It’s Not a Chase For Yield, It’s a Chase For Fees

“One lesson from 2008 is that if it’s very complicated and you don’t understand it, maybe you shouldn’t buy it.” – Harry Markowitz

It appears some people didn’t learn their lesson from the CDO debacle of the last financial crisis. This comes from a story in last week’s Wall Street Journal on a new fixed income derivative product that’s being rolled out by Goldman Sachs (emphasis mine):

Goldman Sachs has been marketing a new structure: a so-called Fixed Income Global Structured Covered Obligation that may come to market in September. It borrows elements of covered bonds, a structure with a long history in Europe. Investors will have a claim on a pool of dedicated assets and against two guarantors, Goldman and Mitsui Sumitomo Insurance.

But in many ways, the deal isn’t a covered bond. Instead of funding mortgages or public-sector loans, it will provide funding for a portfolio of fixed-income securities sourced from Goldman. The deal is structured via a derivative, a total-return swap entered into by Goldman Sachs Mitsui Marine Derivative Products.

And investors won’t know what exactly is in the pool. They will get a breakdown of the kinds of assets included, but not the exact composition. And what is in the structure can change. Crédit Agricole notes the pool could be predominantly residential-mortgage backed securities at one point, sovereign debt at another and corporate bonds at yet another.

From this description, here’s what we know about what this product offers:

1. A complete lack of transparency.
2. The possibility of a higher than average yield.
3. Leverage.
4. Complexity.

Some might call this a chase for yield, but really it’s a chase for fees. This is a way to sell intelligent-sounding products to unwitting investors that are told stretching for extra yield is worth it in this type of structured investment vehicle.

Investors aren’t without fault in these transactions, but sometimes it seems like Wall Street is able to create its own supply and demand for some products because they’re so good at selling.

Many outside of the investment industry could be fooled into believing these types of products must be a great idea because of their complexity. Alas, there are no style points when investing.

There are necessary and unnecessary risks when putting money to work in the markets. Necessary risks include the inherent uncertainty about the future and having to accept volatility to earn returns over time. Unnecessary risks generally come from not knowing what you’re doing. They amplify bad behavior. Investing in products you don’t understand is the epitome of an unnecessary risk.

One of the most overused phrases by financial pundits is ‘this isn’t going to end well’. The truth is I don’t know if this product is going to end well or not. Even if it does “end well” by offering a slightly higher than average yield without blowing up that doesn’t necessarily mean it would be a good decision.

Risk is unavoidable, but one of the questions that investors need to constantly ask themselves when making portfolio decisions is ‘Are these the right risks and are they worth it regardless of the outcome?’

Sure you can get lucky in these types of products on occasion, but over time luck becomes unsustainable.

This doesn’t just concern this one Goldman Sachs fixed income product. Generally, if you don’t understand an investment, you probably shouldn’t invest in it. And just because a product is available doesn’t make it necessary for your portfolio.

Innovation in the investment world isn’t always a bad thing as investors now have access to strategies through ETFs and mutual funds that would have been impossible to replicate in the past at such a low cost. But investors don’t need to feel the need to constantly chase the new and exciting.

Some of the best investment decisions you ever make will be the opportunities you turn down.

Yield Hunters’ New Tune Echoes Financial Engineering’s Past (WSJ)

Here’s what I’ve been reading this week:

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