Alexander Efros...'s  Instablog

There are many different investment strategies and financial instruments available to investors, each with its own benefits and risk factors. This article outlines some of the basic similarities and differences between certain types of investments commonly referenced in financial and news media. This article is intended to be helpful for those new to investing and also individuals looking to widen their financial understanding. If you have any questions regarding your investments, please feel free to contact Athelon Wealth Management at 347-706-1414. You may also visit the firm’s website at athelonwealth.com for more information.

Equities (Publicly-Traded Stocks)

Purchasing the stock of a company provides investors with an ownership interest in a public company. It gives the investor an opportunity to participate in the appreciation and depreciation in the price of the stock over time. Additionally, stockholders may receive dividends, which are distributions of corporate profits made at the discretion of a company’s management. Equity securities tend to be highly liquid and can often be bought or sold electronically within seconds. This also means that equity prices can fluctuate significantly within a short period of time. News reports, public company filings, and even rumors can cause the price of a single stock to rise or fall in value. As such, investors are strongly urged to diversify their investments when holding individual equities to minimize risk within their portfolios.

Mutual Funds

Mutual funds are pooled investment vehicles which allow investors to hold diversified portfolios and have them managed by professional fund managers. These funds may offer a wide variety of strategies and may hold equities, bonds, and derivatives such as options and futures. Although mutual funds offer diversification across geographies, risk levels, or asset types, investors may often hold a combination of several different funds to maximize returns and protect their portfolio against losses. Mutual funds usually charge lower management fees than hedge funds, and are more liquid in that they generally allow for purchases and sales within one business day. Investors should, however, be mindful of sales charges (also known as “loads”) which may be assessed when buying or selling shares of some mutual funds. Such sales charges, if applicable, are typically disclosed in a particular fund’s prospectus.

Index Funds

Index funds are mutual funds which are designed to match the performance of a market index. As an example, a mutual fund may be intended to track the Russell 3000 Index. Such funds are usually passively managed, and as such, tend to capture the increases in the underlying index. These funds, however, are generally not protected against sharp declines in the value of the underlying index. Index funds typically charge lower management fees than ordinary mutual funds because their strategies are mostly dictated by the underlying index. As a result, portfolio turnover may be less frequent and transactions may even be automated to closely mirror the performance of the underlying index.

Private Equity

A private equity investment allows an investor to purchase shares of a company which are not traded on a stock exchange. These shares are often purchased through a direct investment into the private entity or through a private equity fund, which invests in private companies as an intermediary on behalf of its investors. Generally, private equity investments offer less transparency than public companies because they are not subject to the same strict disclosure requirements. This means that obtaining timely financial information for purposes of analysis may be difficult and time-consuming. Additionally, private equity investments are generally less liquid and may require investors to commit their capital for months or even years before shares may be sold. As with hedge funds, investments in private equity may be limited to institutions and individuals who meet certain income and net worth criteria.

Exchange-Traded Funds (ETFs)

Exchange-Traded Funds combine the active management element of mutual funds with the increased liquidity of publicly-traded stocks. While a purchase or sale of mutual fund shares may take one business day, ETFs may be purchased and sold within seconds. While some ETFs offer exposure to various conservative investment strategies, others may utilize derivatives and leverage with the goal of magnifying returns for investors. Lately, demand for more aggressive investment vehicles has led to the creation of leveraged ETFs, which amplify the performance of an underlying index by a factor of 2 or 3. This means that a 5% increase in the underlying index can result in a 15% increase in the ETF. Such leveraged ETFs are meant to be held only for short time periods as they are reset on a daily basis. As a result, a long-term investor looking to capitalize on appreciation in the underlying index would generally be highly disappointed if attempting to use leveraged ETFs to accomplish their desired returns.

