Like most every other business today,
investing is as competitive as ever.
Many companies are vying for your investment business and bombarding the
market with new products. But do these
products really offer anything new?
“It’s like hot sauce,” says Richard Block,
CFA and vice president, wealth management, for MB Financial Bank in Chicago.
“They all come in colorful wrappers and
have catchy names, but really they’re just
pepper juice, water and coloring.”
Smart Business spoke with Block about
today’s various types of investments and
some basic rules of investing.
Are new financial products really all that different from the ‘old’ ones?
Investments, for the most part, fall into
either ownership or creditor interests,
though some hybrid structures, like convertible bonds, often bridge the distinction
between equity and debt. Usually, the new
products introduce a new structure, though
the underlying risk and returns are characteristic of the underlying interest. Examples
of these structures, which have at different
times met with much enthusiasm, are limited partnerships, Real Estate Investment
Trust (REITS), preferred stock and now
Exchange-Traded Funds (ETFs).
ETFs were first introduced with the
launch of the S&P Depository Receipts
Trust Series 1 (SDPRs). The SPDR is benchmarked to the Standard & Poor’s 500 Index.
Later on, ETFs based upon widely followed
benchmarks like the NASDAQ-100, the
QQQQs, Dow Jones Industrial Average,
DIAMONDS Trust and others would follow.
These funds offer essentially the same
investment exposure as index mutual funds
but offer the promise of intraday liquidity,
low management fees and greater control
over capital gains recognition. These advantages, while attractive, may be of marginal
benefit to many investors who already own
index mutual funds.
How does one know if a new financial product is really new or just promoted as such?
Investors must still look under the hood,
so to speak, of the product they’re considering to determine exactly where the
investment expects to generate its return
and understand all the risks associated.
For example, in recent years, the enthusiasm for ETFs has led to the creation of
Exchange-Traded Notes (ETNs).
The purpose of ETNs is to create a type
of security that combines both the aspects
of bonds and ETFs. ETNs often have a
structure that limits downside risk by
offering a minimum return or the return of
some market index, while limiting the
upside potential. This mimics the return
properties diversification brings to a portfolio. These products often come with
much higher management fees and the
return attribution is not transparent, and
you have a single issuer credit risk.
When you buy an ETN, it is the underwriting bank who promises to pay you the
return of the index, less the fees to manage the fund. Because the credit exposure
is to the issuing bank, a change in the
credit rating of the issuer may cause the
value of the investment to decline regardless of any change in the underlying index.
If the bank goes under, ETN holders will
be out of luck.
This may have seemed like a theoretical
distinction a few months ago, but the current crisis in the credit markets has called
into question the creditworthiness of even
the best capitalized banks. Therefore,
ETN holders should receive extra compensation for this risk, which is often misunderstood. Given all of these considerations, we think investors are better off
using stock and bond diversification to
achieve the same result.
What are some basic rules companies
should follow when investing?
The first rule of investing is diversification,
and it may be the one free lunch Wall Street
will ever offer an investor. Owning a variety
of different types of investments, such as
stocks, bonds, real estate, etc., offsets the
risks of one investment against another
while producing higher, more consistent
returns.
The second rule is that the investor should
understand the relationship between risk
and return. Higher risk should inherently be
compensated by higher returns. Owners
should be compensated better than creditors, as they bear greater risk, thus stockholders should command higher returns
than bondholders.
Is now a good time to invest, or is there ever
really an ‘ideal’ time?
If an investor is building a well-diversified
portfolio, some portion of the portfolio is
going to be near the top of the cycle, some
near the bottom and others in between the
two extremes. The key is to begin investing. For long-term holders, the initial entry
point will hardly make a difference after a
few years. Periodically adding to the portfolio and rebalancing to a long-term asset
allocation target will naturally add to positions when they’re at a low ebb while trimming positions at or near their tops. Over
the long run, these types of portfolio management techniques will naturally ‘buy low
and sell high.’
RICHARD BLOCK, CFA, is vice president, wealth management, for MB Financial Bank in Chicago. Reach him at (847) 653-2143 or
[email protected].