Even as global equity markets continue their upward march, oil prices remain depressed; and recently, we learned of a large fund that appears to have lost most, if not all, of its value from its exposure to that commodity.1 Before we launch into a technical explanation for the debacle, we thought we would focus on the broader topic of risk — a subject near and dear to the hearts of everyone working with a financial plan (or, God forbid, without one!).
Thoughts on the nature of risk
Risk is at the heart of all financial plans, and for that matter, all plans. What business plan would be worth the paper it’s written on (or the screen it’s displayed on) if it did not account for all the important things that could go wrong, or that could fail to go right? And what will the response be if X and Y happen? The thought exercise alone is extremely valuable, even though “no battle plan survives contact with the enemy.”2
Likewise, when we plan for your financial future together, we look closely at many things that could go wrong or not go right, and plan for contingencies. Sometimes, insurance can protect against risks (e.g., death or disability) — but often risks are unavoidable, and the calculation of how much and what kind of risk you take are what matters. A skilled and experienced financial planner with the right tools can help you plan intelligently and prudently, and help you understand what your risks are going forward.
It is important to balance the obvious risks, such as market declines, with a myriad of other external risks, such as adverse changes in the tax code, high inflation or lower overall returns in capital markets. And personal risks related to income and spending are important, as well. It all fits together, and if things go wrong, there are many things that can be adjusted to get back on track, acting intelligently rather than emotionally.
Headlines promote fear and greed, as always…
Headlines like this get people’s attention, but good planning minimizes the risk of being significantly affected by something like this. There is a very big difference between a well-diversified portfolio — constructed and maintained with the proper due diligence — on the one hand, and a high-risk single investment on the other. That is actually worth a few moments’ thought: individual investments and strategies can sound exciting and promise high returns, but the disciplined investor is not taken off his or her game by such things.
After the proper due diligence, if an investment fits into the well-diversified portfolio, it takes its proper place as one of many investments — not as a big bet. We always remember the inelegant, but immortal Wall Street truism:
“Bulls make money, bears make money, pigs get slaughtered.”
This is not about finding the very best, market-beating investments; protecting against market downturns; avoiding specific, risky investments; or otherwise doing what fear or greed might prompt us to do. We follow financial plans with discipline to maximize our chances of success and avoid mistakes, especially at difficult moments. Having confidence in your plan (and your planner) makes all the difference.
OK, so what the heck happened to this big fund, and what does that have to do with “picking up quarters”?
First of all, let us make an important point about investments and due diligence. Investments, especially complex ones, are frequently misunderstood, and are sometimes lumped together into inappropriate categories. For example, one of the very worst of the misleading categories is “alternatives.” That category contains everything but the kitchen sink, and that might end up in there as well before we are done. Good strategies and bad, risky and not, liquid and not — if you think you have “alternatives,” you probably have little understanding of your investments.
Due diligence is not limited to looking for fraud and measuring past performance; it very much involves understanding investment strategies, and ensuring that the managers/funds and strategies selected for the portfolio are what they need to be, and continue to be so. Nowhere is this more important than it is in private equity (which is often lumped into the “alternative” category with hedge funds, futures trading and other assorted things).
Private equity is not normally a big topic for these letters; most investors do not invest in it. As you can read in the article cited here, the investors are typically “major pensions, endowments and charitable foundations.”3 These investments are risky, expensive, illiquid and usually require a large minimum investment. And they are not as transparent as mutual funds, and are not subject to the same regulations and reporting requirements.
Private equity funds raise money to invest in private (i.e., not publicly traded on the stock exchanges) companies. These are private deals requiring a lot of deal-making and hands-on management — very different from selecting stocks to buy.
So, is private equity bad, and when are you going to tell us what happened for goodness sakes?!
No — like many types of investments (and sharp knives), used properly, they can be very good. It starts with understanding what each fund does and always includes good diversification, so even a serious setback in one fund does not do major damage to the portfolio.
This was a fund investing in oil fields. In our research, we see a number of prominent private equity funds that invest in the energy business overall; but this fund appeared to concentrate on the oil itself, making it much more subject to the risk of oil price changes, and it appeared to use substantial borrowing to increase that exposure further. Leverage.
We have seen this kind of risk-taking in many forms over the years. Long-Term Capital in the late nineties also used leverage to make big bets; in their case, it was on various interest rates and derivatives, but the basic approach was similar — take a modest return strategy and use leverage to make it a high return. Like picking up quarters on the freeway, it looks like free money, until something goes badly wrong.
So, if we are not investing in private equity, why are you telling us this?
We can answer with another truism: if it looks too good to be true, it probably is. Investments that seem to have great performance and/or low risk come along all the time; somebody always has a great new thing to offer, a manager or fund that has strong recent (or even long-term) performance. And sometimes, you can’t find a particular problem — gee whiz, this looks great!
If you look at the history of investing, you see stories like this over and over. And far more frequently, things do not blow up or turn out to be fraud; they just fail to continue performing. If you start chasing these shiny new things, you will, at best, waste your time; and at worst, learn some very expensive lessons.
So why not stick with your plan and invest in an intelligent and disciplined way? You might miss out on some excitement, but in the long run, what matters is confidence and achieving your goals. This isn’t a game after all, is it?
Editor’s Note: In this letter, we refer to a Wall Street Journal article about the EnerVest fund that lost most of its value, but Hewins Financial has never recommended investing in that fund — it is not part of our program at all. In this context, we use it as an example for our discussion about risk, diversification and headlines. We did not invest in Long-Term Capital either, although we also refer to that fund in this letter. If you have any questions about this topic, please contact your advisor.