In the wake of the financial crisis, almost all investors are looking for safety. As a result, financial firms are peddling a number of investments that promise protection of your principal, regular monthly payouts or guaranteed minimum returns.
But beware, many of these products aren’t all they’re cracked up to be. Some don’t meet their goals, and many charge high fees.
“They may all be appropriate for some investors,” says Harold Evensky, president of Evensky & Katz, a financial advisory firm in Coral Gables, Fla.
“But to overplay their safety without risk would be irresponsible. If it all works, you’re safe in protecting principal, but there is no guarantee. Some of these clearly have market risk. There is no guarantee managers will achieve their goal.”
Among the products touting safety are principal-protected mutual funds and variable annuities.
- Yield curve — A curve that shows the relationship between yields and maturity dates for a set of similar bonds, usually Treasuries, at a given point in time.
- Derivatives — Financial instruments where the value comes from the underlying asset, which could include stocks, interest rates, or currency exchange rates and real estate.
Principal-protected funds aim to do exactly what they’re named: protect your principal. Some of these funds have maintained value by switching to bonds from stocks, which have plummeted 56 percent, as measured by the Standard & Poor’s 500 Index, since October 2007.
Treasury and municipal bonds have performed much better during that period, of course. But over the long term, stocks have outperformed bonds so staying away from equities could be costly. That’s especially the case because, as Evensky put it, “the stock market’s gains tend to come in spurts.”
Moreover, a fund could be taking risk by holding bonds with long durations. “You want to be careful how far out the yield curve you go,” says James Holtzman of Legend Financial Advisors in Pittsburgh.
“Interest rates are pretty much at rock bottom; the only place for them to go is up. The longer you hold the bond, the further the price falls unless you hold it to maturity.”
In addition, “the idea of safety in fixed income is more of an issue given the turmoil and volatility of the past six to 12 months,” says Michael Sheldon, chief market strategist for RDM Financial Group in Westport, Conn. He notes that even municipal bonds and investment-grade corporate bonds have suffered for extended periods.
Many principal-protected funds simply consist of structured notes — often called principal-protected notes — issued by financial institutions. For example, “one we were looking at paid the S&P 500 return over the next 13 months, excluding dividends, capped at say 30 percent,” Evensky says.
“What you get in exchange for that cap is a buffer on the downside, say 15 percent. So if the S&P 500 drops 15 percent, you’re even. If it drops 20 percent, you’re down only 5 percent. You give the upside away to protect the downside.”
Many funds exclude dividends like that. But historically dividends have accounted for a substantial portion of return on stocks. Also, returns on these funds are taxed as ordinary income rather than capital gains or tax-advantaged dividends. “That can be a significant bite,” Evensky says.
The issuers generally use derivatives to guarantee your returns and reduce their own risks. Much of the hefty fees go to fund those derivative positions. Derivative expenses can top 2 percent of fund assets, and those expenses, of course, are subtracted from fund values.
“If anyone is going to guarantee you something, it’s going to cost,” Evensky says. “The better the deal, the more suspicious you should be.”
The principal-protected notes often work better for issuers than buyers, says Patti Houlihan, a financial adviser for Houlihan Financial Resource Group in Reston, Va. “These kinds of things are a way for the underwriters to bring money in and hopefully share some of it with you,” she says.
“They have use of your money for whatever the period of the note is, and you have nothing but a structured product. There is nothing structured by any financial institution that doesn’t give them the most opportunity for return and you the most opportunity for risk.”
Perhaps the biggest risk is that you’re betting on the financial health of the institution issuing the notes.
“When I had principal-protected notes explained to me, the people representing the companies structuring them told me it’s like buying zero-coupon Treasury bonds at 80 cents on the dollar and then putting the other 20 cents into puts and calls [options],” Houlihan says.
“That sounds good, but the rest of the story is that it’s not U.S. Treasuries behind it. You’re giving them your dollar, and they are the guarantor. If it was Lehman Brothers, (which was liquidated last fall), I wouldn’t want them guaranteeing anything.”
Indeed, “many people got badly burned when they had structured products with Lehman,” Sheldon says. “When Barclays bank took over part of Lehman, I don’t believe they honored the agreements. That put holders in a bad position.”
And you don’t know which company may become the next Lehman. “We do structured notes with JPMorgan Chase,” Evensky says. “Two years ago, who would have thought there was any risk with them? Today we put a limited amount with JPMorgan.”
As for variable annuities, they are a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you. The value of your investment — and the payouts — will vary depending on the performance of the investment options you choose.
The investment options for a variable annuity typically include mutual funds that invest in stocks, bonds, money market instruments or some combination of the three.
“But fees can be quite high,” says Holtzman. “Annuities usually sell with a 6-percent commission, and you’re getting a huge surrender cost at the back end. Figuring out your return after expenses, it might not be worth it in light of other risks. If the issuer is Citigroup, you don’t know whether it will be around next week, let alone for say the eight years of a variable annuity.”
Marketers of variable annuities are playing to people’s emotions, Houlihan says. “People want the highest return they can get without risk,” she says. “That’s an oxymoron.”
She says one of her clients is very conservative and was told by the institution selling her an annuity that she was guaranteed a certain rate of return. “But 100 percent of the annuity was in aggressive mutual funds,” hardly a guarantee of any rate of return.
So how do you achieve safety? Evensky says, “There is no such thing as a safe investment. You need a safe portfolio through balancing.” Treasury Inflation Protected Securities, or TIPS, make sense now, he says.
TIPS are government securities with interest rates that are linked to inflation. When inflation rises, so do your interest payments. With the budget deficit exploding, inflation will probably rise, Evensky says. “The price of TIPS can be quite volatile, but they are paying about the same as Treasuries now, so their cost is low.”
Evensky also recommends high-quality corporate bonds, perhaps in a laddered portfolio, where you have a range of different maturities.
Legend Financial has its clients in two Ginnie Mae bond funds. Those are the only mortgage bonds officially backed by the government. The firm also likes short-term bond funds.
“Normally, if you’re uncertain, you would put your money in a money-market fund for safety and yield,” Holtzman says. “The problem is that yields are basically nothing now. Using short-term bond funds, you’re getting a better yield than money markets, and you can reinvest at higher yields if rates rise.”
Chris Wheaton, managing partner of Litman/Gregory Asset Management in Larkspur, Calif., says diversification for his firm starts with stocks and bonds. As a temporary substitute for stocks, “we’ve got about a 15 percent allocation to high-yield bonds,” he says.
You might not think of those as very safe, but “there’s a lot more cushion on the downside because the price of high-yield bonds is so out of line [undervalued] in the aftermath of the financial collapse,” Wheaton says. “And even if you get a capital loss from the asset going down, you have a high yield to offset the risk.”