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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.

4 Guarantees
Guaranteed products, such as annuities, can play an integral role in retirement, tax, and estate planning. But it is probably fair to say they’re overprescribed to investors who are often afraid of the market’s gyrations and are attracted by an annuity’s iron-clad promise of a lifetime income stream or hedged downside. Many times, though, investors end up paying through the nose for a guarantee they don’t need (for it’s really short-term volatility they fear, despite a long time horizon that can help them ride out any bumps), incur a steep opportunity cost (in forsaking market upside or accepting a meager payout), or otherwise complicate the investing process (when some combination of stocks or bonds would suffice).

Another option is to ladder individual bonds. This, too, isn’t perfect. A ladder isn’t the same as a guarantee. What’s more, depending on the terms a ladder might not be able to produce the kind of income stream that a guaranteed product such as an annuity would generate. But if it’s the psychology of a guarantee that a client is seeking— namely, knowing they’re going to earn a competitive return and get most if not all of their money back at the end—a high-quality bond ladder may be a nice alternative. All it entails is waiting for each bond to term-out at par. That simple, cheap, and easy-to- grasp approach can perhaps take some of the edge off of a process that might otherwise be fraught with anxiety.

5 Non-Traded REITs
It’s remarkable how often we run across these securities when examining clients’ portfolios. Why? The cynic in us says it’s because these types of REITs pay plump commissions and boast the sort of eye-popping yields that sell themselves. To be sure, REITs have structural advantages that make them reliable income generators and the underlying assets—if thoughtfully selected, developed, and managed—can be a good source of income growth. But is it worth the price that non-traded REITs extract, be it from initial and ongoing fees, redemption penalties, illiquidity, or leverage risk? For most investors, the answer is no.

Most investors would be better off in a low-cost, diversified portfolio of dividendpaying stocks. Focus on businesses with durable competitive advantages that throw off gobs of cash and have clean balance sheets. Adopt a total-return mindset, only buying when such stocks are trading at a meaningful discount to estimated intrinsic value. And look beyond the usual realms—consumer defensives, telecom, utilities, and real estate—for inviting opportunities.

6 Closed-End Funds
There’s nothing particularly objectionable about the closed-end fund structure. Yes, there are those pesky discounts and premiums to net asset value. And, no, they won’t always trade well in the secondary market. (Woe to investors who purchase them in an initial offering.) But the closed-end structure actually boasts certain advantages, as it’s more conducive to investing in less-liquid or more-volatile fare than an open-end fund structure. What’s more, absent the need to meet investor redemptions, closed-end funds are easier to lever-up so a portfolio’s returns or yield can be greater than a traditional offering. The problem? Well, most investors really don’t need a juiced-up municipalbond closed-end fund, enticing as its yield might look. And even if there is a truly pressing need for income, there’s the question of suitability—should someone who so desires yield, presumably to extinguish near-term expenses or liabilities, really be investing in a highly-levered bond fund that’s prone to occasional blow-ups?

Instead, use low-cost bond mutual funds or ETFs and level with the client. Explain that expenses reduce yield basis point for basis point so pinching pennies is a surefire way to make their money go farther. From there, duration-management, sector-rotation, and issue selection should come into play, albeit within reason. To the extent those tactics don’t generate enough yield for the client, it’s probably time to talk about other ways to close the gap, including rationalizing spending. Can closed-end funds figure into this approach? Sure, but at the margins, and similar to the supporting role a taxable high-yield fund might play in a diversified bond portfolio.

7 Tail Protection
This can take a variety of forms, from gold bullion to slightly more exotic strategies such as investing in out-of-the-money put options. In the right hands and judiciously applied, tail protection can make some sense by adding ballast to a portfolio to fortify it against a shock, however improbable. The problem is usually one of magnitude, though, with portfolios awash in long-duration bonds, precious metals, inverse ETFs, or other fare designed to pay-off when disaster strikes. In these cases, simpler is probably better, especially if the investor has a long enough time horizon to shake-off the occasional drawdown.

If you think the world, or at least global capital markets, are going to pieces, chances are you’ll do fine owning the bonds of high-quality, sovereign issuers. Remember that bonds enjoy their safe-haven reputation because there is greater certainty as to the timing and magnitude of future cash flows, unlike stocks and other risk assets. A bar of gold is undoubtedly a store of value, but that value isn’t intrinsic, as it doesn’t generate any cash flows or have commercial applications. It’s worth what the crowd thinks it is worth. And while put strategies can be useful in certain circumstances, mind the price—many tail-protection strategies cost an arm and a leg, greatly dimming their appeal.

Avoiding the Simple Mistakes
It’s easy to get caught up in new or trendy products. But in many cases, advisors and their clients can take a pass. Here’s a quick look at what to do when temptation may get the better of you.

Don’t Do This: Buy into the hype surrounding alternative funds. Many are expensive, unproven and offer no more downside protection than a traditional bond fund.

Do This: Focus on strategies that diversify client portfolios or leverage a talented manager’s unique skills. Above all, keep costs low.

Income-Plus Strategies
Don’t Do This: Get caught up in a singular quest for yield. Many income-plus strategies stretch into low-rated, long-duration or illiquid securities that could get crushed when investors shed risky assets.

Do This: Focus on risk-adjusted total return instead of income alone. That exercise will open investors’ eyes to the type and magnitude of risk they are assuming.

Structured Products
Don’t Do This: Buy into what can be a fiendishly complex product. Structured products argue that traditional investing methods are passé. But in many cases, investors can get a better risk-reward payoff with a more plain vanilla option.

Do This: Explain to clients the range of potential outcomes with a particular investment. That should enlighten them to the tradeoffs between different portfolio mixes of stocks and bonds. They’ll see they can achieve the same results of the complex structured product without all the baggage.

Don’t Do This: Overprescribe guaranteed products such as annuities to wary investors. Many times, investors wind up paying too much for downside protection even though a long time horizon can usually help them ride out market gyrations.

Do This: Use a ladder strategy with high-quality bonds. While this option isn’t perfect, it should give clients peace of mind since they will get a competitive return and their capital back at the end.

Non-Traded REITs
Don’t Do This: Chase the yields on these products, which can be pricey and illiquid.

Do This: Opt for a low-cost, diversified portfolio of dividend-paying stocks from companies with competitive advantages. And continue to buy these stocks when their prices get cheap.

Closed-End Funds
Don’t Do This: Most investors don’t need a juiced-up municipal bond closed-end fund, even if there is a truly pressing need for income.

Do This: Level with your clients. Expenses reduce yield basis point for basis point so pinching pennies is a surefire way to make their money go farther. From there, duration-management, sector-rotation, and issue selection should come into play, albeit within reason.

Tail Protection
Don’t Do This: Overdue it trying to plan for when disaster strikes. Simpler can be better, especially if the investor has a long enough time horizon to shake-off the occasional drawdown.

Do This: If you think markets are going to pull back significantly, look at the bonds of high-quality sovereign issuers.


The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses or opinions or their use. ©2013 Morningstar Investment Services, Inc. All rights reserved. Morningstar Investment Services, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The Morningstar name and logo are registered marks of Morningstar, Inc.


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