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When to Say No

A well-designed financial plan can get derailed by the wrong investment. Here are seven things investors can probably do without.

Jeffrey Ptak, 10/11/2013

As most practitioners can attest, delivering good outcomes to clients is as much a matter of resolve as it is a triumph of intellect or forethought. We can do a good job of devising a plan, implement it with care, and then blow the whole thing to smithereens by succumbing to some impulse that the clatter of the market triggers. What that means is that we’ve got to be able to tune out a lot of noise and say no quite often, eschewing the vast majority of the choices we face.

At Morningstar Investment Services, we build portfolios and, therefore, know first-hand these tradeoffs. We also know how uncomfortable the tradeoffs can be if a client relationship hangs in the balance. Through that experience, we’ve been able to track the bad habits and ill-conceived ideas that tend to trip-up clients. Here’s a list of some of the things we’ve often found ourselves saying no to—or at least urging clients to dialback on—and some options that make sense in the name of achieving greater simplicity and balance.

1 Alternative Mutual Funds
I wrote an article on how to assemble an absolute-return portfolio (“Approaches to Absolute-Return Investing,” February/March 2013). MIS manages a hedge-fund-like strategy for its clients. Yet, given alternative funds’ cost and complexity, it’s our thought they should not form the core of a portfolio. Many of the alternative funds that have launched thus far have been expensive duds, offering no more downside protection than a traditional bond fund and typically badly lagging when stock markets take flight. The space is littered with newbies, wannabes, and pretenders trying to stake their claim, making discernment and rigorous manager diligence critical to success. Thus, even if we’re considering alternatives to complement a strategic mix of stocks, bonds, and other assets, we should be very picky and carefully monitor exposure.

Rather than dive headlong into alternatives, focus on strategies that have diversifying properties, capitalize on a unique risk factor, or leverage a manager’s talents in a different way. Market-neutral strategies, for example, have tended to be less-correlated with the broad markets than other disciplines. Merger arbitrage, though not as easy a game to play these days, is less sensitive to interest rate gyrations than bonds. Finally, some skilled opportunistic long/short managers have entered the fray, and it can be useful to leverage that format if the manager’s value-add is distinct from more typical, long-only managers. Above all, try to keep costs as low as possible and use alternatives judiciously, not to exceed more than 20% of a broad-based portfolio.

2 Income-Plus Strategies
There is nothing wrong with income-generating securities or strategies. But we think they are largely avoidable because they too often get carried away in their singular quest for yield, stretching into low-rated, long-duration, or illiquid securities that can get crushed when markets de-risk. Investors in preferred stocks, leveraged closed-end funds, publicly traded master limited partnerships, and mortgage REITs, as well as richly valued dividend-paying common stocks, could learn a valuable lesson the hard way. Namely, that it doesn’t pay to pile one risk exposure—credit, duration, or liquidity—atop another in the name of maximizing yield.

Instead, invest studiously for risk-adjusted total return, not income alone. That mindset is likely to make investors pay closer attention to the type and magnitude of risk their assuming. And, in so doing, investors are likely to see income-plus strategies for what they often are—an illusion by which more-distant principal payments are, in essence, shifted forward (so as to produce a higher yield), exposing investors to eventual drawdown and, too often, permanent loss of capital.

3 Structured Anything
Pricey and often fiendishly complex, structured products are usually bad news for investors. They assume traditional approaches to portfolio construction and investing—namely, combining stocks and bonds in various proportions and holding for a suitably long period—are passé and instead resort to gimmickry and illusion. For example, a recent registration statement for a structured note offered investors the chance to participate in all of the S&P 500’s upside but only some of the downside, though they’d have to start in a 5% hole to get that deal. That would be great if it weren’t for the fact that there was a potential to achieve a superior risk/reward payoff, at a fraction of the cost and sans the illiquidity and counterparty risk, if investors just bought a call option on the S&P. Structured products typically don’t spin gold from dross.

Or you might try stocks and bonds. If it’s the probability of various outcomes your client is worried about, then consider tapping a simulator like a Monte Carlo engine. Granted, the simulator isn’t perfect because potential outcomes aren’t beautifully bell-curveshaped in the real world. But the exercise can at least help a client better process the range of potential outcomes, as well as the tradeoffs that various combinations of securities entail. In going through this process, clients are likelier to appreciate the risk and reward attributes of various portfolio mixes and, thus, how one may accomplish roughly the same thing that a structured product might, at a fraction of the cost and without the usual baggage.

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