There is another expense to trading, and this one is very well hidden. It’s called the spread, and it exists on almost anything that is bought and sold. The spread is the difference between the price to buy and the price to sell. (By analogy, we might compare it to the difference between the wholesale price and the retail price.) Most of us understand when we buy a brand-new car that we cannot turn around and sell it for the dealer’s price, but it is less obvious that a similar buy-sell disparity applies to financial assets we buy as investments. Take a look at your favorite stock right now; you will see a bid price and an ask price. The ask price is the amount you would have to pay (plus trading commission) to buy the stock right now. The bid price is the amount (plus commission, of course) to sell it right now. Notice that the ask price is higher than the bid price. Wall Street firms that make a market in the stock do very well by this spread; buyers and sellers do not. Somebody benefits when you trade a lot, but that somebody is not you.
Needless to say, the costs of trading are even higher if you are buying and selling anything that carries a (visible or hidden) sales charge. Be careful to avoid all the ways that the industry has found to hide those charges. For example, those who refuse to buy class A shares that have such sales loads (discussed earlier) are offered class B shares that do not, but the underlying fees on the B shares are marked up enough to more than make up for the lost sales commission in a few years. (That’s right, the operating fees on a mutual fund sold as B shares are actually a lot higher than the regular operating fees, even though the costs of running the fund are exactly the same.) Sometimes new issues are sold as having “no sales charge,” but their price is set so that it is 5.75 percent or 10 percent or 15 percent higher than the price it will sell for the day it begins trading on the open market. When the brightest guys on Wall Street set out to hide the sales charges from you, they can get pretty creative. Caveat emptor.
An article in the Journal of Corporation Law2 stated that mutual fund fees are too high. The authors based this claim on their comparison of the difference between those fees and what some of the same companies charge large pension funds for essentially the same services. They pointed out that the pension funds were in a position to bargain knowledgably and hold down these costs. Mutual fund investors, on the other hand, are the victims of both a conflict of interest between themselves and the directors of their funds, and a lack of comprehensive knowledge. The article went on to suggest that the main reason investors do not have adequate knowledge about the overall costs of mutual funds is that the information is being hidden from them.3 It gave examples where not only shareholders but also journalists, the Government Accounting Office, the Securities and Exchange Commission, and even fund directors themselves were unable to access or interpret information on mutual fund pricing.4
Finally, although I’m sure this point is obvious to you by now, you should never, ever pay a management or advisor fee to anyone who is in any way selling products or making any kind of commissions on the investments you make. By analogy, it is as if you went to the doctor’s office only to be told that your physician was now charging a special fee for determining the best drugs for your treatment. At the same time, the pharmaceutical company manufacturing the drug was paying her a commission for every pill consumed by her patients. This situation could never be acceptable or considered fair. The incentives created by the commission work in direct conflict with the doctor’s duty. Furthermore, you are already paying a fee to the doctor for her promise to fulfill that duty; she must use her expertise to select the very best drug for treating your ailment. Payment for “product placement” adds significant costs and is never going to be compatible with the use of professional judgment.
Chapter Summary
Economists know that the cost of investments reduces their effective return.
Keeping costs lower tends to raise returns.
When comparing similar investments, consider relative costs and fees.
More costly investments do not perform better than those with lower costs.
You should minimize trading.
Do not pay anyone a fee if they are steering you into things on which they make commissions or are otherwise compensated.
Notes
1. One example is funds that invest in mortgage-backed securities in the United States. (These are often called GNMA or “Ginnie Mae” funds, after the government-sponsored consolidator of mortgages.) There are several dozen mutual funds that invest in such mortgage loans. There are very slight differences in the overall interest rates, duration, and creditworthiness of their various portfolios. For the most part, though, these GNMA funds invest in more or less the same thing.
2. John P. Freeman and Stewart L. Brown, “Mutual Fund Advisory Fees: The Cost of Conflicts of Interest.” Journal of Corporation Law 26, no. 3 (Spring 2001): 609.
3. Ibid., 662–670.
4. Ibid., 663–668.
Chapter 34
Investments to Avoid
While there are countless investments for you to consider, some are better avoided altogether. I don’t want to spend too much time on this subject, and certainly don’t suggest that this list is comprehensive, but I did want to write briefly on some types of investments that you should steer clear of.
In every type, variation, and flavor of investment, some are better than others. However, the ones I list here are never a good idea.
