By: Jason Whitby
By: Jason Whitby, CFA, CFP®, MBA, AIF®
In a world where asset diversification has seemingly failed, what do you do? My account is down 10%, 20%, 50%; isn’t there a better way? Aren’t there other options we should consider? What are we doing differently? What have we learned? What have we been considering that is different? These are just a few of the questions that I’ve been getting over the last few months, and rightfully so. You should know what we have been thinking about and considering. Here is a very general overview for 10 of the more noteworthy options which we have either reviewed or been discussing.
- Variable Annuity (VA) with Guarantee Income Riders: I’ve read a lot of prospectuses and have memorized countless acronyms. Yes, I have actually read more than one, cover to cover, most recently the AXA Accumulator. Variable annuities with income riders sound extremely promising and exactly what the doctor ordered! Guarantees for the downside and upside potential, sounds too good to be true. Can anyone say “Free Lunch”? Unfortunately, it isn’t so. First, Variable Annuities are so complicated that I could never cover all of the pros and cons in this article let alone a short paragraph. Additionally, each contract is distinct and different. All we wanted to say is that we have recently reviewed them and decided that they are not of interest to us for new capital at this time. High fees, low liquidity, high complexity and in our opinion, few really understand the potential outcome that will play out with these insurance contracts in 10 to 20 years. Conclusion: No interest but open to future review.
- Fixed Deferred Annuities (FDA): Similar to VAs, there are many different types of FDAs from many different carriers. As with VAs, not all FDAs are the same. You must read the contracts and know all of the rules. The only one I can comfortably say I would condone is the Extended Guarantee Savings Annuities (EGSA) which locks in a guaranteed rate for a specified duration. For example, the USAA EGSA is a two year guarantee at 3.4%. At the end of two years, you are free to move the money with no surrender penalties. While FDIC does not apply, each State Department of Insurance does guarantee the value of FDAs up to the individual state’s limit which is usually $100,000. For select investors, FDAs potentially could be implemented as part of a bond allocation and should be viewed as a CD or bond substitute delivered via an insurance contract. Conclusion: Maybe, case by case.
- Immediate Annuities: This is the nuclear option for risk adverse investors. The investor is essentially saying to the insurance company; “Here is my money, please take care of me till I die”. The advantage is you are guaranteed to never outlive the income stream. The disadvantages are the decision is irrevocable, there is no residual value and you are at considerable risk from inflation. For instance, $500 a month today is very different than $500 a month in 20 years. A recent search at http://www.immediateannuities.com showed a 62 year old couple investing $100,000 into a joint-life immediate annuity would receive $540 per month until the second person dies. This equals a ~7% annual payout per year. But don’t forget, there is no residual value, no flexibility and no inflation protection in this case. If you want to add an inflation protection, your monthly payout drops considerably! Also keep in mind that if the 62 year old couple would have just kept the $100,000 in cash, they could have taken the $540 each month for over 15 years, at which point they would have reached 77. Conclusion: Maybe, case by case for select clients who have no interest in leaving an inheritance and who have a very low tolerance for risk.
- Private Equity: This was a real hot area of interest just recently as a way to protect capital and capture upside. Needless to say the current market environment should have removed all doubt that Private Equity is not an option to reduce risk. More appropriately it should be viewed and compared to a 2xBeta strategy. Conclusion: No interest still. Matter of fact, let’s consider this one closed to future review.
- Hedge Funds: Just like Private Equity, the bloom is off the rose for hedge funds. There should be little doubt that this option isn’t a very attractive option for either protecting downside or for capturing upside. Hopefully investors will begin to view hedge funds as an over-priced and extremely opaque investment vehicle which is exactly what they are. Hedge funds are not an asset class nor do they imply any specific type of investment strategy. Conclusion: Definitely No interest. This one is nailed shut and 6 feet under. Consider this one closed to future review.
- Managed Futures: This area did provide a lot of interest especially when you consider the performance of investments such as RYMFX. Now you might not know what a managed future is, that’s okay. What you should know is the basic premise of managed futures is the belief that commodities and financial futures follow trends and these trends are somewhat predictable which seems a little hard for us to swallow. Even still, the managed futures did seem intriguing until you consider the high fund cost (RYMFX costs 1.73%), the extreme complexity of the underlying investments as well as the extremely short track records for public investments in this area. Time will tell if managed futures are just a short-term fad or a truly viable investment option. For now we will hold off and wait. Conclusion: No interest but open to future review once simplified.
- Gold: Ah, gold! The one that never seems to go away. Let me come out and say that I’m in the camp which believes gold provides no future expected return. So if gold has no economic future return, why hold it as an investment? You wouldn’t. The only reason to hold it then would be to speculate or you believe gold is a safe haven. Since we don’t believe in speculating, the only way gold is going to make it for our clients would be for preservation of capital. But here is where it gets tricky. Why gold over cash? Why gold over bonds? And how much would be enough? And how would you buy it and where would you store it and how would your protect it? And keep in mind, every dollar you place in gold is a dollar with an expected long-term negative real return. So if you have meaningful, excess amounts of money that you really don’t need and you feel secure buying gold and just forgetting you have it in your vault, fine. Otherwise, gold as a separate investment just doesn’t seem to have any compelling reason to invest in. Conclusion: No interest
- Options: In fairness with complete disclosure, I would like to state that I really like options. I like writing and buying. I like calls and puts. I especially love the academic theories and concepts of all the different strategies which options allow. But that’s where my love affair with options pretty much ends. Though options can be a valuable tool for select circumstances, they don’t provide us with an attractive long-term investment strategy. The option strategy that is being sold today essentially involves buying put options on your holdings or the entire stock market. You should view put options as an insurance contract and the cost as such, an insurance premium. Over time, this cost creates significant drag on returns and creates an additional level of complexity which adds risk in and of itself. Essentially, the idea is to give up a little upside to reduce a lot of downside. But we feel this can be better accomplished by simply reducing your equity exposure and holding more bonds. The application of option strategies is vastly more complex and time consuming than at first glance. In case you are wondering, Bernard Madoff claimed to run an option strategy utilizing put options for protection and we know how that worked out. Conclusion: No interest given the high cost and risk of appropriate execution.
- Inflation Protected Securities & TIPS: We still haven’t decided if this makes sense for all of our clients but can see how it might fit for a few specific cases. Primarily for those with no appetite for equity risk. Conclusion: Pending
- Equity to Bond Mix: We strongly feel that the best option is still to recognize whether or not you are capable, willing and/or need to take on more or less risk by changing your equity to bond allocation. To us, this option continues to provide the highest probability of success at the lowest cost and lowest risk with the highest transparency and flexibility. We do believe that many now have a truer sense of their risk tolerance and might be better served by dialing down the risk in their portfolio by lowering their equity exposure. Conclusion: Best option
Hopefully this has provided you with some ideas of what we have been considering and discussing during these difficult times. As I mentioned earlier, there is no way I could have done justice to each of these ten topics given the space provided. But hopefully I have captured the general idea and have been able to communicate it to you in a manner that makes sense. Please feel free to contact me or your advisor if you have additional questions or feel we might be mistaken.
It is important to remember that investment options that are directed to protecting principal only become popular after a crisis, and rarely before. The last time there was so much focus on principal protection was in late 2002, after the last market crash and after the value for most of the strategies had been exhausted. Essentially, closing the barn door after the cows have gotten out only ensures they won’t come back on their own. Moving your principal to “safe havens” after the ride down only ensures you won’t be there for the ride up.