March 10, 2009


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Since sometime last year, there have been a number of articles in the press - both general and financial - about the financial product known as accumulators. They have earned the unfortunate moniker "I-kill-you-later" in Asian financial circles, due to the number of private clients who have lost significant chunks of their fortunes as a result of trading this product.  I recently came across an article appearing in the leading English newspaper in town, and I just have to set the record straight...

As a former derivative product banker, I am naturally defensive when I encounter unjust attacks upon my work or the works of my peers. Derivatives has been a dirty word ever since the days of Proctor and Gamble, Gibson Greetings and Metallgesellschaft (how many people know or remember what I'm talking about?), but I've always felt that the instrument itself was not to blame, but rather the leverage embedded in the product. This is true of most of the big blow-ups that we have seen, and is certainly the case with accumulators.

Accumulators, like most derivative products, was created as a means to express a particular view. In this case, the investor wishes to purchase a block of shares, and instead of giving a large "buy" order, the order is spread over a period of time such that the shars are "accumulated" slowly. The underlying premise is that the investor likes the stock enough to, say, own up to $1 million of it. And an important pre-requisite is that the investor has the financial means to pay for the shares.

At this point the investor has three choices: 1) purchase $1 million worth of stock all in one go at today's price; 2) spread out the purchase over a period of time, buying a small chunk each time, at the prevailing market prices at the time of purchase which can fluctuate; or 3) contract to purchase up to $1 million over a period of time, at discounted price that is fixed today, with the possibility of not purchasing the full $1 million under certain market conditions - namely the stock price rising above a certain trigger.

If this were a blue-chip stock that can be a long-term core holding in the investor's portfolio, and the discount were significant enough (10% or more, for example), it's easy to see why investors would choose option #3. You will always buy shares at a cheaper price compared to option #1, and your biggest downside is the possibility of having purchased only a small amount of shares at discount before prices run up and the transaction is "knocked out".  I've personally recommended the structure (as well as its counterpart, the "decumulator") to both private clients as well as corporations and institutions. I see nothing wrong with using this strategy to achieve the goal of buying or selling large quantities of shares. So what went wrong with the countless investors who lost their shirts?

Well, to put it simply: greed. Or a manifestation of that greed: leverage. Somewhere along the bull market run, investors decided that they weren't happy with getting a single-digit discount. They wanted more. So to achieve the desired double-digit discount, the structures had to be leveraged - two or even three times. The result is that the investor would continue to buy shares at the discounted price, but now they would have to buy two or three times the original number of shares as the share price fell below the discounted price. What used to be a $1 million exposure suddenly became 2 or 3 times that. An investor who has the risk appetite for $1 million on a certain stock may not feel the same way if the amount were $3 million, and the same investor may not be able to put up enough cash to settle the $3 million purchase.

Another way to achieve a larger discount was to choose stocks which were more volatile. So instead of accumulating blue chips, investors were turning into ever more speculative names. Obviously this increased the risk of share price falling below the discounted price - at which point your exposure multiplied. And you would be buying more shares just as prices are falling. Picking up blue chip stocks in a falling market can be a good investment strategy. If the companies are fundamentally sound, long-term investors can wait for the markets to recover. If you were looking at speculative stocks, however, that may not be such a prudent strategy...

The long-running bull market simply fooled many investors into thinking that they can't lose. They had done so many transactions where it was easy to make money, so naturally no one thought about the downside. In a bull market, accumulators kept getting knocked-out early so nobody ever thought that they'd be in a situation where they would be stuck buying the entire $1 million (or $3 million if leveraged). All they could think about was how little stock they managed to pick up on the last trade at the discounted price, which probably led to the decision to increase the size of the next trade so they can REALLY make money...

In the end it is the investors' own greed that became their downfall, not the derivative product which was simply a tool.  The banks may have provided the gun but it was the investors who loaded the bullets and shot themselves - and they even asked for a gun capable of firing three-round bursts instead of a single shot... My opinion is that the fault lies squarely with the investors.

Of course journalists would never write anything that puts the blame on the investors. It is simply too easy to paint the banks into villains who victimize the poor investors. As the article claims: "...The investor's risk is unlimited; the bank's is fixed."  The author also writes: "...the upside is limited and the downside is unlimited."