Variable Annuities
Variable annuities are a terrible investment, expensive as the dickens, and wildly popular in America. What’s wrong with them? For starters, they are loaded with costs and surrender charges. These are additional fees you must pay if you want to get at your money during a surrender period, typically in six to eight years. In addition, variable annuities turn long-term capital gains into regular income (a very bad thing from a tax point of view). Furthermore, they are sold as having an insurance component when, in fact, that insurance is a cruel hoax. Happily, you don’t have to take my word for it; just see the issue of Forbes magazine dated February 9, 1998.1 The cover of that magazine says it all: “Don’t be a sucker! Variable annuities are a lousy investment.”2
Hedge Funds
Hedge funds were the flavor of the week for quite a while, and though they have fallen slightly out of favor, are still prevalent. They are also full of very troubling details. Supposedly, a major advantage of hedge funds is that they can make bets that investments will lose value (taking a short position), as well as the more traditional wager that their favorites will gain. That sounds good until you remember what economists know: If nobody can consistently pick what will go up, the exact same logic shows us that nobody can consistently choose what will go down, either. Hedge funds are extremely expensive: The manager is paid a fee to run the fund and then a big chunk of any profits (the going rate is 20 percent). Furthermore, hedge funds are not regulated by the government in the way that mutual funds and stock and bond investments are. (The governmental attitude on this seems to be that these investments are only for big boys and girls who can take care of themselves.) Thus, hedge funds are free to report their results, or not, as they see fit. It will come as no surprise that they tend to be more diligent about reporting when they have had a good year than when things have not gone their way.
Hedge funds are famous for making big bets, and this is part of the problem. Anyone can take another person’s money and bet, for example, that oil3 will go up. Through the use of leverage (borrowing), they can make a very big bet. If oil goes up, they look smart. If oil goes up a lot, they look like geniuses (and attract a lot more money to play with). And if oil goes down, they get wiped out, close up the fund, and walk away.4 We note that they could make the same bet on oil going down, to the same effect. The key point is that hedge fund managers have nothing to lose in making such bets. You do. Be extremely wary of anyone who is betting other people’s money and thus has an incentive to go for broke in this way.
Derivatives
Derivativ
e is a catchall word for a bunch of investments, the values of which are derived from other investments. The most common of these are stock options. Using “puts” to bet a stock will go down and “calls” to bet on a rise is marketed heavily and appeals to folks who like to gamble. What these are, really, are the contractual rights to sell (put) or buy (call) the stock at a given price and date. Andrew Tobias offered this warning in a recent edition of his book, The Only Investment Guide You’ll Ever Need: “Just remember this: it is a zero-sum game and the odds are definitely against you. Anything you do win is fully taxed as a short-term capital gain. There are no dividends, lots of commissions. It may be addictive.”5 My memory, though, was that he gave an even graver warning in an earlier edition with respect to the danger of playing with options: “For most people, the bottom line is this: it’s an exciting game, but if you play long enough, you will lose all your money.”6
Callable Bonds
What is a callable bond, and why would anyone choose to invest in one? The concept is pretty straightforward. While a traditional bond, such as most U.S. Treasury bonds, promises to pay you the stated interest rate until the maturity date, one that is callable is a bit more complex. A callable bond can be redeemed by the issuer prior to its maturity. In other words, if it suits the issuer, the bargain can be terminated early, and you get your money back.
Sometimes the return of principal includes a premium (extra money) to compensate for the fact that the redemption isn’t so great for the bondholder. Sometimes it does not. That depends on the terms of the bond—which are the equivalent of a long and complex legal contract.
The primary reason such a bond is redeemed before its final maturity date is that interest rates have fallen. In such a situation, the issuer would be able to refinance the debt more favorably. The market price of the bond would almost surely have risen. And, of course, you as the bondholder are going to get your money back at a moment when only lower interest rates are available if you wish to reinvest on similar terms.
Thus, a callable or redeemable bond is structured so that the issuer has a choice as to whether to end the deal and give bondholders their money back at certain points in time. Bondholders, of course, are not offered this flexibility. It is not a fair or even deal. That should be okay, though, since the price of the bond is adjusted to reflect that this provision is a one-sided covenant in the issuer’s favor.
A properly functioning and highly liquid marketplace will price these bonds correctly to adjust for this one-sided provision. But what if the marketplace for bonds is either not functioning properly or not highly liquid? This complexity in the structure and fairness of the bond is going to benefit the party who has more information. If both sides of the transaction are highly sophisticated bond experts, the whole thing is going to turn out fine. That, however, reflects the reality of neither the world generally nor the voracious financial industry. Rather, the information asymmetry will probably be used to take advantage of the party less able to protect its own interests in this deal. And that is going to be you.
At a conference I recently attended, a speaker was talking about bond market trading. In the middle of a discussion about deals between highly sophisticated institutional traders, someone asked a question about individual bond investors. The expert paused briefly and said, “Retail investors get slaughtered in the bond market.” No explanation, no concern, and no further comment. He just offered it as a widely known and indisputable fact. Then he went back to what he had been talking about.
