Investment Advisors and zany investment products. Caveat Emptor!

Caveat Emptor. Let the buyer beware.

I encourage anyone about to embark in a huge financial decision to do some research to gain confidence. For instance, if you want to buy real estate for the first time, go to the public library and look up books on mortgages and home ownership. Look at the blurbs on the back cover of the books and see who is recommending the book. If you need help with investment advisors or doing your own investing, again  – get to the public library. Also, go on Amazon.com and look at the book reviews of investment guides. Do research, it can save you a lot of tears and is absolutely worth your time and focus.  After all, this is your financial security we are talking about.

One thing to NOT do is to go on Yelp and try to find a five star investment advisor. “My guy is really great! He’s super nice.” How many financial advisors are total jerks and treat their clients like crap? ZERO. Their job is to kiss your ass.  What does that have anything to do with investment performance or fees? I would invest with Attila the Hun if I thought he constructed the soundest asset allocations with the lowest fees. Do these Yelp reviewers benchmark their advisor’s performance against well known indexes? I’ve never seen a single yelp review of an advisor post their realized performance vs a benchmark.

Meeting an investment advisor is very intimidating. There is dramatic information asymmetry out there. They seem to know a lot, and you feel like you don’t know much. It’s a terrible awful powerless kind of feeling. At the end of the day, you just may throw up your hands and give this person your life’s savings because they seemed trustworthy enough and you don’t have a clue. This is why I encourage you to read up on investing from books such as “Dummies guide to Personal Finance” or any Dummies book written by Eric Tyson, or “Bogleheads Guide to Investing”. However, even if you read such books, you can meet with an advisor and get totally thrown for a curve,. This advisor may recommend products that these books never mentioned. Now what do you do? Maybe these products are better than what was mentioned in the Dummies books?

No. They aren’t better. They are worse. (no) Surprise!

A friend of mine met with an investment advisor. Wow, Wall Street just keeps churning out all kinds of new fangled bad tasting sausage. Whoever said, “there is nothing new under the sun” has never meet with an investment advisor! Let’s take a gander at some of the options.

1. “40 Act funds” Long/Short, Global Macro, Total Return Funds.
A 40 Act fund refers to the Investment Company Act of 1940 which regulates mutual funds. This is just a fancy way of saying that you are getting kinda sorta hedge fund type exposures but in a mutual fund. In a regular hedge fund, the investment minimums are huge. They can be $500,000, $1 million, $5 million, even up to $25 million or $50 million. There are very very few people who can afford to invest in a variety of hedge funds to diversify their exposure. You never EVER want to put all your money in a single hedge fund – remember Madoff and his (newly) poor clients? Also, to invest in a hedge fund, you have to be a “qualified investor” or “accredited investor” meaning you have investible assets of greater than a million dollars or make more that $200K/year. This is probably not you.

Furthermore, it is very difficult to get into the best hedge funds. The managers actually don’t want the burden of managing too much money. Believe it or not, is harder to go fishing for wins and get performance gains when there is too much money to manage. Also, there is a lot of turnover (buying and selling)  in hedge funds – which creates short term capital gains and are taxed at 35% federally.  The entities best positioned to take advantage of hedge funds are non-taxable entities like endowments and pensions, not you, even if you are worth a hundred million dollars.

These “40 Act” funds still aren’t real hedge funds. They don’t make leveraged bets and they are not, in fact, hedged against downside risks. Also, these funds NEVER outperform the equity indexes when equities are going up and up, and their fees are unreasonably high. I’ve seen some of them that charge 5% a year! Even a “normal” hedge fund only charges 1% or 2% a year (they also take 20% of the gains, but that’s a different story). I think advisors pitch these funds to investors because they sound exotic and sophisticated, when in fact they typically underperform equity indexes in a 3 year horse race. Just as an exercise, if this ever happens to you, ask for the ticker symbol of the recommended “40 act” funds. Take a look at the total AUM or Assets Under Management of the suggested fund, and also look at the historical performance vs the S&P 500 Index. The fund isn’t very big huh? Just a couple million in it, or a couple hundred million. The smart money just isn’t going there. If there was an iota of gain to be had from these funds, the endowments and pension funds would be flooding these funds and they would be billions of dollars. But they aren’t. So neither should you.

