John Rafal recently met with a new client who had a $9 million portfolio, stuffed with the kinds of things brokers sell, but investors shouldn’t own.
“Her portfolio is a textbook of what you shouldn’t do,” said Rafal, founder of Essex Financial Services, an independent advisor with about $3.3 billion under management in Essex, Conn.
It had fee-heavy hedge funds. Overpriced municipal bonds. And a $1 million deferred income annuity that had probably cost her at least $60,000 in commissions and had the nasty effect of converting capital gains into higher-taxed ordinary income.
“It was ridiculous,” Rafal said of the portfolio his firm is now working to fix. But ridiculous is the norm in many broker-driven accounts, where investors load up on products with hidden fees or tax consequences based on the advice of would-be advisors who have a glaring conflict of interest. The more they sell, the more they make.
Independent advisors charge an hourly fee or a percentage of assets managed, so they don’t rely on commissions and hidden kickbacks from fund managers to pay their kids’ tuition or the note on the BMW. They come with their own risks – a flat percentage of assets can be an invitation for laziness, and many put their clients into cookie-cutter portfolios – but at least independent advisors can speak freely about products investors shouldn’t buy.
Here Rafal’s list of The 10 Worst Ideas For Your Investment Portfolio:
- Tax-deferred annuities. Most come with a 6-10 percent commission on the front end and are designed to defer income to some future period when the buyer’s taxes will be lower. “But that’s never the case,” Rafal says, at least among his clients with multimillion-dollar portfolios. Meanwhile they convert capital gains, which are taxed at a lower rate, into ordinary income taxed at a higher rate. Buy an index fund instead and cash out in retirement by selling shares taxed at the lower gains rate.
- Non-traded REITs. These private editions of Real Estate Investment Trusts have all of the drawbacks of owning real estate and few of the benefits of owning a REIT. Most provide an ill-defined pool of real estate that may or may not generate income, and may or may not be able to be sold, with 10% commissions subtracted from your investment up front. Private REITs are “a low-end retail product sold by brokers interested in high commissions,” Rafal says.
- Municipal bonds sold by retail brokers. Many brokers “mark up bonds in outrageous fashion,” Rafal says, citing a Wall Street Journal study that found average markups – on purchase and sale – of 1.7%. That’s a 3.4% round-trip haircut equivalent to a year’s interest or more at current rates. Most of those markups are obscured from the investor in the form of a slight decline in yield. The solution is to deal directly with an independent bond manager who isn’t affiliated with a brokerage firm and selling paper out of inventory, but that generally requires a minimum investment of $500,0000. Any individual bond purchase below $100,0000 – known as an odd lot in the trade – is likely subject to “ridiculous markups,” Rafal says. Check out the pricing history of the bonds in your portfolio at the Electronic Municipal Markets Access website.
- Anything sold on a yield basis. Investors frequently fall prey to investments that promise high yield but are effectively handing them their money back in quarterly chunks. Cornerstone’s Strategic Value, Total Return and Professive Return Funds all show up on a Bloomberg screen of funds with a 12-month dividend yield in excess of 10%, but all three have five-year total returns of less than 3% a year. Pimco’s High Income Fund boasts an 11% yield and 4-star rating from Morningstar, but it also comes with a 57% premium to net asset value, meaning investors are paying $1.57 for each dollar of assets just to get Bill Gross’s expertise at wringing high yields out of a leveraged portfolio. If that premium shrinks – as it did in 2012, when it fell from 60% to 23% — investors who bought high take the hit.
- Currencies. Brokers are pushing the concept, often with leveraged and double-leveraged ETFs, but are you really going to win against professional traders who move trillions of dollars a day in this market? No.
- Hedge funds. The premise behind hedge funds is protection of capital, hence the word “hedge,” but most funds have long since morphed into fee-heavy vehicles that package leveraged beta, or market returns, and sell it as alpha, or returns generated by superior stockpicking. “They are supposed to lower risk, but they might actually have higher risk,” Rafal says, which is hidden by the infrequent reporting of fund asset values that masks their underlying volatility. Try selling in a panic like 2009 and you’ll find out the steep price of illiquidity. Meanwhile even in good years the 2-and-20 fee structure eats away at your returns.
- Hedge-fund mutual funds. So-called “alternative” funds keep the 2% management fee and expose investors to the same or more risk, often with hedge-dampened upside. “Where you don’t want to be in a bull market is in a hedge fund or selling short,” Rafal says. AQR’s Multi-Strategy Alternative fund has a $5 million minimum, a 1.98% expense ratio, and has badly trailed Morningstar’s Moderate Target Risk benchmark over the past three years. The SEC is looking into whether these publicly traded brethren of private hedge funds present higher risk because investors can pull their money out more rapidly, triggering a “bank run” where the fund must sell illiquid assets at a loss.
- Newly issued closed-end funds. Only a sap would buy these on issuance, as they include a 2-4% hidden fee paid to brokers that initial purchasers fund when they buy the shares. That new-car smell is always expensive.
- Options and futures. “I, to this day, have not found anybody who makes a lot of money doing options,” says Rafal. High commissions erode away most of the gains, even if you do win.
- Structured notes. The collapse of the auction-rate preferred market should be warning enough that any investment backed by the balance sheet of a bank is risky. Now banks are selling products with exotic names like “index-linked CDs,” that promise a coupon that fluctuates with the performance of a basket of stocks, commodities or bonds. Most come with a principal guarantee plus up to $250,000 in federal deposit insurance, but ultimately investors are betting on the credit quality of the bank. “Why would you do that?” Rafal asks. Good question.