Swedroe: Avoid ‘Bad & Ugly’ Strategies

Over the past week, we’ve taken an in-depth look at why today’s investors are facing a “perfect storm” of factors that, when combined, can significantly hinder the pursuit of higher expected returns.

In taking on this problem, we have so far discussed the elements working against investors, as well as some steps to help combat these head winds. We have also explained why exposure to certain investment factors not only can provide a higher expected return and diversification benefits, but help mitigate risk as well. However, to this point, we’ve only covered strategies that investors should consider adopting if their goal is to increase future expected returns. Today we will turn to some of the strategies that are generally better avoided.

But first, a quick note on two additional planning options that, if properly applied, may help investors increase the expected return of their portfolio.

Payout (Not Variable) Annuities Can Play A Role

If you are already about age 75, purchasing an immediate annuity would improve your odds of not running out of money in retirement. The reason is that, by age 75, what are referred to as “mortality credits” usually become large enough to raise expected returns above what you could accomplish on your own.

If you’re younger than that, you might consider purchasing a deferred payout annuity, with payments beginning at age 75 or later (the longer the delay, the greater the mortality credits).

Finally, there’s one last option worthy of consideration: extending maturities.

The Term Premium

While the annual average return on one-month Treasury bills has been 3.5%, the annual average return on five-year Treasury notes has been 5.4%, a term premium of 1.9%. Note that while there also has been a term premium beyond the five-year mark, returns to the premium have diminished sharply as you further extend maturity (which is why the intermediate term is often referred to as the “sweet spot”).

Twenty-year Treasurys have provided an annual average return of 6.1%. Thus, while investors earned a term premium of about 1.9% per year in the first five years, the additional premium over the next 15 years has been only about 0.70% (6.1% minus 5.4%) per year.

The historical evidence also shows that the term premium has been best rewarded when the curve has been steep. In other words, just when investors have been most afraid of extending maturities has proven to be the occasions they were best rewarded for doing so.

Here again, the message is that it’s OK to extend maturities when you’re being paid to take more risk, but do it in moderation, adding perhaps a year or two to the average maturity of the portfolio.

As I mentioned previously, so far we have only considered options for raising expected returns that fall into the “good” category. And while the marketing machines of Wall Street have created an almost infinite list of bad ideas and/or products, here’s a short list of some of the most commonly used that I would classify as either “bad” or “ugly.”

The Bad And The Ugly

• Credit Risk: While the other premiums we have discussed have been well rewarded, taking credit risk has not. Even before considering implementation costs, the credit (or default) premium (defined as the difference in returns between long-term Treasurys and long-term corporate bonds) has been only 0.3%. And credit risk doesn’t mix well with equity risk, as they tend to both appear at the same time. That puts credit risk in the “bad” category. I recommend limiting bond investments to only the safest bonds. In general, that would be Treasurys, FDIC-insured CDs and AAA/AA municipal bonds that are also either general obligation or essential service revenue bonds.
• Actively Managed Mutual Funds: While active management does provide the possibility of outperformance, the odds of doing so are so poor that it’s not prudent to try. What’s more, as shown in my newest book, The Incredible Shrinking Alpha, which I co-authored with Andrew Berkin, the odds of winning have been collapsing. Twenty years ago, about 20% of actively managed funds were generating statistically significant alphas. Today that figure is 2%. And that’s before considering the impact of taxes. Thus, the use of actively managed funds, especially ones with high expense ratios and/or high turnover rates, will generally fall into the “bad” category.
• Hedge Funds: The performance of hedge funds has been so bad that they make actively managed funds look great. Over the last 10 calendar years, the HFRX Global Hedge Fund Index returned just 0.7%, underperforming every major equity asset class by wide margins. That figure is even worse than the return on virtually riskless one-year Treasury notes. Thus, the use of hedge funds falls into the “ugly” category.
• Structured Notes: Wall Street has created a laundry list of very complex instruments (such as reverse convertibles) that are financial derivatives whose payoff at maturity depends on one or more classical assets (mostly stocks or stock indexes). There’s only one thing you need to know about them—if you’re ever offered one, run away as fast as you can. They manage to make even hedge funds look attractive.

Growing Problems For Retirees

In conclusion, an unfortunate set of circumstances has made it much more difficult for today’s investors to reach their financial goals. And we didn’t even discuss the problems related to the underfunding of Social Security, Medicare and Medicaid, which almost certainly will result in some combination of reduced benefits and/or higher taxes.

However, ignoring the problem not only won’t make it go away, it would almost certainly decrease your chances of having a financially secure retirement. Thus, it’s important to accept the fact that expected returns from financial investments are now much lower than they have historically been.

The bottom line is that your retirement plan must deal with the cards you’ve been dealt. I’ve provided you with what I think are the options worth considering, along with a list of the ones you should avoid like the plague. Running a Monte Carlo simulation can help you identify the mix of strategies that will give you the greatest chance of success while assuming no more risk than you have the ability, willingness or need to take.

Two Important Numbers

Monte Carlo simulations require a set of assumptions regarding time horizon, initial investment, asset allocation, withdrawals, rate of inflation and, very importantly, the distribution of annual returns for the different asset classes.

In Monte Carlo simulation programs, the expected final wealth distributions are determined by two numbers: the average annual return, and the standard deviation of the average annual return. The Monte Carlo simulator will randomly select a return for each year and calculate the wealth values over the expected retirement period. This process is repeated thousands of times to calculate the likelihood of possible outcomes.

Given the complexity of this issue, you might find that working with a good financial advisor can help you examine the various alternatives so you can determine the best options for you. These are the options that will give you the best chance of achieving your life and financial goals while also allowing you to sleep well at night so you’ll be able to stay the course and avoid panicked selling during the inevitable periods of poor performance that all strategies will face.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.