Well that is completely false. Anyone who knows anything about investing knows that when you go "long" and buy an asset, your loss is limited to the price you paid for the asset (in most cases anyway).  It is your upside that is unlimited because the asset price can theoretically keep going up and up. The only time you may be faced with a theoretical unlimited loss is when you go "short" and the price of the asset rises to infinity...

The bank also takes on more risk than meets the eye. There could be situations where the bank can lose on its hedging positions due to sudden and large moves in the market. But then the author of the article wouldn't know anything about that, would he... even though he is reported to be a "senior investment banker in the Hong Kong office of an international bank" according to our friends at Wikipedia. I understand our author was trying to be witty, being a "satirical business writer and humorist". But I don't see the humor in inflaming public sentiment with statements which are blatantly false.

Oh, and he also needs to work on his understanding of the rate of return, as his math is clearly wrong. Either he doesn't have a clue about how to calculate this number, or he is deliberately distorting viewpoints to paint a picture other than the simple facts. Either way I am not amused.


s tsui said...

interesting perspective. i always believe that we can learn much from history.

it is just another example that there are simply too many "senior investment bankers" in the world, and how much damage unemployed bankers can do when they're driven into other professions.

Lambda said...

It wasn't too long ago when young twenty-something, fresh out of school, barely knew the difference between being good and being nice got paid half a million a year selling products they have no hope of deciphering. That generation was often praised as the rising star in the financial world who will redefine what young people should aspire to do.

It wasn't too long ago when lots of people on public transportation talked about what a wonderful day of killing they had in the stock market and they decided to take some time off for a trip to Europe for some new shoes and bags. A job was only a job. Performing one's duty at work as contracted (and the reason of getting paid the salary!) is not anything important.

It wasn't too long ago when people labelled themselves as the new real estate tycoons trading units of new developments. I remember sitting at my desk looking at a secretary who talked about netting HKD 5 million from trading flats on the mid-levels in the space of two weeks. She knew the market well....

And now, lots of people lost a significant portion of their networth. Instead of asking what they can do better next time, there are lots of finger pointing. The danger of being greedy is the one thing that we should have learned from history but no one wanted to be reminded.

I lost money too but I know exactly how I got myself into the mess. Other than myself, I cannot blame anyone. Who said not to sell GBP when it was trading at 1.85? I hope people can really learn from this financial tsunami. It's going to be a while before we can reach the other side of the rough sea.

s tsui said...

lambda, it seems like you and i are (were! i'm quitting) in the same industry.

i agree with you 100%. i've walked out of one stream of this industry before, and got lured back by the pay and relatively easy lifestyle of another stream. the over-capacity in the whole industry never ceased amazing me. it has always been clear that there are too many people doing things and making decisions that they are in *no way* qualified to do / make, period.

if there is one thing that we should have learned from the euphoric run-ups to '97, '00?, '07, it is that greed is f&@(!#*king NOT good.

btw, i've been watching this kinda retail Luxembourg based fund named Superfund. it claims to invest in managed futures and returned 35% in 08 and 2.8% YTD. it's also sponsoring major glitzy events. :P (this may not be the right forum, but i haven't found better ones online anyways - ) does anyone know how it works?

Lambda said...

Lucky you! I cannot quit till they tell me to go as I have a mortgage.... And no, it's not an investment. I actually have the entire family, three generations living under the same roof!

Anything that pays more than riskfree rate should set off the alarm. Oops! There's no such thing as riskfree anymore (or ever has been?) I worry if the US gov't will go bankrupt after bailing out all the financial super one stop shops. Docs on website probably won't give you much details. I say call a banker for the subscription papers.

Peech said...

Superfund used to be called Quadriga and they are a CTA...which means very high volatility. I've seen -20% for monthly returns from them. Their peers would be Man AHL, Winton...etc. Only touch CTAs if you can stomach the volatility.

s tsui said...

Superfund is still called Quadriga (firm name vs fund name or something like that). Yes, high volatility, monthly trading, and very opaque. (Man Inv is far more mom-and-pop-friendly, if you will.) Having watched these funds passively for a few years, I am intrigued by this Superfund / Quadriga firm. Flamboyant, European, high return, secretive operations. yummy recipe...!


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