Why Above Market Return Claims Are A Warning Sign For Further Due Diligence
- Discover the only three ways an investment can beat the market.
- How to use process of elimination to focus due diligence.
- The two risk profiles to determine whether investment claims are true.
We live in an increasingly complex investment environment.
It's no longer sufficient to master just stocks, bonds, and real estate because financial engineers are busily creating all kinds of hybrid investment products to satisfy demand.
These Frankenstein-type investments usually involve derivatives and create complex risk profiles that few people have the expertise to understand.
For example, a financial coaching client became interested in a closed-end fund claiming to duplicate the performance of the Dow Jones Industrial Average while paying a 10% annual safe dividend.
The problem is the claim of stock market-like returns with dramatically higher yields doesn't smell right. You can't get something for nothing, so there has to be more to the story.
The very characteristic meant to lure you in (high yields with stock market-like returns) should make you extremely cautious.
Unfortunately, for most investors it does just the opposite.
I want to share with you the investment principles I taught my client when examining this investment.
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The Only 3 Ways You Can Beat The Market
To begin, the first thing you want to notice about this investment is the attempt to offer above market returns.
This is a classic sales strategy you'll run across frequently that should always be a warning sign.
Investment reality in a competitive marketplace dictates there can only be three ways to achieve above market returns:
- A competitive trading advantage that captures exploitable market inefficiencies in excess of transaction and administration costs. (This is the only good reason – all the remaining reasons are bad.)
- Taking above market risk. (This provides no long-term advantage unless #1 above is valid.)
- Investment fraud where the promoters are simply lying and misrepresenting in an attempt to dupe you.
This particular investment was an exchange traded fund offered by a big-name investment firm. This means the investment has passed the regulatory scrutiny of both the banking regulators and the securities laws.
For these reasons, it's highly unlikely to be outright investment fraud, but more likely a case of slick salesmanship.
Why? Because there's a huge market right now for any investment offering high yields. Interest rates are artificially low and retirees can't make ends meet with normal yields.
Many investors are desperate for higher returns and are taking inappropriate risks to earn adequate income from their portfolio.
If it's not outright fraud (#3 above), then let's consider the odds that above market returns are the result of a competitive advantage (#1 above).
What's The Likelihood Of A Competitive Advantage?
This ETF is offered by a big-name retail investment house, and the portfolio is filled with the most popular and widely researched 30 stocks in the United States.
This reduces the odds of a competitive advantage sufficient to produce a gross yield advantage of 10% (transaction and administrative costs must be factored in to give a net) down to basically nothing… zero-zilch-nada.
There simply aren't a lot of market inefficiencies in the most widely held stocks, and there certainly aren't enough exploitable inefficiencies to produce a 10% annual yield.
Signs Point To Taking Above Market Risk
That leaves us with principle #2 – risk profile – as the most probable explanation.
I believe this investment has a risk profile that not one investor in 100 will figure out or understand. The organizers are using complicated options and derivative contract strategies to produce the excess yield.
The end result is likely what's called a “fat-tail risk”. In layman's terms, this means that everything goes fine 95% or more of the time, but blows up during times when the markets have extreme price moves, thus eliminating any long-term advantage.
Again, this can be very complicated stuff when you get into these esoteric investment products using derivatives. The salesman will over-simplify the situation by claiming stock market returns with safe, high yields because a confused investor will not buy.
He has to make it sound simple to get the sale; however, you know better because there's no free lunch on Wall Street. There's always a reason.
Unfortunately, the salesman will get away with his claims because few investors have the statistical and investment background to ferret out the implications (or financial advisers, for that matter) or understand the legal disclosures and risk profile.
Two Other Risks To Watch Out For
And if the fat-tail risk isn't the problem, then another place to look would be in “basis risk”. In other words, the marketing materials claim the investment will perform “similar” to the Dow Jones Industrial Average, but what exactly does that mean?
There's going to be a “basis risk” or tracking error where the performance won't be identical to just owning the 30 stocks outright. How much that basis risk costs you in the future can't ever be known with confidence due to the fat-tail risk cited above.
You can at least check historical performance very closely to discern how well it tracked in the past. Watch carefully for the consistency of the tracking and where it fails. The failures will provide important clues.
These are just two of the most obvious risks that I wanted to mention, but there may be others as well.
The first thing to learn whenever an investment is sold with above market returns is that you must check further by performing thorough due diligence. A claim for above market returns is always a warning sign to dig deeper.
When examining this particular investment, we saw the above market return isn't likely explained by outright investment fraud or competitive advantage due to its specific characteristics. That leaves a poorly understood risk profile as the likely culprit necessitating more thorough due diligence to resolve.
I hope this line of reasoning proves as helpful for you when considering some of the esoteric investment alternatives produced by the financial services industry today as it did for my coaching client.
As he builds his portfolio, he'll be much better prepared to analyze these types of investments in the future as a result of this education.
Similarly, you'll run into this stuff as you build your wealth, so I thought it was important to share these principles with you as well. I hope it helps.
Please let me know your thoughts in the comments area below…
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Sharing the investment principles you taught a client is great. Using a recent real life example is appreciated, makes it more real. More discussion and case studies involving hedge funds and esoteric investment products using derivatives would be of benefit to a lot of readers.
Thanks for posting.
@ DJ – Thanks for the feedback. It helps me know what people like and don’t like.
Dividend Growth Investor
I have similar experiences with investors who always look for stocks or other instruments yielding excessive current yields. Most of the time these yields are unsustainable, and get slashed in half or even eliminated in a few years bringing down principal with them. Investors do take excessive risks trying to get the highest yield, without diversifying their portfolio. For example a reader once told me how I knew nothing on income investing, yet that reader had a portfolio consisting entirely of Canadian Income Trusts ( back in 2008).
@DividendGrowthInvestor – I’ll bet that reader isn’t too smug anymore:-) Yes, it is hard for some people to understand risks without learning the hard way.
Anyway, thanks for stopping buy and sharing your thoughts. I’ve visited your blog several times in the past and enjoyed quite a few of your posts on dividend investing. You are a welcome addition to our community. Stay in touch…