Better investments Featured

7:00pm EDT February 24, 2008

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 rblock@mbfinancial.com.