arguing that if cash flows are imaginary and dependent on uncertain outcomes in the distant future, why should I pay now for the entire contract?

  Fair enough, in today’s markets, most participants trade derivatives with each other, while only a tiny fraction of the full nominal value of the structure are paid and settled for. Let's say the nominal value of a contract is $1 million. Professional participants would have deposit just a fraction of this, for instance, $50,000, as collateral. Attached with the promise that if anything goes wrong, you will pay it later and settle the difference. The existing spirit among financial institutions is “Don’t worry; I have the money somewhere—I am good for it.” Over the years, insurance companies, governments, and even the largest hedge funds, joined the party, such as previously mentioned LTCM.

  The real beauty of this financial innovation is that it is not only a combination of standard derivatives products with different forms of future cash flows, but it also has an opaque and complex nature of individually negotiated super contracts. As soon as financial regulators and rating agencies gave their green light, it was henceforth possible to trade these newly engineered financial instruments. They were traded between trading departments of investment banks, their largest institutional clients, and sophisticated professional investors in private transactions over the counter (OTC)—hidden far away from the public, regulators, shareholders, and sometimes even their own top management.

  Why do These WMDs exist?

  The official textbook explanation for their existence is that derivative structures provide vital liquidity to all financial markets, and provide insurances (hedges-protection) against a wide range of risks that investors face on a daily basis.

  So why do they exist? It’s very simple; they represent fantastic win-win opportunities for anybody who deals with them, except for the taxpayer who might pay the bill at the end of each boom and bust cycle that financial markets a prone to experience.

  Derivatives structures are the perfect fee-generating product for financial institutions.

  “Modern derivatives products are excellent fee generators, bet with other people's money and collect high margin fees on both sides of each transaction.” One investment banker once told me that as a general rule, the more exotic and complex they are, the more financial institutions can charge for them. They can make very generous commissions on huge volumes that are just mind-boggling to anyone who has never seen Wall Street salaries and bonus payments.

  It’s perfect for players of these products, too, of whom there are many. Because there are so many market participants trying to hedge all possible risks, there are plenty of gambles available for players who are willing to take the opposite side of the trade. For anyone who wants to hedge risks or simply transfer risk, someone on the other side must be willing to take on this risk. These are usually players with a much bigger risk appetite or want to collect risk premiums that function almost as insurance premiums at insurance companies. This group can satisfy its urge to bet on a wide range of possible future outcomes. The derivatives markets also come with a giant market of auxiliary services attached, ranging from information, research and pricing technology companies to catering to all of the possible needs that risk hedgers or risk takers might have.

  Derivatives and Society

  The textbook explanations for complex derivative products and their markets might still be acceptable for society as a whole. After all, we have already gotten used to legalized gambling.

  Unfortunately, these financial instruments are part of real industries and real economies. From ordinary commercial banking handing out consumer and student loans, to traditional investmen
t banks at the heart of any functioning economy is normal. Because they are so incredibly complex and gargantuan in size, any mistake could cause a chain reaction similar to what we experienced from 2007 to 2009.

  The real cost of derivatives

  What textbooks and academic research simply ignore is the cost of fraud and other illegal activities that necessarily are a byproduct of any financial product and market. Recent history has repeatedly proven that any motivated party that wants to hide losses or manipulate international capital markets has found the ideal instruments to do so. It ranges from simple fraud with Orange County’s state finances, to more elaborate schemes that included Enron, Long Term Capital Management, and Greece’s fudging of budget data to get into the Euro. What is the real economic long-term damage for entire nations and today's incredibly interlinked world economies? Nobody knows, but we will certainly find out in the next financial crisis that inevitably is bound to happen.

  Let's take a look at our final game category, a game that has become so attractive that, in the hearts of the biggest Wall Street players, it ranks second only to derivatives products: Funds, the lovable game of money pools.

  FUNDS: THE CONDUITS

  Have you ever met a person who got rich through investing in standard mutual funds or index funds? I haven’t. You will certainly never see stories with young smiling couples leaning on sports cars in front of large mansions, with subtitles like, “We made millions with mutual funds” or “How to get rich with mutual funds in 30 years—almost risk-free.”

  On the contrary, I have met many people who got incredibly rich managing funds and providing fund products and advice to clients of funds. Whenever money flows, they scoop up their fees. It’s obvious from a business perspective that the main incentives managing other people’s money lie in increasing their assets under management (AUM) to improve their fee income.

  Funds are investment products that people invest in different asset classes and have various investment strategies and philosophies depending on who’s managing them. They only differ in contract details, individual terms, and conditions. Mutual funds, exchange-traded funds and even hedge funds are included in this category. As a whole, they present a giant slice of global financial markets. The mutual fund's industry alone controlled $23 trillion globally in 2011, with Blackrock managing over $4.7 trillion for clients.58 For retail investors, it provides exposure to global financial markets and a sense of how the big players on Wall Street play their games. On the other end of the client spectrum, it allows institutional investors to have their vast financial resources managed by third party fund management companies.

  Any fund represents a pool of money that charges management fees to those who manage operational expenses, such as salaries for staff, offices, and budgets for research sources, technology, and software. Clients can buy them at banks, through the internet, in private placements or on public stock exchanges. It is only reasonable to assume to read the fine print for each fund product. Nevertheless, they all promote themselves as diversification tools that allow individuals to participate in many different asset classes and financial securities around the world. This is something impossible with a $50,000 portfolio.

