Beware Packaged Wall Street Solutions for Historically Low Rates
With interest rates at historically low levels and investors clamoring for yield, Wall Street has been busy concocting all sorts of packaged products designed to offer income. If you work with a large financial firm, chances are pretty good they have pitched you on one of these products.
When these products are presented, often the emphasis is put on the yield and too little is said about any risks involved. Investors in these products typically do not fully appreciate the risks they’ve undertaken until something goes wrong.
I would suggest you be very cautious with these products, as the risks often outweigh the promise of higher income.
In its simplest form, we’re talking about mutual funds or exchange traded funds (ETFs). As you know, there are a host of different funds available for you to buy. As you would expect, new funds are often created when investors are looking to own a particular slice of the market.
Now that interest rates have collapsed to levels offering virtually no income, the mandates of traditional income-producing funds are too constraining to offer attractive yields. With the 10-year Treasury below 1%, no existing fund employing a “buy Treasuries” strategy can provide much yield. Funds that invest in corporate or municipal bonds are similarly constrained. Traditional fixed-income strategies cannot produce the level of income that investors are accustomed to earning.
This is leading to a new approach to generating yield, and it most often involves either complex strategies or outright ownership of equities.
For example, one brokerage firm promotes something called an “advisory” note. The product is purported to be able to generate yields of 8-11%. Receiving that yield, however, is contingent on equity markets performing within a specific range over the next two years. It doesn’t take a genius to understand the yield offered is not income, it’s a bet on the stock market.
The prospectus for advisory notes states that investors could lose all their principal. That’s not the sort of thing investors with fixed income are able to tolerate.
Over the years, another way to offer higher yields was through master limited partnerships (MLP). These investments have high yields because they annually pay out most of their earnings. The underlying investments are equity investments, so the annual payout depends on the underlying business.
The energy market was traditionally popular for MLPs, and while the energy market was doing well, these MLPs provided attractive pay-outs. However, when the energy markets collapsed, these investments followed suit.
Take, for instance, the Goldman Sachs MLP Energy Infrastructure Fund.
What has the fund done since inception in 2013? How about a negative 8.31%. While the fund’s current pay-out produces a reported yield of 12.5%, over the last three years the fund’s total return was -17.23%. Year-to-date 2020, the fund is down 39.62%.
Anyone attracted to the yield paid was in for a surprise. They failed to appreciate that the pay-out of the fund was just one component of their total return. Chasing yield without understanding these risks can be disastrous.
I’d also caution you against thinking the name of a fund tells you its risks. Take the Pioneer Multi-Asset Ultrashort Income Fund, for example. In my opinion, it sounds like a safer strategy using the terms “ultrashort” and “income” which might imply a lower-risk profile.
However, a perusal of the prospectus shows the fund is constructed using a host of equity investments and higher-risk junk bonds. Not exactly what the name implies.
But there is another risk investors face with any pooled investment product, and that risk is in the very structure of these funds.
At times of high volatility, the fund’s manager may be forced to liquidate positions at exactly the wrong time. This occurs when the fund’s investors start selling at the same time.
This happened in March when interest rates spiked amidst the pandemic-driven market collapse. During this period, the Pioneer Multi-Asset Ultrashort Income Fund sank approximately 10%.
At the end of the day, understanding the underlying risks should always be front and center when it comes to evaluating Wall Street packaged products. It may seem enticing to reach for higher yield, especially when gimmicks give the illusion of safety, but it may be best to resist that temptation.
By focusing on your specific needs and situation, Nicollet Investment Management can help you better understand the risks of all investments and the long-term health of your portfolio. If you would like to learn more give me a call to discuss.