Evercore Pan Asset

I find global investment markets exciting enough without needing to gear the bet. When markets can halve one year and almost double the next I do not fancy borrowing extra money to invest. Nor do I use fancy financial instruments so I can put £2 at risk for every pound I have.

The logic of compound arithmetic is remorseless. The investment adviser lives with the tyranny of percentages.  He or she needs to remember that if you lose half your money in equities one year, they need to double the next to get you back to where you started. Even after such an exciting roller coaster ride, you are worse off than if you had left the money in the bank and taken the interest reward. Shares have to more than double if you held them through a damaging bear market that halved their value.

Borrowing or gearing can make your plight worse, unless you have perfect foresight and judgement. If you invest a million pounds and the share market of your choice falls 20%, you lose £200,000. If you invested through futures and options so you had a £2 million bet on the index, you lose £400,000.

Some funds gear their bets much more than that. They do so claiming that the financial instruments they buy and sell trade in narrow ranges. That they say allows them to hold big positions without too much risk. It also means if they are right they have to hold big positions, as the return on the instrument they are buying is not sufficient without the gearing to make it work. If they buy just £1million of an instrument they think will go up by 1% they only make 1%. If they expose themselves to £10 million of that instrument using their initial £1 million of capital to back derivatives to that value, they make 10%, a worthwhile return.

The problem comes if they are wrong. Sometimes low risk instruments develop an alarming life of their own. Sometimes dull markets become very lively. Black box models to run funds based on past price changes are fine until the investment concerned breaks out of the historic trading range. If you gear tenfold a 10% fall can wipe you out.

Derivatives can be good ways of reducing risks for traders and professionals. They are bets with or against an Investment bank. If you do not understand how the bets work in a given fund, or if you can see that there is high gearing or borrowing involved, you should remember the power of gearing works both ways. It can be savage if you are on the losing side of the bet with that Investment bank.

As published in Investment Week