The intent is always good, but sometimes it comes with unintended consequences, this is the lesson from the well-known Cobra Effect. Dating back to the British rule of colonial India, the British government tried to reduce the number of venomous cobra snakes in the country by offering a bounty for every dead cobra. While their intentions were positive, their efforts backfired, when people began breeding cobra to collect a bounty later. When the program sponsors got wind of this, the program was canceled causing breeders and would-be bounty collectors to release their snakes further increasing the cobra population.
Similarly, requirements to disclose certain accounting line items as “fees” are pushing asset managers to look at different ways to gain exposures while managing the optics of their fees.
As we discussed in an earlier blog, You’re Paying What? Breaking Down Long/Short Fund Fees, advisors and clients alike are finding mutual fund fees and fee disclosures confusing—and lack clarity around how much investors are “actually” paying. To help clear this up, many mutual fund companies display the net expense ratio and net with limitation ratio, alongside the fund’s gross expense ratio, the latter of which is required by FINRA.
However, FINRA has started enforcing a rule that requires the net with limitation expense ratio to be less prominent and placed in a footnote below the gross expense ratio. In addition, ratings and rankings services now display a fund’s net expense ratio; whereas previously they displayed the fund’s net with limitation expense ratio (a number closer to what the investor will actually pay). And this is where the confusion begins.
Since long/short equity funds typically include non-operating costs, such as acquired fund expenses and interest expense on short sales, as a line item in their prospectus, some firms are now seeking to “lower” their net expense ratio to stay competitive by the ratings and rankings services. In other words, because there is a requirement to disclose dividends on the short side, as a fee, it could force asset managers to change the way they gain short exposure. Some mutual funds, for example are doing this by utilizing swaps, a type of derivative. While it’s true that incorporating a swap into a portfolio does lower the net expense ratio, (because a total return swap doesn’t contain dividends so the requirement to disclose them as fees on the short side of the books does not exist) it could introduce counter-party risk that may not have existed previously (i.e., though unlikely, the banks that issue the swap instrument could default and not pay the promised returns.) Thus, the use of complex financial instruments opens the door to potentially introduce unintended consequences into what was originally a well-intended idea.
To be clear, we’re not saying that adding a swap to a portfolio is a bad thing. We’re simply saying that, again, good intentions, sometimes have unintended consequences so investors need to simply be aware.