Beating Wall Street at Its Own Game (Part 4) – Products

Thursday, April 15, 2010

Be wary of Wall Street’s new products. They could be geared more to the emotions in your head than the opportunities in the markets.

Wall Street is great at producing new products that many investors want. However, there are potential problems with buying whatever Wall Street is selling.

The products are often mistimed

Wall Street likes to design products to take advantage of yesterday’s markets, not tomorrow’s. The reason? Many investors rely on past results (good or bad) to make their investment decisions. Outstanding junk bond returns last year? Then look for junk bond products this year.

Popularity can diminish quality

When Wall Street creates a new type of product, the initial designs are typically sound. Then, when those products find favor, the selling excitement and competition among Wall Street firms heats up. They try to outdo one another by “enhancing” their products. Those enhancements typically mean higher risks to investors.

A common tactic: Faux “future-looking” products

Products mirroring investor feelings are typically packaged to look modern and just the thing for future markets. For example, many investors are buying specialty products offering stock market “participation” with no risk of loss. An advanced, modern product? Hardly. I cannot remember a post-bear market period in which Wall Street didn’t roll these things out. The end result? A disappointed set of investors who limply tagged along behind the stock market’s rise.

ETFs at the forefront

The many exchange traded funds (ETFs) issued recently are a good example of the Wall Street product machine in high gear. These funds are often viewed as a wave of the future. For example:

“The rise of the ETF industry has been truly remarkable in almost every way. A surge in product offerings has democratized asset classes and investment strategies previously available only to institutions and the super-rich.” (“Three Active ETF Gamechangers,” by Michael Johnston, April 8 )

Well, if by “democratized,” he means anyone can elect to have his/her money at risk in high leverage and aggressive derivative strategies applied to non-diversified investing sectors, he’s right. Most of the many newer funds are wild, representing mini-market segments, oodles of leverage and no one at the tiller (because they’re index funds).

Besides having the characteristics of a frothy product bubble, there is a significant warning sign: The SEC has gotten worried. Instead of waiting until something blew up (the SEC’s modus operandi), they have taken the unusually proactive step of putting a stop to new derivative-based ETFs.

“Although the use of derivatives by funds is not a new phenomenon, we want to be sure our regulatory protections keep up with the increasing complexity of these instruments and how they are used by fund managers,” said Andrew Donohue, Director of the SEC’s Division of Investment Management. “This is the right time to take a step back and rethink those protections.”(March 25 SEC press release)

Another warning sign: Investor actions. You wouldn’t think that investors who were upset by the recent high leverage + aggressive derivative smashups in Wall Street would clamor to own this stuff. But they do, encouraged by glowing Wall Street and media reports.

An example of a lesson unlearned…

J.P. Morgan Income Builder Fund, an income product for retirees, was recently in the news. We get a clear picture of just how Wall Street does it from The Wall Street Journal (“Fund Explores CMOs for Retirees,” by Matthias Rieker, March 8, page C-7):

“J.P. Morgan Income Builder Fund isn’t your grandfather’s retirement fund.”

Implication: “Tried and true” is now “old and outdated.” You need “new and modern.”

“J.P. Morgan says investors can improve income with a portfolio that spans across various asset classes, including stocks and bonds outside the U.S., without adding sizable risk.”

There they are: The magical words to make today’s investors sit up and write a check.

“In addition to the stock-and-bond mix usually seen in mutual funds geared to investors nearing retirement, Income Builder Fund invests in collateralized mortgage obligations, real-estate investment trusts, convertible bonds, emerging-market stocks and high-yield debt around the world.”

Wait a minute! All that stuff is high risk. And “around the world” doesn’t mean diversified. It means added risk. High-yield (junk) bondholders have a real possibility of default and restructuring. In other countries, bondholders have varying, and often weaker, protection and rights.

“Stocks, mostly foreign, currently account for 32% of the fund’s holdings, investments in global REITs account for 5%, while the rest are allocated in various fixed-income instruments. Ms. [Anne] Lester said the fund’s high-yield allocation is at 45%, having reached as low as 40% and as high as 60%. ‘We’ve been at zero in convertible [bonds]; right now we are almost at 10%. We’ve had emerging-market debt as high as 18%, right now we have 8%,’ she said. Mortgages constitute 4% of its portfolio.”

And now we know that “without adding sizable risk” is nothing but marketing. There are three major risks from these allocations. First, a junk bond allocation of 45% is huge. Second, the range of 40% to 60% is overly large, adding significant risk from a bad timing call. Third, rather than the high-risk investments being “in addition” to a traditional stock-and-bond mix, they have taken over the fund.

Wondering why derivatives are not part of the mix? Well, they are. From the fund’s website,

“We use derivatives to primarily manage portfolio risk…. to hedge exposures we don’t want to have.” – Anne Lester, Portfolio Manager, Income Builder Fund

To me, not only is this fund not grandfather’s retirement fund, grandpa shouldn’t go near this thing.

A fact to remember: There are only two types of investments

So many products, and yet there are still only two investment types in the securities markets. They are equity securities (representing shares of ownership) and fixed-income securities (representing portions of a debt). Everything else (such as convertibles, options, funds, futures, hedges and “specialty” items) is simply a blended or modified product. These product designs can serve a sound investment purpose, add in financial elements (e.g., leverage) or simply fool investors by giving the impression that there is a way to have their cake and eat it, too.

So… Be wary of Wall Street’s product machine, particularly when its in full operation amid excitement and glowing reports. The way to beat Wall Street is to pick the time and place to use their products. That time is usually earlier in the product’s development or after the bubble has popped and most investors have moved on.

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