  If you look closer at their holdings kept at any point of time, they very much look alike. Depending on their fund and asset category, they all invest in the same things at the same time. It’s a known fact that fund managers copy each other. They go to the same conferences and watch the same TV channels and read the same research. Sometimes you might read or hear that a fund outperformed its competitors because it was “overweight” in tech stocks, which simply means it had a slightly larger position in Google or Apple Inc. (or some other similar) shares in their portfolio than the rest.

  Completing the spectrum of third party asset managers, I would like to add venture capital and private equity funds. Venture capital provides early-stage capital for startups and promising technologies until they cash out when companies go public in IPOs or sell to other strategic investors. At the other end of the spectrum are private equity funds that restructure businesses and entire industries. In the process, they take ailing, publicly listed businesses private, restructure them and sell them at a profit by either selling them to strategic investors or relisting them on public stock exchanges. In a bull market, these listings have the same effect as start-up companies doing IPOs. They generate huge profits for private equity firms, which are lucky enough to ride bull markets. At the very end of the lifecycle spectrum, we have special funds that only focus on distressed assets or companies. That could be non-performing loans at banks, distressed real estate portfolios or purchasing the remaining caucus of businesses that declared bankruptcies to squeeze out the remaining money which might be left over. When Lehman Brothers declared bankruptcy in 2008, it was a feast for these type of investment funds. They scoured over the dead body to find any jewel that might have been hidden in giant portfolios of toxic sub-prime market assets.

  APPENDIX II

  THE PLAYERS

  The players that participate in Wall Street’s money game can be divided into two broad groups. On your right-hand side, there is an army of retail, individual, and slow-moving institutional investors. On your left-hand side, you have your smart money or those players who have an edge or create one for themselves. Prop desks and a few select hedge funds with the right connection on Wall Street belong to this group. It's only natural to assume that they are all in it for the money, and they all want to win. But they all can't be winners.

  Each group can be subdivided into several subgroups. This is where I would like to introduce the most significant and noteworthy players to orient you to the world of finance.

  RETAIL INVESTORS: THE VERY BOTTOM

  By far, the largest group in terms of sheer numbers are retail investors. They have average jobs, but they feel very strongly about being involved in financial markets and investing in stocks or funds—they want to play the money game. They invest either through their 401k, IRA, or online brokers. Since governments and public companies have been pushing the defined, contribution schemes like the 401k in the U.S., many individuals find it necessary to study the basics (at least) about fund investing and financial markets.59

  Among them is a growing number of DIY investors and traders. They spend countless hours after work and on weekends studying the market or considering quitting their boring day jobs and becoming full-time traders. They are lured in by popular books and trading courses, which promises easy profits and excitement. I compare them to the growing number of full-time poker players. Yes, some of them make huge amounts of money. But, being up on top requires constant playing and honing their skills. The performance curve is, of course, skewed to the extreme. Only a small percentage makes the majority of the trading profit. The rest provide liquidity and money to the few winners and operators.

  In reality, amateur traders compete against armies of professional traders bankrolled by investment banks and hedge funds. As a beginner, you will always be regarded and treated as the very bottom of the Wall Street food chain. “Dump money,” “cattle,” “zombie herds,” “sheep,” and “Muppets” are the many expressions that professionals use to describe that crowd. To be fair, they don't use these terms on retail investors, but also on large and less sophisticated institutional investors.

  For brokers, advisors, or private bankers, the average retail client represents peanuts; so, it is not worth spending much time on them. That’s why Wall Street has been working on standardized procedures and packages to serve this group in the most mechanical and efficient manner. Promises are for individualized, and customized services go right out the window.

  It is simple economics. Your average 20k or even 50k portfolio does nothing to move the needle for a financial institution and their advisors unless it is packaged into larger money pools (funds, the conduits). Everybody knows that an email auto-responder is much more efficient at communicating with the customer individually. The same sta
nds for computer voices on telephone hotlines. The lower the human interaction between client and financial institutions and the lower the cost per customer, the higher the potential net profits become. According to Reuters, “Facebook’s Zuckerberg has opened up its Messenger app to developers to create chatbots, hoping that by simulating one-on-one conversations between users and companies, it will expand its reach in customer service and enterprise transactions.” We will certainly hear more of “fin-tech” or “robo-advisors” in coming years.

  SUPER RICH: THE CONNOISSEURS

  Among professionals, the super rich are referred to as Ultra High Net Worth Individuals (UHNWI). They usually have their private bankers in Switzerland and even have their own family office where their sole mission is to manage their money affairs. According to Investopedia, “A person with investable assets of at least US$30 million, excluding personal assets and property such as one's primary residence, collectibles, and consumer durables. Ultra High Net Worth Individuals (UHNWIs) comprise the richest people in the world and control a disproportionate amount of global wealth.”

  UHNWIs are catered to by the top of the crop of private banking and financial services industry. Whether they need help with their inheritance, estate planning, new family trust, or structure of their tax declarations, they get advised by the best of the best. If they want access to new pre-IPO shares from brokers, placement of new hot funds, or invite to exclusive events, they will usually get their wish fulfilled. Like all clever investors, they want to be the “first in, first out” players. Of course, their private bankers and advisors listen for a generous compensation.

  UHNWIs are not without their weaknesses and faults. Like any investor, they can become victims of their extreme insecurities. They are exposed to smooth talking, private bankers and their advisors who are interested in maximizing their fees. When bubbles reign on entire economies, they too are captivated by it. Otherwise, they quickly see themselves becoming unpopular in their exclusive circle of the ultra-rich.