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By Ray Turchansky,
The Edmonton Journal
Wednesday, September 27, 2006
EDMONTON - Vancouver financial advisor Adrian Mastracci had just sent out his newsletter called Five Strategies to Manage Investment Risk when he was on the phone to add a sixth step.
Adrian Mastracci, Portfolio Manager at Vancouver’s ‘fee-only’ KCM Wealth Management, says, “Savvy investors don't get carried away with borrowing to invest. Leverage can sting fast, deep and long. Reducing borrowing exposure makes good sense anytime.”
"Savvy investors don't get carried away with borrowing to invest," said Mastracci. "Leverage can sting fast, deep and long. Reducing borrowing exposure makes good sense anytime."
The warning about borrowing money to invest came in the wake of news that the American hedge fund Amaranth had lost about $6 billion US when trader Brian Hunter, a 32-year-old who drives a Ferrari in the summer and a Bentley in the winter and is allowed to work out of his home in Calgary, made a bad bet on how expensive natural gas would be next spring.
Analysts estimate that Hunter, who trades natural gas futures, was borrowing $8 for every $1 of Amaranth's funds.
As a result, the San Diego County pension fund apparently lost $100 million of its investment with Amaranth. The figure was only about $16 million for a New Jersey state pension fund.
Hedge funds can use strategies such as short-selling, namely betting that the price of a stock will go down, and leveraging to magnify huge wins or losses. Some economists say that hedge funds improve financial market efficiency by introducing competition, new ideas and liquidity. However, investors such as Warren Buffett say hedge funds are designed to run up huge commissions and fees for traders.
Eighteen months ago Business Week reported that the Amaranth Partners fund charges 1.4 per cent of net assets for "bonus compensation to designated traders" and 2.3 per cent for "operating expenses," and that if an investor's account has a net profit over the previous 12 months the manager gets a 20-per-cent cut of each investor's profit, from which operating expenses and trader fees are paid.
In March of this year the National Post reported that Hunter earned an estimated $75 to $100 million US during 2005, while making an $800 million US profit for Amaranth.
"When it goes your way, everybody's a genius," said Mastracci. "But when it bites, it takes a long time to recover from something like that.
"I as a portfolio manager would have a very difficult time telling you which hedge funds are good ones. Even if you had exact up-to-date lists of investments as of right now, by tomorrow things could all change. It's a really fast moving stream."
His caveat: "Be careful when you let the investment manager borrow and invest on your behalf. You lose control over the process. A better way is to retain borrowing control in your hands."
A key reason for borrowing is that as long as the investment is outside a registered retirement savings plan, the interest paid is tax deductible if the funds are used to produce business or property income, the latter including interest, dividends, rent and royalties, but not capital gains.
However, in practice, interest paid on money borrowed to buy stocks or mutual funds which produce only capital gains but have the potential of someday paying dividends is usually deductible.
A few years ago AIC Group of Funds came out with a marketing ploy called "upvesting," essentially advising investors to borrow money before buying, holding and prospering. It sent out booklets urging people: "Don't just invest, Upvest."
Ironically, AIC founder Michael Lee-Chin is a value investor in the Warren Buffett mould, but does not share the latter's distaste for leveraging.
The booklet said the advantages of borrowing to invest were having a forced investment plan, building wealth using other people's money, boosting returns, reaching financial goals faster and creating a tax deduction for interest costs.
The booklet also mentioned the following risks: your investments could decrease in value, interest rates could increase, your cash flow could suffer, margin calls could be made if the gap between the amount you owe and the value of your investment is too great, tax deductions could be disallowed, you might get greedy and you could lose sleep at night.
As Mastracci points out, "loans still have to be repaid when things don't turn out."
His other strategies to avoiding risk - invest long term, diversify broadly, cut losses early, invest periodically and seek objective advice - are things AIC agreed on.
Oh, and as for Amaranth, it has since announced that it is out of the energy trading business for good.
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