Reality check: Are these investments really safe?

June 29, 2011: 5:56 AM ET
One way to manage portfolio risk -- understand these new financial products.

One way to manage portfolio risk -- understand these new financial products.

(Money magazine) -- Just when it looked as if the stock market was starting to calm down late last year, Treasury and municipal bonds got the yips. And just when it seemed like those jitters had largely passed, commodity prices took a big belly flop in April. Your nerves may be getting frayed by now. Which part of your portfolio will come unglued next?

Wall Street claims to have a solution. The financial industry's wizards have increasingly been pitching a bunch of investments -- some new, some updated versions of old classics -- with soothing descriptions like "absolute returns" and "principal protected." Of course, this was the same industry that made mortgage-backed securities sound safe just a few years back.

Given how popular some of these new investments are becoming, and how actively they're being pushed, it's time to look under the hood. Some of these products can, in moderation, offer you a safer ride, but many have such high fees that they still can't beat a tried-and-true diversified portfolio of low-cost funds that's rebalanced on a regular basis.

Here's a reality check on some of the hottest products geared toward frightened investors, listed in descending order of their potential usefulness to your portfolio.

Hold-to-maturity bond funds

The pitch: There's always been a flaw with traditional bond funds. While they provide instant diversification, they take away one bit of security that individual bonds offer: a maturity date at which you know you'll recoup your money.

Enter the hold-to-maturity bond fund. Invented in 2010, these funds buy baskets of bonds like traditional portfolios do. The difference is they invest in bonds that mature in the same year and hold them. When those securities pay off, the funds liquidate and distribute the money back to you.

This means these funds should, in theory, become less risky over time, as the maturity date nears.

The reality: The concept sounds great, but these funds are still really new. And so far there are only a handful of offerings, limited to corporate and municipal securities.

Also, hold-to-maturity funds can still experience some ups and downs.

The iShares 2017 S&P AMT-Free Municipal Series ETF has bounced between $54.03 a share and $49.38 in the past year. So they're most appealing if you plan to hang on to the fund until maturity.

Even if you have to sell before that, they come in handy if you want the reassurance of a maturity date without the risk of owning just a handful of individual bonds, which are harder to unload in the open market than ETF shares.

What to do: Because these offerings are so limited, you can't use them to build out a total bond portfolio. But if you have a specific need at a certain date -- like paying for your kids' college -- then the iShares hold-to-maturity muni ETFs can be useful, says Scott Burns, Morningstar's director of ETF research.

The iShares funds sport expense ratios of 0.30%. That's a tenth of a percentage point more than Vanguard bond index funds charge, but far less than average fixed-income-fund fees.

Floating-rate bank loan funds

The pitch: Funds that invest in short-term loans that banks make to businesses with less-than-stellar credit have been around for years. They've surged in popularity this year, though, pulling in nearly $20 billion in new money on fears of rising interest rates.

Floating-rate funds are a classic rising-rate play. Like other short-term bond funds, they can reinvest at higher yields as loans come due quickly.

Know just enough about investing to succeed

Better yet, since the notes reset quarterly, you also benefit from rising yields before the loans expire. And unlike regular bonds, these bank loans are secured against a firm's assets. So while these funds own lower-quality credits than investment-grade bond funds, they're higher in the pecking order to be repaid in case of a bankruptcy.

The reality: They solve only one type of risk -- jitters stemming from rising rates. Should bond yields sink, as they did in 2008, these funds can lose more than other short-term funds. Why? Most firms that require this financing are junk-rated. And if rates fall because the economy is slowing, financially weaker firms will be at greater risk.

Floating rates have also grown so popular that as prices rise, their yields are shrinking, possibly to the point at which they may not be worth the added risk, says Roger Nusbaum, portfolio manager at Your Source Financial, a Phoenix-based money manager.

What to do: The average floating-rate fund charges fees 40% higher than a typical short-term bond fund. Stick with one that charges less than 1% of assets annually and that focuses on higher-quality credits -- like Fidelity Floating Rate High Income -- and you can buy some added protection against rising rates. Just keep your stake to around 10% or less of your fixed-income portfolio.

Absolute-return funds

The pitch: These funds don't try to beat a market index; rather, they aim to make you money in good times and bad. Since we've just been through a decade in which stocks lost value, you can see the appeal.

The reality: "This is a marketing ploy. There is no such thing as absolute returns," says Rick Ferri, founder of Portfolio Solutions, based in Troy, Mich. In fact, 16 of the 20 absolute-return funds that were around at the start of 2008 lost money in that down year, according to Lipper.

Also, since these funds -- many of which charge annual fees in excess of 2% of assets -- use complex instruments like futures, options, and derivatives, they can be volatile.

What to do: Hold off. There simply aren't any low-cost absolute-return funds that you can go with that have a track record of making money consistently in down markets.

Principal-protected structured notes

The pitch: These investments, which have been sold by banks and brokerages for years, use a combination of bonds and derivatives to promise you two things: some protection against losses plus the possibility of earning stock-like returns under certain circumstances.

No wonder sales of all structured notes jumped 46% last year to a record $49.4 billion, according to Bloomberg.

The reality: These are complicated, mostly non-tradable securities that are often only as secure as their issuers.

Now defunct Lehman Brothers marketed millions of dollars of "100% principal-protected notes" (PPNs) that were "protected" by nothing more than Lehman's own creditworthiness. You can guess how that turned out.

The Financial Industry Regulatory Authority (FINRA) in April fined UBS Financial Services $2.5 million and required it to pay $8.25 million in restitution for misleading investors about the safety of Lehman's PPNs.

Even the best of today's PPNs may not make you big money. J.P. Morgan Chase recently marketed PPNs that pay 8% in the first year and then promise annual returns ranging from 0% to 12%, depending on a complex formula linked to the S&P 500 index and the London Interbank Offered Rate (LIBOR). But if the formula produces high returns, Chase can call the note back at any time. Meanwhile, investors must wait until 2026 to redeem.

Larry Swedroe, research director at Buckingham Asset Management, says he has analyzed hundreds of structured notes. "I never found one that made any sense," he says.

What to do: Stay away.  To top of page

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