Risks Lurk in Popular Retail Investment Products
As part of his ongoing scholarship, Professor A. Joseph Warburton examines investment products that are popular with the public. Warburton’s most recent research into two investment products finds that both contain risks that are not transparent to investors and come mainly in the form of embedded financial leverage or borrowed money that these investment products take on, putting investors’ money at risk.
In his Business Lawyer feature below, Warburton analyzes business development companies (BDCs), a type of investment company popular today among retail investors and retirees because of the high dividends BDCs pay. But because of leverage, BDCs incur more risk than the market benchmarks and significantly underperform once you account for that extra risk.
An earlier article in the Journal of Empirical Legal Studies co-written with Michael Simkovic of the University of Southern California, shines a light on a surprising degree of borrowing activity by the everyday mutual funds
Business Development Companies: Venture Capital for Retail Investors | 76 Business Lawyer 69 (January 2021)
A BDC is a type of investment company that finances small and growing American businesses. After raising capital in public markets, BDCs then fund companies considered too small or risky by traditional lenders. Many BDCs are open to retail investors and offer an alternative to private venture capital firms that are often out of reach. Investors are attracted to BDCs because of their potential to pay out high income, but the rewards come with risks.
BDCs are favored by Congress, which excused these types of companies from key provisions of the regulations that govern other investment companies. BDCs are allowed, for example, to incur greater leverage through borrowed money. The more capital BDCs can obtain from investors, according to Congress, the more BDCs can finance small and growing enterprises, thereby promoting job creation and economic growth. BDCs have largely stepped into a role that banks have vacated, becoming an important component of the financial system for small and midsize businesses. While Congress has championed BDCs as a way for small and midsize businesses to obtain financing and grow, it has not analyzed hard evidence on how BDCs perform for the investing public, as this article does.
This article is the first academic study to examine the BDC comprehensively. Why has the literature overlooked BDCs? One reason is the complexity of the regulatory framework. Another reason is the lack of available data. Warburton’s research and findings address both obstacles.
Through his research, Warburton explores the history of BDCs and their purpose. He dissects the laws that govern BDCs – which are neither exempt from the Investment Company Act of 1940 nor fully regulated by it. In order to fulfill their mission of assisting emerging enterprises, BDCs are highly restricted in their investments and activities. The Investment Company Act requires that BDCs finance primarily private or small public companies, which restricts their assets to illiquid or thinly traded securities. To promote the growth of BDCs (and the growth of companies in which they invest), key provisions of the Act are applied to BDCs in a relaxed manner. The rules permit BDCs to engage more freely in leverage and related-party transactions than other investment companies.
Next, Warburton’s research shows an empirical analysis of BDCs using a unique dataset built from hand-collected information from BDC filings. The figure below displays the number of BDCs in existence, by year, for all BDCs and publicly traded BDCs, revealing that BDC formation has come in two major waves: 2004–06 and 2011–15.
Today, there are more than 50 BDCs that are exchange-traded and available to retail investors. In addition, dozens of BDCs are public but not exchange-traded, and others that are private.
Looking at the performance of publicly traded BDCs over a 21-year period, the research shows that BDCs live up to their reputation for high income, with the typical BDC yielding about 10%. Moreover, the total returns (stock returns plus dividends) of BDCs appear to match or beat the benchmark indices (high-yield bonds and leveraged loans). However, BDCs incur substantially greater risk than the benchmarks. BDCs are permitted to be highly leveraged, nearly all BDCs employ leverage, and their performance is highly volatile. On a risk-adjusted basis, the typical BDC significantly underperforms the benchmarks, trailing by four to six percentage points per year.
During the March 2020 market crash at the outbreak of the COVID-19 pandemic, shares of publicly traded BDCs declined by over three times as much as the benchmarks, on average.
The figure to the right shows the performance of $10,000 invested in an index of publicly traded BDCs during 2020, compared to the two market benchmarks (high-yield bonds and leveraged loans). The $10,000 investment in BDCs was worth $9,115 at the end of 2020, versus $10,711 if invested in high-yield bonds and $10,312 if invested in leveraged loans. BDCs were also more volatile over the year than the benchmarks, which themselves are among the riskiest parts of the fixed-income market.
Warburton advises retail investors and their financial advisors to consider the findings of this research before investing in publicly traded BDCs. Before adding a BDC to your portfolio, be sure to consider its track record and avoid BDCs with a history of negative risk-adjusted performance.
Mutual Fund Borrowing Poses Risk to Investors
Reprinted from the Harvard Law School Forum on Corporate Governance and Financial Regulation | A. Joseph Warburton and Michael Simkovic (University of Southern California), January 3, 2020
Millions of Americans rely on mutual fund investments to pay for their retirement, but mutual funds contain hidden, previously under-appreciated risks.
Warburton and Simkovic’s new study published in the Journal of Empirical Legal Studies, “Mutual Fund Borrowing Poses Risks to Investors”, provides evidence that mutual funds borrow in an attempt to improve their performance. Those attempts not only fail to boost average returns, they also increase the volatility of returns, potentially creating serious problems for those who need to withdraw their money at a time when the market is down.
The Investment Company Act of 1940 permits mutual funds to have a capital structure that is up to one-third debt. Warburton and Simkovic’s paper is the first to study the performance of open-end funds that exploit their statutory borrowing authority.
Through their research, the team constructed a database using information contained in annual filings of open-end domestic equity funds covering 17 years from 2000 to 2016. They discovered that a surprising number of funds—18 percent— bulked up at some point by borrowing money for leverage. These borrowing funds underperform their non-borrowing peers by 62 basis points per year on a total return basis, while also incurring greater risk. After accounting for risk, borrowers underperform by 48 to 72 basis points annually. The research explains that funds often borrow in an unsuccessful effort to juice performance after having lagged in the mutual fund rankings.
Mutual funds that borrow are plain-vanilla mutual funds, not exotic investment vehicles often associated with leverage, such as alternative funds and levered index funds. By contrast, Warburton and Simkovic found that funds that use derivatives and other financial instruments perform about as well as unleveraged mutual funds, before and after adjusting for risk, and with less volatility. This suggests that many mutual funds use derivatives to hedge risk rather than as a substitute for leverage through the capital structure.
Concerned about leverage, regulators have recently been examining funds’ use of derivatives, but that focus may be too narrow as borrowing also presents a risk to investors. The SEC has recently proposed new rules on the use and reporting of derivatives by registered investment companies. According to their research, Warburton and Simkovic suggest that regulators would benefit from collecting further data on mutual fund borrowing, to provide greater transparency into mutual fund capital structure.
Professor Warburton advises individuals to investigate leverage before putting money into any investment product. Although this can require digging into the fund’s annual report, a phone call to the fund might be sufficient. The effort is worthwhile in the end. Funds that borrow money for leverage carry extra risk. He adds, “If you decide that you are ok with that extra risk, then be sure to consider the fund’s track record. Avoid funds with a history of negative risk-adjusted performance when using leverage.”