Why Do We Buy?

Here’s a recent Wall Street Journal headline:

Five Popular—but Dangerous—Investments for Individuals

I’ll get to the investments mentioned in the article (by Kristen Grind - July 11, 2014) in a minute, but let’s start with the headline. Why are dangerous investments popular? I have never met anyone who honestly stated that taking risk was something they enjoyed. Even when taking risk means enjoying potentially higher returns, most people balk at the thought. Sure, we would love high returns with low risk, but no one wants a potentially dangerous investment. So, why are the five products listed in this article selling so well?

Well, the key word in that question is “selling.” Every one of these products is being aggressively sold. Why are they promoted so heavily? Two reasons:

  • They seem to provide something that investors want.
  • Their high fees that make the promoters a lot of money.

Let’s look at the five “hot” investment products in the light of those two points (the WSJ piece has a lot more detail on the structure of these products.

One. Liquid-Alternative Funds.

These sound pretty safe. You “liquid” capital should be safe, as it is in a money-market fund. So, are these money-money alternatives? Not even close! They are the “poor” person’s version of a hedge-fund. These funds are complex, long-short equity, futures trading, possibly leveraged beasts that most professionals have a tough time understanding. One investment advisor quoted in the WSJ piece said. “"Advisers are challenged to understand what they do, let alone investors.”

Why are they sold:

  • They promise a magical mix “…of the upside of stock returns in good markets while offering protection in down markets.”
  • The average annual fee for these funds is a whopping 1.9% per year and many sport a broker-pleasing load of up to 5.75%

Two. Nontraded Real-Estate Investment Trusts

Left to your own devices would you seek out an investment that offered almost no liquidity, couldn’t really tell you what it is worth, and has historically averaged about half the return of the index of liquid, fully disclosed investments on the same asset class? Probably not. Yet nontraded REITs are raising about $20 billion per year from someone. With illiquidity and nebulous pricing going against them…

Why are they sold:

  • They promise magic dividend checks of up to 7% per year. They neglect to mention that they sometimes have to sell assets to pay the dividends. What other investment pays out your money in the guise of a return? Yes, Ponzi schemes are one example (although these aren’t that bad)
  • While ongoing expenses are probably high, they are tough to determine (there’s no public disclosure, remember?) However, sales people love the commissions of up to 11% (commissions are your money).

Three. Leveraged and Inverse Exchange-Traded Funds

Leverage enhances both returns and risk. If a non-leveraged fund might lose you all of your money, leveraged funds have the potential to lose you more than your money. A straight leveraged fund is an “enhanced” bet on a market’s upside. An inverse leveraged fund is betting against a particular market. Either way, the key word is “bet.” These are pure gambling vehicles. If you are going to gamble, make sure your broker at least matches Vegas with free dinner or drinks.

Why are they sold:

  • Investor greed! These are loved by those hoping to make a killing in the market by betting correctly on a market’s direction. Sounds like the description of a gambler.
  • Distributor greed! Regular ETFs can only command a tiny expense ratio. Vanguard’s S&P 500 ETF (VOO) charges 0.05% per year. The ProShares UltraShort S&P500 ETF (SDS) charges 0.90% annually. That’s 18 times more!

Four. Structured Notes

Structured sounds safe. Notes pay interest. So, structured notes should be safe and pay interest. That’s the way they’re sold. Remember collateralized debt obligations (CDOs)? They were sold as high-yielding and safe. Same with structured notes. What’s the difference? Good luck figuring that out. What happened to those safe CDOs? Could the same thing happen to structured notes? Since they are being sold by the same investment banks, what do you think?

Why are they sold:

  • A reprise of the same old promise: high returns, low risk. 
  • Unlike dull, boring, semi-understandable bonds structured notes include big fat commissions for the broker. A $100,000 corporate bond transaction might make a broker $1,000. That same transaction in structured notes could carry a $3,000 commission.

Five. Unconstrained Bond Funds

unconstrained |ˌənkənˈstrānd|
not restricted or limited

These bond funds can do anything needed to get you the yield you want (which is a lot). How do they do it? There is only one way: take more risk! The average “unconstrained” fund has about 40 cents of every dollar in junk bonds, yet the name sounds better than “junk.”

Why are they sold:

  • Bonds are boring, and returns are low. Ignore the fact that boredom and tiny returns are the hallmarks of safe investments.
  • The top performing “unconstrained” bond fund over the past five years, Metropolitan West Strategic Income (MWSIX) charges investors almost 2% per year. Vanguard Total Bond Market Index (VBTIX) only squeezes a measly 0.07% from its investors each year. 

Let’s see what that extra 1.9% per year means:

Source: Morningstar 7/16/14

Source: Morningstar 7/16/14

As you can see, the more expensive fund is forced to increase risk to do no more than match the yield of the safer Vanguard fund.

So, what is the point of the of these riskier products? It doesn’t appear to be well-being or wealth building!