Hedge Funds

Hedge funds are similar to mutual funds in that they are pooled investment vehicles which provide active asset management. The difference, however, lies in the liquidity and transparency when compared to mutual funds. The public disclosure requirements for hedge funds are minimal and do not provide a complete picture of the underlying investments or strategies being used by the investment manager. Hedge funds also charge higher fees than mutual funds, with “2/20” being the most common fee structure. It means that the fund charges 2% of asset under management annually, and also charges 20% as a performance fee. A hedge fund utilizing such a fee structure would allow the fund to keep 20 cents of every dollar earned by investors. This policy does not work in reverse, as investors are made to absorb all losses incurred by the fund. In general, direct investment in hedge funds may be limited to institutions and individuals who meet certain income and net worth criteria.

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (also known as REITs) provide investors with an opportunity to participate in the revenue earned from hotels, office buildings, residential properties, interests in mortgage securities and other assets held by the Trust. Essentially, investors act as a conduit and provide the REIT with the capital necessary to purchase the underlying assets with the intent of collecting future payouts.

As the process of purchasing and selling real estate can be complex, time-consuming, and costly, REITs often require investors to lock in their investment for a certain period of time before they can exchange their shares for cash. While some REITs are relatively illiquid and non-marketable, there are also marketable REITs that offer additional liquidity and those that are publicly-traded on stock exchanges.

Bonds

Bonds allow investors to collect interest paid on corporate and governmental debt. Interest may be paid periodically in cash, or through a single appreciated amount in the future (zero-coupon bonds). Unlike dividends, entities that issue bonds are required to make the payments to the debt-holders as described in the issuing documents. Bonds may produce a more steady income stream than holding stocks. However, they are subject to credit risk, as the ability of the issuing entity to make its payments in a timely manner is tied directly to its financial stability. Therefore, riskier entities will generally issue debt which pays a higher percentage return than more financially stable entities. In addition, bonds are subject to interest rate risk in that bond prices tend to fluctuate in relation to changes in market interest rates. As such, investors are strongly urged to diversify their investments when holding individual bonds to minimize risk within their portfolios.

Alexander Efros, MBA, CPA

President / Founder
Athelon Wealth Management, LLC

When considering an investment opportunity, investors typically rely on a single number in making investment decisions: the nominal return of an investment. The nominal return is the amount quoted in statements such as “this investment can show you 15% annual returns” or “this product pays a 10% fixed annual rate”.

The 15% and the 10% figures are known as the “upside potential” of an investment. When presented with an attractive number such as 15%, it is easy to forget that there is also a “downside” component associated with every investment. This downside potential is the risk that you are taking on in exchange for those returns. When we consider both the upside potential (the reward you are seeking) together with the downside potential (the risk you need to take on) we can then arrive at a very important figure: the risk-adjusted return.

In a perfect world, high returns such as 15% would be available completely risk-free. That is, your upside potential would be 15% while your downside potential is 0%. In this case, the risk-adjusted return is 15% – very attractive!

In reality, however, nothing is risk-free, and we must take on at least some risk to enjoy higher returns. So let’s say that for the 15% return referenced above, we estimate that the downside potential is 10%. This means that if we invest $100, we are hoping to make $15 after one year while being prepared to lose $10 in exchange for those potential gains. In this case, the risk-adjusted return is only 5% (15%-10%). We can see now that when considering the risk aspect of the equation, the exact same opportunity for gains is suddenly much less attractive than it originally appeared.

It should be noted that risk-adjusted returns are not an indicator of the specific return that you can expect to receive on a particular investment. That is, a 5% risk adjusted return does not mean you can expect to earn 5%. Instead, risk-adjusted returns provide a method of comparing different investment options to find the one most suitable to your needs and goals.

To illustrate this point, let’s consider two investments side by side: Investments A and B. If Investment A promises 15% returns with a 20% downside, and Investment B is offering 10% with an 8% downside, we can determine that the risk-adjusted returns are -5% for Investment A and 2% for Investment B. When risk is considered, Investment B may be the better choice, even though its nominal quoted return is lower.

Although considering the risk-adjusted return is a simple and quick method to determine whether an investment is right for you, this is where many investors can get themselves into trouble. The reason is that when presented with a seemingly attractive investment opportunity, people often forget to consider why a particular return is being offered.

