Ask Lynn - This Week’s Column

When you’re rummaging in the kitchen for something to eat, you know what you should resist. Potato chips, with or without French onion dip, are a culinary sin. A stack of Oreos and a mountain of french fries are equally suspect. And just about anything you’d ingest at a gathering that involves sports and a flat screen TV would make a registered dietitian blanch.

Many investors, however, don’t appreciate that plenty of investments will give their portfolios as much heartburn as a dozen glazed doughnuts. The trick is to stick with the investments that are as healthy and essential as carrot sticks and skim milk and avoid the junk.

So what investments, you may be wondering, represent the worst empty calories? To answer that one, I’m going to defer to David F. Swensen, who is a true star in the institutional world of finance. Swensen oversees Yale University’s endowment fund, which has earned a remarkable 16% annual return since he showed up 20 years ago. Thanks to Swensen, many regard Yale endowment fund as the best run and most influential in the country.

Swensen’s book, Unconventional Success: A Fundamental Approach to Personal Investment (Simon & Schuster), Yale’s chief investment officer lays out which asset classes are critical for a typical investor’s portfolio, as well as which are as worthless as an insincere apology.

Fixed-income investors will want to take particular note at what Swensen says since he expresses blistering skepticism at many types of bonds. For a variety of reasons, most fixed-income choices, he concludes, don’t stack up to inexpensive U.S. Treasuries. According to Swensen, here are some of the investment candidates that could easily be inducted into an asset allocation hall of shame:

Municipal bonds. This is going to be a shocker to affluent investors, who have never questioned their allegiance to tax-exempt bonds. The wealthy embrace muni bonds, which are issued by state and local government entities, to build such thing as roads, sewer plants and bridges, because the interest income is shielded from federal taxes. And, in some cases, you can also avoid state taxes. It’s this attractive tax break that blinds investors to what Swensen argues are considerable drawbacks. So what’s the knock against munis? High trading costs, credit risk and call options can significantly erode the muni tax advantage. Individual investors directly hold about one third of the $1.9 trillion in outstanding muni bonds and to hear Swensen tell it, they may as well have the letter “S” stamped on their foreheads for “sucker.” That’s because the bond industry holds the upper hand when individuals buy or unload munis. While muni pricing has become more transparent recently for individuals, the system is still rigged against them. If you imagine how easy it would be for a bully to stiff a couple of kids trying to make money at a lemonade stand, you can appreciate the plight of muni investors. Most of them, however, don’t even know that they’re getting ripped off.

Muni investors also typically don’t receive enough of a yield premium for their bonds’ lack of call protection. Without call protection, the bond issuer enjoys the right to repurchase its bonds from investors at a fixed price if interest rates go down. When this happens, it leaves investors in the lurch because now they have to hunt for a new parking spot for their money when rates aren’t as attractive.

Corporate bonds. The folks who sink money into investment-grade corporate bonds, don’t think they aren’t asking for too much. They simply want to eek out a slightly better yield than what they could get by investing in U.S. Treasuries. Under normal circumstances, however, investors receive scant compensation for buying bonds that exhibit some of the same irritating drawbacks as munis. Corporations, for instance, can also retrieve their bonds at terribly inopportune times for investors. The bonds can also plummet in value if a corporation hits a patch of turbulence or worse. WorldCom investors, for example, saw their bonds drop from investment-grade to junk status to bankruptcy in less than three months.

Junk bonds. Investors who gravitate to high-yield bonds are willing to drive without a seat belt, but Swensen says the dangers of a wreck are too high. In fact, he flat out insists that “junk bond investors cannot win.” These bonds are obviously more speculative than investment-grade corporate bonds, but they are also far less liquid, which can make them more expensive to purchase and harder to dump in a hurry. When the fundamentals improve for a company forced to issue junk bonds, stock returns overshadow the bond returns. And when interest rates decline, noncallable bonds provide superior risk-adjusted returns. The ability of companies to retrieve their junk bonds when they can grab lower rates elsewhere, Swensen warns, sets up investor for a “heads you win, tails I lose,” scenario.

Hedge funds. Swensen warns that the little guys should stay away from overhyped hedge funds, which too often can’t even outperform a lowly money market fund. And why would you want to accept these anemic returns when hedge funds demand that you expose a chunk of your life savings to far greater risks? If that doesn’t deter the curious, this one should: Hedge funds are hideously expensive. That’s why so many portfolio managers have scrambled to establish their own hedge funds to cash in on the spectacular fees that mutual funds can’t charge. While some sophisticated institutional managers, with considerable resources, can find successful hedge fund opportunities, hardly anyone else can.

Also on Swensen’s do-not-touch list are asset-backed securities, foreign bonds and venture capital opportunities. Next week, we’ll look at the investment categories that the Yalie believes you and just about everybody else should own.

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This entry was posted on Saturday, October 20th, 2007 at 2:27 pm and is filed under Investing Behavior. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.