It’s true. Small retail investors get slaughtered in the bond market. They are playing on a field they don’t belong on, like a kitten on a superhighway. Unlike large-capitalization U.S. stocks, bonds are not traded in a properly functioning liquid market. Rather, small bond investors must rely on bond desks concerned with their own inventories, markups, and profitability. The small investor must contend with complexity, opaqueness, rent-seeking, and asymmetric information that all work against her.
The simple answer is to avoid callable bonds entirely. There are plenty of good alternatives. You can stick to bonds that are more straightforward. Even better, you can delegate the entire problem to a low-cost mutual fund or ETF. Perhaps better still is to invest in an index fund that eliminates entirely the question of which bond is better than another.
Having completely sidestepped the problem, all you need is a succinct answer as to why. When a friend, neighbor, or bond salesman asks you why you decline to invest in these bonds, your reply will be simple: “When the game is ‘heads they win, tails I lose,’ I prefer not to play.”
Convertible Securities
Convertible securities are investments that have some of the characteristics of stocks and some of the attributes of bonds. At first glance, this can look like a nice compromise. On further reflection, though, it is a bad idea.
A stock is a piece of ownership in a company. Holding a share of stock brings with it a certain bundle of rights. A bond is an IOU from a company, government, or other entity. You have lent them money, and holding the bond entitles you to certain rights that include interest and the collection of your principal when the term is over. Now consider a preferred stock or convertible bond that gives you some of the rights—but not all—from each of those bundles. The rights and restrictions you receive are complex and difficult to understand. They are not a perfect split down the middle of the stockholder and bondholder privileges; rather, they are fashioned by the Wall Street financial engineers who created the security. Those folks charge dearly for their financial wizardry, and the instrument you bought must cover those costs. It is worse, though, in that such a hybrid security is invariably created by a firm that is looking out for its own interests. The creators will want to carve up the rights so that those remaining after the sale of the security are valuable to them.7 By analogy, consider your local butcher.8 He has a huge 20-pound roll of salami and a huge 20-pound roll of bologna. You tell him you want two pounds of a hybrid mixture of salami and bologna. Now you must wonder: Will he put the less desirable end pieces from each meat into your hybrid? Will he put less of the more expensive salami and more of the cheaper bologna? Will he use the highest quality brand of salami or one of those lesser brands? Will he put his finger down harder on the scale to compensate himself for his creativity? Instead of buying two individual items that you know how to measure and evaluate, you have asked him to create one hybrid that you have no idea how to assess. Wouldn’t it have been wiser to simply buy one pound of salami and one pound of bologna? So it is with convertible securities.
As with callable bonds, convertible and hybrid securities have much in common with long and complex legal contracts. They are rife with conditions, trade-offs, preferences, and compromises that must be fully understood to ensure fairness. Once again, the asymmetry of information is going to benefit those who created the instrument and work to the disadvantage of those less able to protect their own interests. In other words, the average small investor is going to be the loser when complex investments are created out of relatively simpler ones.
High Costs, Complexity, and Creative Geniuses
Other investments to avoid include complex partnership deals (which can also give you fits at tax time), investments of one kind that are indexed to another (such as certificates of deposit that pay you some percentage of the gain on the stock market), and any kind of investment scheme that involves insurance.
This list of investments to avoid is far from complete. It is only a sampling of categories and types of investments that offer far greater peril than they do advantage. What they all have in common are high costs, complexity, and the burden of having been created by highly paid geniuses who are richly rewarded for their clever financial engineering. In general, it seems fair to say that complexity is not your friend as an investor. It invariably involves added costs, and it creates information asymmetries that will never be to your advantage. No amount of negotiating skill will enable you to completely erase these deficits
. If you invest in any of these types of instruments, you start off behind the eight ball and are far less likely to do well.
Chapter Summary
There are many categories of bad investments, and only some are mentioned in this chapter.
Do not allow yourself to be sold a variable annuity product.
Hedge funds are a great deal for the people running them but not for investors.
Derivatives such as puts and calls are not a good idea.
Complex bond structures that create one-sided advantages should be avoided.
Complex partnership investments, schemes to invest via insurance contracts, and investments of one kind indexed to another should also be avoided.
Steer clear of high costs, complexity, and products created by financial geniuses.
Notes
1. Forbes, February 9, 1998.
2. Consider the corporate courage of Forbes to print such a cover story: A tremendous number of their advertisers sell the very annuity products they were so prominently criticizing. Consider too, though, how bad these investments must be for Forbes to muster that much courage.
3. Or Microsoft stock, or the Thai baht, or almost anything else.
4. Some mutual fund companies have used the same logic to start new funds with records of fabulous returns. They incubate 10 funds, all making very different bets, and see which one does well (one of them must). Then they can bring the big winner to market while folding up the other nine funds. Remember the story about a single person in the room flipping heads many times in a row.
Negotiating Your Investments Page 26