2. Tangible Assets – commodities as an inflation hedge, REITs
Whooo boy. Now we’re playing with fire. Commodities, in and of themselves, do not produce any income. A piece of gold, unlike a stock, does not make earnings and return dividends. The investment philosophy here is that as inflation rises, the intrinsic value of commodities will also rise. But if you have been paying attention, you will see that commodities are mainly for speculators, and certain commodities move in and out of favor. Furthermore, not many commodities players make the front page of the Wall Street Journal as the master of the markets. In fact, the most recent commodities guy who made the front page was Jon Corzine of MF Global Holdings, whose company made the wrong bets and then stole from client accounts to cover their losses. There’s the occasional hedge fund commodity player who hits big and makes the news, but this performance is not commonly repeated in the intervening years. Regardless, this was a hedge fund, and not the instrument your advisor was pitching you.

For sure, you can get exposure to commodities through an ETF, the favored instrument of speculators everywhere. You will go for an almighty ride. Commodities are also seen as a counterpoint to equities. When the chips are down in stocks, investors tend to flee to commodities (and Treasury Bonds) as their value is seen as more stable, and then the speculators move in too. Some commodities exposure can be helpful from a rebalancing standpoint. Commodities may help your overall portfolio hold on to value if you rebalance regularly, but it is not essential. You will see that in environments of rising inflation, stock prices also nudge upwards and dividends increase. Bond funds can also play the yield curve and extract performance that keeps pace with inflation.

Real Estate Investment Trusts, or REITs, are a nice addition to a portfolio. REITs make money because the real estate the trust owns collects rents from tenants, and also owns the underlying real estate. Rents and real estate values go up with inflation, and responsibly managed REITs are a nice diversifier in an asset allocation. There are as many different kinds of REIT strategies as there are types of real estate (hospital, shopping mall, housing, etc). Just make sure you get a REIT that does not have expense ratio over 2% or a front end load, has been around for more than a decade, and doesn’t have a tiny AUM of just a couple of hundred million dollars. A good REIT will have staying power, and investors will have been attracted to that REIT. Vanguard has a REIT, and it’s all right.

3. Individual Bonds.
Bonds are more stable, make slow and steady gains, and offset the risk in your portfolio. Every well managed asset allocation will have some exposure to bonds. People nearing retirement and looking to lock in value will lean towards 80% fixed income or 90%. A simple rule of thumb is to have as many bonds as the decade of your age. If you are 43, have 40% bonds in your portfolio, etc. It is a fine idea to have some bond mutual funds in your portfolio run by a very big fixed income asset manager, such as PIMCO, Vanguard, BlackRock, or JP Morgan.

You should never EVER own an single individual bond issuance. Unless you are worth over $250 million dollars, seriously, you should never be sold individual bonds for any reason, whatsoever. The fees advisors charge in individual bonds can be as high as 20%. This fee is disguised as the difference between what the advisor paid for the bond, and what you bought it for. It is hidden. you will never know how ripped off you were. Unlike the stock prices, price discovery on individual bond issuances is not easily accessible by the individual investor. Bonds are sold in a decentralized over-the-counter manner. For instance, if trading institution has a large lot of bonds to sell, they will alert institutional purchasers and have an auction. This collection of purchasers will submit their bid for that bond, and the highest bidder wins. It is not like the stock market where you can see the stock price and just buy that stock for the listed price.

And if you ever try to sell that bond, you will be ripped off again. No one should own a collection of a $10,000 muni bond here and a $5,000 muni bond there, etc. No individual should ever own a single corporate bond. If you have this, you were paying hidden commission fees. Honestly, does your investment advisor think he can do a better job of managing a bond portfolio than Bill Gross of PIMCO and meet/beat the bond indexes? If your advisor could do this consistently, he/she would be on the cover of the Wall Street Journal and as rich as Midas.

4. Separately Managed Accounts.
Goodness. The fun never ends! There are all kinds of separately managed accounts. This is where your money is managed like its own mini mutual fund. If you have an equity separately managed account, basically your advisor is picking stocks for you. If you have a fixed income separately managed account – didn’t I already tell you not to have one since the fees are outrageous?