Just as with anything else in life, higher returns come at a higher cost, and that cost is risk. Risk can come in the form of volatility, which is the tendency for the price of a security to fluctuate over time. Risk may also be based on the financial health of a company, as entities which are at risk of becoming insolvent must pay higher rates to borrow money. In addition, risk can stem from the inflexibility or illiquidity of an investment, or other factors. Fundamentally, higher returns are in most cases an indicator of a risky investment because the issuer is paying investors more for the use of their funds.

So while 15% may be the quoted return for a particular security, the reason for such a high rate may be that issuing company is having financial difficulties or may even be on the verge of bankruptcy (whether the investor is aware of this or not). Another explanation may be the particular security involves an investment in a country with lax governmental oversight and disclosure requirements. In such scenarios, the risk, or downside potential, might be as high as 50%. This means that there is a high likelihood that you could lose 50% or more of your entire investment. In this situation, the risk-adjusted return would be -35% (15%-50%).

While a 50% downside potential is definitely undesirable, it can get even worse when the downside potential is unknown. Some investments, such as hedge funds, private equity funds, OTC (over the counter) securities, and private companies in general are not subject to the same scrutiny and strict oversight as publicly-traded entities. As a result, the process of estimating the downside potential can be very difficult and in some cases, impossible. This becomes even more convoluted as the complexity, volume, and variety of transactions and security types within the financial markets keeps gradually increasing.

So if we consider, for example, 15% upside with an unknown downside, we may end up putting money into a security with a hidden 50%, 60%, 80%, or even 100% downside potential. If we don’t know the downside risk, it is impossible to calculate the risk-adjusted return. As a result, a modest market downturn could have a potentially significant impact on a client’s overall portfolio.

The reality is that in many cases, the upside and downside potential may be very closely related. This means that a 15% potential upside is often accompanied by a respective 15% downside. This is also the case with promised returns of 30%, 40%, or higher – the greater the return, the greater the potential downside.

This relationship between risk and reward is often not clearly explained to investors looking for high returns. In some cases it may also be misrepresented. The result is that many investors may be risking much more money than they are financially or emotionally capable of losing. Additionally, investors may not be adequately compensated for the risks that they are taking.

Even though an investment with a greater upside generally carries with it a greater downside, it is not necessary to actually reach that downside. Instead, it is often beneficial to set a predetermined threshold which will dictate the maximum loss that you are willing and able to tolerate. So, for example, if you choose investment with a 40% upside, you may decide that you are only willing to take a maximum 10% loss in pursuit of those gains. This is where active portfolio monitoring and an objective, non-emotional approach can be very helpful in maximizing your returns while reducing risk.

Alexander Efros, MBA, CPA
President / Founder
Athelon Wealth Management, LLC

Over the last three decades, 401k plans have become a venerable darling of the investment world. Millions of U.S. employees currently contribute to their tax-deferred accounts with the hope of a prosperous retirement. However, the high level of confidence in 401k plans may be more attributable to misinformation rather than the actual facts regarding these accounts.

Myth #1: The 401k plan was designed to provide adequate income for retirement.

401k plans were originally just one part of a trifecta intended to provide individuals with a means to comfortably retire, with the other two components being social security and defined benefit pension plans. With social security facing an uncertain future, it remains to be seen whether the program will be able to provide retirement income in the coming years. The situation is no different with pensions as they are rapidly becoming a relic of the past.

While at one point defined benefit pension plans were the main retirement vehicle available to employees, employers soon realized that pensions were an expensive proposition which imposed a great burden on their companies. As a result, the 401k plan was a welcome alternative as it allowed the employer to avoid contributions altogether or simply match a contribution made by the employees. This was a much less expensive approach which meant that the company could avoid the substantial liabilities resulting from the obligation to provide pension payments for the life of each retiree.

An interesting dichotomy emerges when considering employer sentiment regarding 401k plans. According to the 401k Benchmarking Survey (2008 Edition) published by Deloitte, 81% of employers surveyed considered their plans to be “an effective recruiting tool” and 75% of employers held that these plans “assist in retaining existing employees”. However, it is also noted that “…only 18% of employers polled in this year’s survey believe ‘most’ of their employees are ‘saving adequately’ for retirement. An almost equal number (17%) believe that ‘very few’ are saving adequately.” Essentially, employers are knowingly providing access to a retirement vehicle which they feel is not likely to provide adequate funds for retirement. This represents a profound disparity between the employer and employee perspectives regarding 401k plans.

