In 1993 I was still a relative newbie to the investment world, having made the move from practicing attorney to Wall Street trading floor the year before. The junk bond market was very hot then – seemingly everyone was looking to get (more) involved. The investment bankers were happy as bigger and hotter new deals kept getting done. Traders and salespeople were happy because the markets were hopping. And investors were happy because prices kept going up and cash kept coming into the junk market.
Everybody was winning.
At what I would later recognize as the market peak, I went to a road show for what was said to be the next hot deal. It was at the St. Regis in New York, then as now a truly luxury hotel on 5th Avenue near Central Park South (the lowest priced room there is available tonight for the bargain basement price of $895). The idea was to ply investors with food and drink and then sell them on the deal. Unfortunately, this would-be next hot deal was for a chain of Texas pawn shops.
Really. Talk about a sell signal!
Because the junk market had been hot for a long time, quality new issue supply was a major problem. Not surprisingly, the pitch was focused on great cash flows and strength during recessionary periods (1989-1993 saw a major recession) since people in economic trouble patronize pawn shops (obviously). Even I – neophyte though I was then – could tell based upon that deal that the junk bond trade was getting really crowded and dangerous. That the economy was improving steadily provided more danger. Sure enough, in 1994 the bond market ended up getting crushed, with junk leading the way and losses totaling way more than $1 trillion (that’s with a “T”).
Things got really U-G-L-Y. Lots of people lost lots of money and Wall Street firms retrenched significantly. It wasn’t fun at all to be on the dance floor when the music stops and everyone starts racing around trying to make sure they had someplace to land.
Of course, it is axiomatic in the investment world that as an asset class becomes more popular, it suffers from both falling expected returns and rising correlations – like junk bonds in my narrative above. In other words, good trades get crowded and their advantages tend to disappear. This crowding happens because success begets copycats as investors chase returns. Mean reversion only tends to make matters worse.
Last week I argued that the “Yale Model” and the “alternative investing” craze it spawned fell into this category and that investors would be wise to look in a different direction now. Yesterday, my friend Tadas Viskanta made a similar point and sagely asserted that alternative investments are no longer all that alternative on account of crowding, high costs, excessive complexity and increased correlations. In his words, “there is no magic investment that consistently generates high returns and low correlations.” Or, as stated by William Bernstein and quoted by columnist Jason Zweig in The Wall Street Journal and Tadas:
“The first person to the buffet table gets the lobster. The people who come a little later get the hamburger. And the ones who come at the end get whatever happens to be stuck to the tablecloth.”
My purpose in adding on to this discussion today is to suggest a current equivalent to the Texas pawn shops junk bond deal – an indicator of market “frothiness” (to put it very mildly) in the alternative investments space and the danger investors face in the current environment. This harbinger is the Security Benefit Total Value Annuity. The “TVA” is an indexed annuity managed by a hedge fund (Guggenheim Partners), marketed only through four independent marketing organizations and utilizing a new and proprietary crediting strategy with an utterly opaque but cool sounding to retail investors “volatility overlay,” giving it the added caché of “hope and exclusivity,” which is great for sales but does nothing for performance.
Astonishingly, this annuity’s proprietary index for interest crediting purposes uses various futures including currencies (Aussie dollar, British pound, Canadian dollar, Euro, Yen and Swiss franc), energy futures (heating oil, light crude, natural gas, and gasoline), U.S. interest rates, grains (corn, soybeans and wheat), metals (gold, silver and copper), “softs” (cocoa, coffee, cotton and sugar) and livestock (cattle and hogs) together with a “volatility overlay” said to offer some performance stabilization by increasing exposure to the index when vol is low and decreasing it when vol is high. The specifics and the mechanics of doing so are not described.
The pitch is simple yet effective (and altogether crazy): “By incorporating an alternative index crediting option based on an underlying index that is non-correlated to traditional, equity-based indices, you can help provide clients with diversification.” Alternative investments with an annuity wrapper. Ingenious. Clients pay dearly for this alleged diversification, of course. The TVA is not a commodity index ETF costing significantly less than 1 percent. The TVA provides a 7 percent commission to the agent, a 3 percent commission to the marketing organization and a 1.25 percent “yield spread” fee paid by the investor. It is being gobbled up like hotcakes.
Really. Talk about a sell signal!
The TVA has just about everything a retail consumer shouldn’t want – a remarkable lack of transparency, little historical data to evaluate (the product and the index were just created a year ago and, to the extent that data is available, the performance history is poor and the alleged lack of correlation – especially in a market crisis – remains utterly untested), fees and expenses among the highest possible, problematic expected returns and (since indexed returns are linked to the five-year return of the index), no way to know how the product’s performance will turn out for those five years as well as no annual reset (an important feature for those looking for principal protection in an indexed product).
Even I could recognize that the Texas pawn shop deal signaled how dangerous junk bonds were back in 1994. Today’s risks in alternatives are well evidenced by a similarly ridiculous offering – the Security Benefit TVA. It’s that thing stuck to the tablecloth on the financial services buffet.