By Skyline On Saturday, July 31 st, 2021 · In ,

FIELD NOTE: JULY 2021

WHERE YOUR INVESTMENTS ARE NOT

It’s easy to get swept up in the latest trending news cycle and start questioning whether or not you ought to have set up your digital cryptocurrency wallet by now. Or wondering if maybe you should have joined all the Reddit users in their GameStop frenzy? In and of themselves, many of these popular “investment” trends are little more than gambling.

 

Most of these financial fashions fall somewhere within the list of account restrictions detailed in our Investment Policy Statement (the document outlining the governing rules for our advisors as they aim to meet your investment goals). This is meant to elucidate why we avoid those strategies, but generally speaking, each of these investment vehicles are either too risky or benefit the seller more than the buyer.

You Won't Find These in Your Account at Skyline*

Individual Stocks — The reasons not to own individual stocks are many: 

  • Risky: Owning an individual stock leaves you vulnerable to the ups and downs of that single company and sector. The magic of Modern Portfolio Theory is that you can combine different investments to maximize your returns and minimize your risk by diversifying your unsystematic risks
  • Expensive: It takes a significant amount of time to research individual stocks and manage a strategy for the stocks. When you employ an advisor to actively manage individual stocks, you are paying a premium for the additional time and resources needed to conduct this research. You will also increase transaction costs and fees as individual stock strategies typically involve high portfolio turnover. Finally, portfolios that turn over at high rates generate large capital gains burdens .
  • Low Success Rate: when compared to their standard benchmark, professional active investment managers fail to beat the performance measure at least 75% of the time. If experts paid to manage individual stocks fail to outperform the broad market at least three out of four times, it is probably better to just buy the market.
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On average, 13.2% of active public equity funds that met or exceeded their index benchmark in the fifteen years preceding June 2019.

Source: Standard & Poor’s Indices Versus Active Funds Scorecard, year-end 2019. Index used for comparison: US Large Cap—S&P 500 Index; US Mid Cap—S&P MidCap 400 Index; US Small Cap—S&P SmallCap 600 Index; Global Funds—S&P Global 1200 Index; International—S&P 700 Index; International Small—S&P World ex. US SmallCap Index; Emerging Markets—S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database.

Individual Bonds — in addition to all the reasons listed for individual stocks (low diversification, high costs, etc.), individual bonds can have liquidity issues, meaning they can be difficult to sell quickly without having to drastically reduce the price.

Futures Contracts — Futures contracts are legal obligations that require the buyer to purchase an underlying asset (or the seller to sell that asset) at a predetermined future price and date, regardless of the market price at the future expiration date. Trading futures is a zero sum game. If there is a winner, there is also a loser. Futures contracts typically offer between 10x and 50x leverage, which means a $1 per contract loss can become a $10 - $50 loss. Finally, futures can “go below zero”. At the extreme, the price on a contract can drop to the point you must pay to get rid of it.

Option Contracts — Options are contracts that give you the right, but not the obligation, to buy or sell a security (compared to a futures contract which requires the purchase or sale of an asset at a future date). You pay a premium to use them and can be the source of speculation, adding a layer of risk to their use. Navigating the various types of option contracts requires complex administration, adding more overhead cost to their use. We do employ certain option contracts in a limited capacity when disposing of an incoming concentrated position.

Private Placement in REITs — A real estate investment trust (REIT) is a company that owns and operates various real estate properties in which the majority of its income is paid to its shareholders as dividends. There are publicly traded REITs we use as part of our diversified portfolio. Private placement REITs are not listed on a major exchange and subject very loose SEC regulatory requirements. The lack of regulatory scrutiny creates a great deal of managerial risk. Because of this, many private REITs are only accessible to accredited investors (those determined to be financially sophisticated based on income and net worth requirements) making the cost of entry extremely high. Finally, many REITs charge high commission fees and lack liquidity — with liquidity restrictions varying greatly from fund to fund.

Private Placement in Oil & Gas — Similar to private REITs, private placements in oil and gas are  loosely regulated, illiquid, and typically restricted. In a private placement, a company sells shares of unregistered securities to a limited pool of accredited investors in exchange for cash. Private placements in oil and gas are usually administratively complex and highly variable.

Hedge Funds — An expensive substitute to other pooled fund investments, hedge funds are actively managed alternative investments. Hedge funds share many of the downsides of Private Placement REITs: lack of SEC regulation, absence of transparency of the management and performance, accessible only to accredited investors, insufficient liquidity, and an overabundance of risk. Additionally, hedge funds often charge both an expense ratio and a performance fee (typically +20% of any profits) and usually employ leverage (take on debt) to amplify returns. Moreover, certain hedge funds in the past have presented significant moral hazard.

Closed-end Funds — These are portfolios of pooled assets that have an initial public offering (IPO) and sell shares on a stock exchange. It is called a closed-end fund because after it’s IPO, no additional shares are ever issued and the fund won’t ever buy back shares. This causes liquidity issues when trying to dispose of closed-end funds and the funds often trade below net asset value (NAV) at a discount. The price is determined entirely by supply and demand on the secondary market, making the investment vehicle subject to more volatility. Closed-end funds do have niche applications in small marketplaces, but for the general investor there are better options.

Short Selling — This investment strategy relies on speculation around the decline of a stock price. If an investor expects the price of a stock to drop in the future, they can borrow stock shares and immediately sell them on the open market. When they are due to return the borrowed stock, they hope to buy the stock back in the open market for less than they sold it for — making a profit on the price drop. The degree of speculation in this process is high and there is no limit on the amount you can lose (hello GameStop and the nearly $13 billion lost).

A Winning Strategy for the Long Term

 

We’ll leave the GameStop antics to Reddit and continue course with our data-driven approach to low-cost, passive investing. We’ll keep guiding you to a long-term investing strategy that takes your particular goals, situation, and risk tolerance into account. We’ll stick with the tried and true principles of successful investing: diversification, risk adjusted return, low expenses, and compound interest.

 

Have questions about your long-term investment strategy? Contact your Skyline Advisor today.

* Exceptions are made for positions brought into Skyline that have various consequences attached to their disposition.

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