When your advisor picks stocks or bonds for you in a separately managed account, they make a commission on every trade. Oftentimes, the commission your advisor makes on individual stock trades far outstrips the expense ratio of a mutual fund. If you invested $1,000 in the Vanguard S&P 500 Index fund, the expense ratio is 8 basis points. Or, you are paying 80 cents a year to Vanguard for investing in the fund. I promise you, if your advisor buys $1,000 worth of stock for you, you will be charged far more than 80 cents. You may be charged $50, or 5%. Think of it this way, if the stock market ever fell 5% in one day, it would be a worldwide calamity that would hit the front page of every newspaper in the world, and this calamity just happened to you because you have a separate account.

If your advisor does manage separate accounts, just for fun, ask for the actual historical performance of the separate accounts against an appropriate benchmark. They probably won’t give it to you. And honestly, if someone had the midas touch as a stock picking separate account manager, they wouldn’t be an investment advisor. They would take that performance record and be picking stocks for a huge insurance company, pension fund, or endowment and making a paycheck in the millions of dollars. Or they would be named Warren Buffett.

Some separate accounts try to mimic the performance of an index, such as the S&P 500. They say that you’ll get approximate S&P 500 performance, but they’ll sell the stocks that lost value and you’ll be able to have a tax write off on those losses.  Some managers will do a separate account for a flat fee, which tend to be very high. The managers that say they’ll do it “for free” are the ones that are taking commissions on each trade. Don’t be fooled. Always follow the money. The best of them only charge around 30 basis points and are run by specialty firms that cater to wealthy families. However, the tax losses peter out over time as your separate account becomes bloated with stocks that have only increased in value. And then, this overweight of bloated stocks doesn’t always keep pace when the market goes on an upward tear. If you like to make a lot of charitable donations, one strategy is to take the stocks that have increased in value and donate them to charity, and you can get a tax deduction. But this strategy is really only for people who have more than $25 million to invest in a separate account equity strategy.

What you should do.

Here is a guy who is trustworthy and knows what he is doing. He manages the endowment of Yale University and his name is David Swenson. Swenson has won the respect of Warren Buffet – not an easy thing to for a portfolio manager to do. This guy has been a great success for Yale. He could have been a billionaire private equity guy or hedge fund manager. Instead, Swenson has a job, collects a salary, and writes books giving sound investment advice. He occasionally pops up on NPR. Like all the best guys, he recommends low fee Vanguard Index funds. Here is an example that he gave of an asset allocation. It has global exposure to the stocks, some real estate, and bonds. You get inflation protection embedded in the portfolio, and any upside the markets provide. You can open an account at Vanguard, and get going. DISCLAIMER – I am not your financial advisor and I am not responsible for your losses if you invest in the below funds. You are reading this blog at your own risk. As for the below funds, past performance is no indication of future results.

30% Domestic Equity. Vanguard Total Stock Market Index Fund (VTSMX)
15% Foreign Developed Market Equity. Vanguard Total Intl Stock Index Fund (VGTSX)
5% Emerging Market Equity. Vanguard Emerging Market Stock Index (VEIEX)
20% Real Estate Investment Trusts, aka REITs. Vanguard REIT Index Fund (VGSIX)
15% US Treasury Notes and Bonds. Vanguard Intermediate Term Treasury Fund (VFITX)
15% US Treasury Inflation Protected Securities. Vanguard Inflation Protected Securities Funds (VIPSX)

If you’re going to invest, first make get out of all credit card debt, save 6 months of living expenses as an emergency fund, and then max out your 401K or IRA tax deferred investing. Here is a link to the NPR article on David Swenson, and it also says a little something about his book.

http://www.npr.org/templates/story/story.php?storyId=6203264

Good luck to you. This is a risky game. It is terrible that we Americans have only our 401K contributions, other investments, uncertain investment savvy and scraps of social security to keep us afloat in our retirement years. Each one of us has to be an investment professional, and a lucky one at that! Many Americans cannot afford to set aside money for retirement and will rely on social security alone. Who said that investing the maximum amount in a 401K year after year will even lead to a secure retirement? The market could fall 40% like it did in 2008, and if you weren’t a psychic with a keen sense of timing, you would be out of luck. We invest because we have no choice. Our cash savings won’t get us to a dignified retirement. We need those compounded returns to get us there, on a wing and a prayer.

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