Have you ever bought a mutual fund or ETF and received a prospectus in the mail? Some of them are over 100 pages. One of the reasons they’re so thick is the requirement by mutual funds to disclose the strategy’s risks. The government requires it. They want to make sure investors know the risks they’re taking before investing. How many people actually read the prospectus is beside the point. My point is the government wants investors to be careful and know they may lose money. Seems simple enough.
Out of curiosity, I pulled up a prospectus of a popular bond fund today. The fund’s risks include: principal risk, interest rate risk, call risk, credit risk, high yield risk, market risk, insurer risk, liquidity risk, derivatives risk, equity risk, mortgage risk, asset back security risk, foreign investment risk, emerging market risk, sovereign debt risk, currency risk, leveraging risk, managing risk, and short sale risk. Now you know why prospectuses are so long!
With interest rates at record lows and negative rates becoming more common globally, what is the biggest risk fixed “income” investors face today? I’ll give you a hint, it’s not on the list above. In my opinion, the biggest risk to bond investors, and all investors in all asset classes, is central banks and the possibility that their eight years of “emergency” policies fail. Among other things, the failure of these policies could create inflation, deflation, a currency crisis, a sovereign credit crisis, a fiscal deficit funding crisis, an inequality crisis, and a major reset in interest rates and asset prices. Don’t kid yourself (and I doubt many of you are), but interest rates and asset prices are not where they are because of fundamentals. Without the faith and confidence in central bankers, everything changes, everything.
How would bond investors respond tomorrow if central banks announced they were no longer able to buy bonds? Instead of buying, what if central banks had to sell the bonds they bought during their QE operations? In other words, what if the currency markets, or inflation, or a sudden shift in crowd psychology (i.e. zero to negative rates were perceived to be bad) forced central bankers’ hands and they went from the market’s unlimited bid to the world’s largest seller? Bond investors would lose trillions. Why isn’t the largest risk to investors, central banker policy failure, listed in the bond prospectus I referenced above? In my opinion, it should be listed, it should be mentioned first, and it should be in bold. Furthermore, it should be listed in all prospectuses, including equity funds.
What I find particularly interesting about all of this is how the government has a conflicting role in disclosing and encouraging investment risks. On the one hand, you have one government agency warning investors of the risks of investing – they’re trying to protect investors. On the other hand, you have another arm of the government, the Federal Reserve, actively encouraging investors to take risk. Eight years of ZIRP and negative real rates have screamed take equity risk, duration risk, liquidity risk, leverage risk, credit risk, market risk, and anything is better than cash risk!
The Federal Reserve is on record stating monetary policy has been successful in raising asset prices and that it has helped stimulate the economy. From Ben Bernanke’s op-ed article on November 5, 2010, “The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011…this approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth.” Later in the article Bernanke again discussed the wonders of asset inflation, “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion [emphasis mine].”
So what is it Mr. Government? Do you want to protect investors from the risks listed in the prospectus, or do you want investors to take risk in order to drive up asset prices? It’s like the Surgeon General requiring cigarette manufactures to place warning labels on their packaging, while encouraging smoking by giving out free cigarettes! The Federal Reserve is running a smoke ‘em if you got ‘em monetary policy. Although the risks of the Fed’s policies are not being fully disclosed, investors should be aware that these policies can be very hazardous to their financial health.
As it relates to investing, identifying and fully understanding all of the risks of an investment is an important part of the research process. It is also critical to the valuation process as the measurement of risk goes directly into determining an investor’s hurdle rate or required rate of return. An accurate required rate of return is essential in properly valuing many assets including corporate debt and equities (especially when using DCF valuation methodology). In conclusion, absolute return investors should not rely on government warnings when it comes to understanding the most important risks associated with an investment. Read the risks. Read the disclosures. But also do your own work, think for yourself, and just because the risk isn’t listed doesn’t mean it isn’t there.