Five misunderstood investments: from hedge funds to leveraged ETFs

Did you enjoy the first week of the year in the stock market? It was ugly out there, to say the least.

While it’s one of the worst starts to a new year in recent memory, Jonathan Chevreau says don’t panic. It could be an opportune time to add to your equity positions.

If you find yourself stressed out, take a look at your portfolio again. Do you understand everything that is in there? Were some investments simply flogged by your broker and sounded good at the time? Do you have some structured products on which you are constantly paying high fees even though you never get any good returns?

You probably have some real duds, but don’t feel too bad. Most investors do. One of the problems in the investment world is that many investors end up owning securities they do not understand. As the saying goes: If you don’t understand it, then don’t buy it.

But many investors forget this advice. Let’s take a look at five types of investments that are often misunderstood by investors. Split shares Split shares are structures created by dealers whereby a closed- end fund separates into two classes of shares: preferred shares and capital shares.

Capital shares pay higher income, but dividends are only paid if a certain minimum net asset value is maintained on the structure. Investors get enticed by the high yields, but then see dividends stop altogether.

This can happen even if the securities held by the fund continue to pay dividends. Many investors misunderstand this point. They see yields of 10, 11 per cent or more on certain capital shares, and then, when there is a problem and net asset value declines, their yield drops to zero.

This happened recently with Dividend 15 Split Corp. II. Its capital shares stopped paying dividends in December, and the shares have lost 40 per cent of their value since the announcement. Exchange- traded notes Exchange-traded funds are backed by a pool of assets and are fairly secure. Exchange- traded notes, on the other hand, are not backed by a pool of assets and are typically backed by a third party, which brings inherent credit risk.

An ETN is only as strong as its backer. Thus, investors may think they are getting exposure to a certain asset class, but they are really only getting exposure to a bank or broker.

ETNs can still be useful in a portfolio, but understand there are additional risks involved. Leveraged ETFs Leveraged ETFs sound good. You take a bet on the direction of an asset class, and make twice ( or three times) as much if your call on the market is correct.

However, because these products use derivatives that need to be bought/sold daily, there is a daily, consistent decay in net asset value due to these resets and trading costs. You could be right on your call and still lose money.

We would not recommend any leveraged ETF product. They are just gambles, not investments. Preferred shares Many investors buy preferred shares on issue at, say, $ 25 per share, and then expect to get $ 25 per share back at maturity. Last year, many preferred investors were shocked to see how much preferred shares can decline.

Unless you own retractable preferred shares (which are exceptionally rare these days), the issuing company is in total control of whether it ever redeems your shares.

Investors should consider all preferreds as perpetual. That is, the company is unlikely to ever buy back your shares. It will only do so if it is in its own interests, and then, conversely, it is probably not in your best interests. Hedge funds Many investors hear about the huge returns on hedge funds. During the financial crisis (in 2008, not the one this week), some hedge funds posted returns of 300 per cent or more by accurately shorting financial and housing stocks. But we think their strategy is accurately described as betting against these stocks.

Almost all hedge funds use leverage, and some take very, very concentrated positions. This is, plain and simple, a bet.

When they win, the use of leverage generates huge investment returns, and giant performance fees for the manager. When they are wrong, though, it is the investor who loses (lots), and performance fees from the good years are not returned to you in the bad years.

Most hedge funds promise a low correlation to the market and decent monthly performance year in and year out. Most hedge funds, though, are disguised long funds using leverage to max out performance fees.

Be very cautious here, and make sure the hedge fund you are about to buy actually hedges.

In today’s difficult market, it is hard enough to make money with more standard investments. As always, make sure you know what it is you are actually buying.