Financial Innovations: A Double-Edged Sword

Financial innovations — from derivatives to sub-prime mortgages — can cut both ways, as the recent economic downturn led by the mortgage markets has demonstrated. Innovations are created because they present new opportunities. But they also carry new risks.

 "Financial innovations arise because of demand," said Christopher C. Geczy, Wharton assistant professor of management who teaches about alternative investments in the AIMSE/Wharton Investment Institute. The program, developed by the Association of Investment Management Sales Executives and Wharton, runs in January. "The concern should be that there are risks inherent in new products that either aren't obvious or only emerge rarely. These risks are sometimes downplayed. We should not, however, be quick to equate financial innovation with outsized risk or losing money."

The key is to understand the risks and when they are changing. "Taking a risk is not a bad thing," he said. "That is why we invest. Prudent investment choices arise from direct recognition of the risk, understanding of risk, and diversification of risk," he said. "And some innovations can help."

"Taking a risk is not a bad thing," he said. "That is why we invest. Prudent investment choices arise from direct recognition of the risk, understanding of risk, and diversification of risk."
—Christopher C. Geczy, Assistant Professor of Management, The Wharton School

While the risks of financial instruments are not necessarily inherent in the instrument, investors need to understand the characteristics of the instruments they are using. "Derivatives come in many shapes and forms, but generally have leverage built into them," said Krishna Ramaswamy, professor of finance and academic director of the program. Leverage, or debt, carries risk. "Professional managers at financial institutions should understand leverage and know the risks."

He noted that high-profile news stories about problems with derivatives have often involved speculation or fraud. As organizations adopt innovations, they need to create appropriate controls that limit risks from employees who might use the instruments in risky ways. "If a derivative permits you to speculate, for example, you have to be vigilant that your money manager is using it in a disciplined way so you avoid unintended consequences," he said.

Assessing Innovations

As new financial products are developed, investors should assess them before using or investing in them. Geczy offered several strategies:

• Be cautious but not too cautious. You need to know the products and the risks involved, but you don't want to be so conservative that you miss a valuable opportunity. "You need to be cautious, but you don't want to be so cautious that you take no risk." One of the reasons the concept of "portable alpha" has been so powerful is that it has helped investors accept necessary diversity and risks that may be politically difficult to take, such as alternative investment exposure. "It may be the spoonful of sugar that helps the medicine go down," Geczy said. Portable alpha refers to investment returns "alpha" that are made "portable" by separating them from changes in the overall market, often using strategies such as diversification.
  
  
• Understand the risk. On the other hand, there are risks in portable alpha that are sometimes glossed over. "Portable alpha programs are becoming increasingly popular. But this is not a lay-up. Some laws of physics prevail. Impure alpha can be laced with other kinds of risk. There are occasionally credit or currency risks embedded in that alpha. At some point in time, the risk can manifest itself. The investor should be prepared for this potential.
  
  
• Consider the liquidity. Some instruments are less liquid than others. This difference in liquidity affects the usefulness of any product. Products with low liquidity, or with low liquidity under certain market conditions, make it difficult for an investor to adjust a portfolio as market conditions change. On the other hand, low liquidity may not be a problem for long-term investors. "Differential liquidity affects the usefulness of any financial product," he said.
  
  
• Consider the leverage. The leverage inherent in the instrument can affect its usefulness. Leverage can magnify returns but also can magnify risks. Investors need to be aware of the leverage involved and how it can affect the investment with changes in the market.
  
  
• Weigh the fees. Being first isn't cheap. For new and exciting products, the fees usually are much higher. Innovations such as fund of funds, for example, have been called "fees on fees." When considering an innovative approach, look closely at the fees to determine if they are justified or whether you can wait until the fees come down.
  
  
• Look beyond the bells and whistles. Ensure that there is real value and advantage in the innovation, rather than just impressive bells and whistles. "You wouldn't necessarily buy a new car just because it is new or aided by an impressive computer chip," Geczy said.

Geczy notes that innovations that were shocking and controversial when they were first introduced later have become widely accepted. "Remember that securities trading on organized exchanges itself was once an innovation," he said. "Now it feels very plain vanilla."

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