Risks in Liquid Alternatives

Liquid alternatives may be used to reduce risk. Nevertheless, they may employ techniques that may be unfamiliar and can present certain risks. To use liquid alternatives prudently, investors need to be aware of the risks involved with these techniques. Such techniques include:

  • Short Selling
  • Leverage
  • Derivatives
  • Liquidity

Short Selling

A trading strategy intended to capitalize on falling prices.

Key Points

Key Points

  • Action on a belief that a security might be overvalued (striving to benefit if the value decreases). 
  • Can be effective during market corrections or rising interest rate periods, but may limit gains during up markets. 
  • A "short squeeze" occurs when there are no shares available to buy back for the original owner.
Purpose

Purpose

  • Profit from falling prices: Short selling is the opposite of buying low/selling high. It means you buy a security and expect the price to decline.
  • Hedge: Seeking to reduce risk in the long term with offsetting short positions. You might short sell to help guard against a sharp decline in a specific security or the market as a whole.
caution

What Can Go Wrong?

If the price of the borrowed stock goes up instead of down, an investor faces losses on the amount that it appreciates—which in theory could be unlimited since there is no price ceiling. With bonds, short losses are limited to the face value of the bond.

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Example to Share with Clients

A portfolio manager effectively borrows and then sells a stock or bond they anticipate will decline in price.

  • The manager does not own the stock or bond, but instead will buy back the shares in the future to return them to the original owner.  
  • The profit or loss is the difference between the amount the manager originally sold the stock or bond for and the amount paid to buy it back.

Leverage

Using borrowed money for an investment and expecting the profits to be greater than the interest owed.

Key Points

Key Points

  • May augment returns or ability to hedge risks.
  • Mistimed or excessive leverage can lead to large losses.
Purpose

Purpose

  • Leverage is generally to help increase the magnitude of profits by gaining additional shares, assets or market exposure through borrowing.
  • Leverage, or greater purchasing power, can be obtained through certain derivatives to help increase profits.
  • Leverage magnifies both gains and losses.
caution

What Can Go Wrong?

Losses can be amplified when borrowing because there would be a loss if the investment decreases in value and there’s also typically interest due on the borrowed money.

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Example to Share with Clients

Leverage can help investors finance additional investments. Mutual funds regulations limit  the amount of explicit leveraging, when money or assets are contractually borrowed for a fee.

Derivatives

Contracts where the value is based on the performance of other assets, interest rates or indices. Two common types of derivatives are options and futures.

Key Points

Key Points

  • Derivatives are typically bought for much less than the asset's price, but move up and down with the asset's price.
  • Often used as a hedge for risk management purposes.
  • Risky when used in excess or inappropriately; can cause portfolio instability and/or large losses.
Purpose

Purpose

  • Derivatives are used to hedge against changes in interest rates and price movements, and can be a cost effective way to help gain access to otherwise hard-to-trade assets or markets.
  • The value reflects several factors, like the asset's future price compared to the set price, the time until it expires and how volatile the asset price is.
caution

What Can Go Wrong?

Derivatives allow investors to earn large returns from small movements in the underlying asset’s price. However, investors could lose large amounts if the price of the underlying asset moves against them significantly. Counterparty risk is inherently involved in most derivative transactions and means that a contract holder may default on their obligations, which could lead to a loss.

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Examples to Share with Clients

Example 1: Options

Two basic types of options contracts:

  • Call Options - A buyer can, but is not required to, buy an asset like stock in the future for a set price. The seller is required to sell at that set price if the buyer exercises this option.
  • Put Options - A seller can, but is not required to, sell an asset like stock in the future for a set price. The buyer is required to buy at that set price if the seller exercises this option.

A portfolio manager holds a stock she believes has risen to its fair value and will not likely appreciate further any time soon.

Scenario 1

She can sell the stock, creating a taxable gain and losing the upside potential if the stock continues to appreciate. But, this may free up capital to buy other assets.

Scenario 2

She can sell call options on the stock. This means she keeps the stock in hopes of further gains if the value keeps rising. At the set price, the options may be exercised.

Example 2: Futures

A contract where the buyer and seller are both required to buy or sell an asset, like a stock, bond or index, at a future date at a set price.

A portfolio manager is expecting a large new investment in cash in a month and he expects the market to rise in this time period.

Scenario 1

He can wait for the money to arrive in a month and then invest it in the market despite the fact that the market may have already risen.

Scenario 2

He can buy a futures contract now on an index with an obligation to settle at a future date at a set price. Even without the new money yet, he won't miss a short-term market rise.  But, is obligated to settle at the pre-determined price even if the market declines.

Liquidity

Measure of how readily a security can be bought or sold on demand. A liquid security can be easily bought or sold with little or no impact on price. A liquid market is when the spread between the selling and buying price is close together. The spread will increase as markets become less liquid.

Key Points

Key Points

  • Alternative investing strategies may involve less liquid or harder-to-sell securities.
  • By regulation, mutual funds must limit investments in less liquid securities (called illiquid securities) to less than 15% of assets.
Purpose

Purpose

  • Less liquid investments may be attractive for investors willing to trade off the ability to sell quickly for longer-term return potential.
  • Liquidity is an important factor in the price of a security. When many investors may want to sell illiquid assets at the same time, there may be less buyers for those securities, which may negatively impact price.
caution

What Can Go Wrong?

During periods when markets decline suddenly and sharply, liquidity is an important consideration because investors may become risk-averse and there are typically many more sellers than buyers. This is true for even the most liquid of securities (e.g. blue chip stocks) but the impact will be magnified for less-liquid.

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Example to Share with Clients

A stock may have less shares available in the market place and less daily trading value.

An investor has bought microcap stocks, which are stock in public companies whose total value of outstanding shares is considered small ($50 million to $300 million).  This kind of asset will generally take a bit more effort or time before it can be bought, sold or realized as cash and is considered to have low liquidity.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.