<< BackNo such thing as a free lunch!
Posted on Wednesday, July 21, 2010
When looking at funds, what makes me most nervous is when risk and reward appear to be out of line.
We have been invited to consider a fund recently that provides a 7% annual income, which will rise with inflation. This is a pretty decent return. If you assume inflation is 2.5% per annum, this means that next year the fund could yield around 7.1%, the following year 7.3% etc.
The risk of this investment appears to be virtually zero (or it is according to the fund manager trying to sell it to us!). The chance of losing money seems (on the surface) to be almost nothing, and the returns are fixed in advance.
This smells wrong to me! My immediate instinct is that there must be a hidden risk that I can’t see. If there isn’t, all the big institutions would surely be investing in this way and the opportunity would have disappeared.
There are many different types of risk. In financial services, people often think of volatility (the amount an investment goes up and down) as being the same as risk. It isn’t. It is just one type of risk. Others include:
· Liquidity risk. The risk that we won’t be able to sell a fund when we want to.
· Risk of catastrophic loss – such as those hedge funds that provided straight line returns, right up until the moment they went out of business.
· Fraudulent risk – with unregulated funds or those domiciled overseas our due diligence needs to be watertight.
· Too hard! If we don’t understand a fund we can’t invest in it because it will definitely do something we didn’t expect.
· Too good to be true risk. The golden rule of investing (and life!).
If this opportunity is as good as it sounds, we would be mad not to consider investing. We will therefore do very thorough due diligence and work out whether this investment is really too good to be true.
We have some great contacts in the industry, meaning we can access specialist expertise in virtually every type of investment. We will therefore call in some favours and ask some specialist analysts for their views on this type of fund, the risks and the potential returns.
We will never proceed with an investment until we understand exactly what could go wrong. Only then can we decide if the potential returns are worth it.
Mike Deverell
Investment Manager