Myth #2: 401k plans benefit employees by providing more freedom.

The growth in the popularity of 401k plans was hailed as a revolution which allowed employees to have more choice as well as the ability to carry their plan from one employer to another. The unfortunate result, however, was that millions of Americans were left to fend for themselves in the highly complex and often unpredictable financial markets. During the booming years of the 80’s and 90’s, this was a welcome alternative as many employees enjoyed double digit gains due to the bull markets. However, with the volatility and uncertainty of today’s financial environment, it is becoming increasingly more difficult to accumulate adequate funds for retirement. Accordingly, the likelihood of a prosperous retirement amongst Americans is rapidly decreasing, along with their confidence in the once glorified 401k plan.

Myth #3: 401k plans provide access to the best investment options available.

401k plans provide a menu of investment options (usually mutual funds) which employees must choose from. Investors are often surprised to learn that in many cases, the investment options offered within a 401k plan are there simply because the issuer of the fund paid the plan administrator to have them included – not because they are the best investment options available at a particular time. Alternatively, the mutual funds offered may be those which are in some way affiliated with the plan administrator. As a result, over time the typical 401k menu of investments has turned into a list of underperforming and overpriced funds which may provide lower returns and carry higher risks than other alternatives available in the market.

It is often argued that the limited nature of the investment options within a 401k plan is actually a benefit which helps employees make investment choices more easily. The reality, however, is that even when the number of investments available is limited, the construction of a well-diversified and risk-managed portfolio requires careful analysis and financial understanding. This is not made clear to plan participants who are often left to allocate their retirement savings haphazardly and without considering the actual risk exposure within the portfolio.

It is an unfortunate fact that many Americans have not been adequately educated in the financial matters that can greatly affect the outcome of their investments, and therefore they require more guidance than what is provided within a typical 401k plan.

Myth #4: The tax-deferred treatment of 401k plans means that investors will pay less in taxes.

The tax-deferred treatment of 401k plans is often hailed as a benefit to plan participants. However, the fact is that the account is still taxed, although taxed at a later date. Proponents of 401k plans maintain that the effective tax bracket for an individual is likely to be lower in their retirement years because their amount of income will decrease. This statement is questionable, however, because future income – just as anything else in life – is difficult to accurately predict. Even more unpredictable is the tax rate which will apply 20 or 30 years from now. As tax rates tend to fluctuate significantly over time, the extent to which retirement funds will be taxed is simply unknown. As a result, you might pay less in taxes on your retirement account, but then again, you may end up paying more.

Even if the effective tax rate does indeed drop, this may not be as advantageous as it seems. This can be clearly illustrated with an example. Let’s assume for a moment that the effective tax rate for a 45 year old individual is 35%. Let’s also assume that the effective tax rate for that individual drops to 15% at 65 years of age. In this simplified example, this amounts to a 20% difference over 20 years. In other words, the decision to hold funds in a 401k for 20 years produced a 20% return over the life of investment, which amounts to just roughly 1% per year.

This 1% annual benefit raises an important question: how are plan participants being compensated for dealing with the limited liquidity of their 401k? As you would typically be charged a 10% penalty in addition to paying taxes on the withdrawal of funds from your 401k before a certain age, the accounts are therefore relatively illiquid and limited in their possible benefit to the plan participant.

This illiquidity represents an increased risk because your money may not be available for you when you need it, which typically calls for a higher return to be provided to the investor. This higher return, however, is not made available to 401k participants. Instead, participants are left to simply accept whatever the market produces for them, including losses incurred by the limited selection of funds made available to them. So as you can see, even when assuming that the effective tax rate is substantially lower in retirement years, it is evident that the benefit to the individual is marginal despite the advantages constantly hailed by the financial industry.