This series explores two strategies: structured products and private market investments. Both strategies aim to enhance returns using different methods. This article explores the fundamental difference between these two methods.
What is “active” investing?
The alternative to passive investing is active investing, which comes in many types, but requires additional effort or insight to enhance returns.
The traditional approach
The traditional form of active investing is to identify a promising yet neglected and/ or underperforming asset and invest in it.
For example, an investment fund that is considering buying a stake in the development of a beachfront resort or financing it partially with debt needs specialized knowledge of issues such as regulation (zoning laws, environmental protection), the local tourism market, construction and operational knowledge to support and improve the project after completion. Most importantly, the fund must identify the opportunity in a timely manner, which requires connections and history in the field.
The investment itself (e.g. a beachfront property) may not be difficult to understand, but the process of identifying such investments and fixing problems that arise is complex and requires expertise. Traditional active investing therefore carries risk and should only be undertaken by or with an experienced investment team.
Financial engineering
Another way to actively enhance returns is through “financial engineering,” designing a new product using mathematical models and/ or incorporating multiple financial instruments.
A classic example of financial engineering is the synthetic collateralized debt obligation (Synthetic CDO). Instead of lending directly to a single company through a traditional bond, the investor may own a share in a pool of derivative products (credit default swaps) linked to multiple bonds issued by many organizations.
The pool may also be divided into tranches that define the order by which defaults in the underlying debt is absorbed, where the senior tranches would only incur a loss after the more junior tranches are written off completely. Investors may earn higher returns by buying the riskier tranches that would be the first to take the loss from defaults in the underlying debt portfolio.
When invented, Synthetic CDOs were considered an ingenious way to benefit from a diversified pool of collateralized debt without lending directly and select the tranche that suits their risk appetite.
Unlike the beachfront resort, however, the human brain cannot process the mechanics of such a product intuitively without complex mathematical models. The subprime mortgage crisis showed that even experts can lose track of the assets to which they are exposed by overreliance on mathematical models.
Conclusion
Active investing is complex by definition. If it was easy, it would be commonplace and could never outperform the market.
The process of traditional active investments is complex (due diligence, maintenance, exit), while financially engineered products themselves are complex. Even experts may struggle to handle the intricacies.
The next article looks at the pros and cons of structured products in more detail.