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BEFORE ITS FAILURE in 2008, Lehman Brothers had been one of the most prominent investment firms in the United States. After 158 years in business, what caused it to collapse so suddenly? In a word: complexity.
Lehman had been involved in the securitization of mortgages, a process that resulted in taking something relatively simple—a home mortgage—and turning it into something much more complicated, thus obscuring its true risk level. That was the proximate cause for the firm’s failure.
In addition to mortgage bonds, Lehman specialized in creating other complex instruments. A document titled “The Lehman Brothers Guide to Exotic Credit Derivatives” can still be found on the internet. The strategies it describes are the sorts of things that ultimately brought the firm down.
When it comes to making investment choices, risk is unavoidable. No one can know what path the economy, the market or any given investment will follow. But that doesn’t mean investment risk is entirely outside our control. There are, in my view, certain characteristics we can look for in investments that can help tilt the odds in our favor. Here are four to consider.
Simplicity. Peter Lynch, former manager of the Fidelity Magellan Fund, had this warning for investors: “Never invest in any idea you can’t illustrate with a crayon.” Lynch felt that simplicity was paramount because investing is hard enough. As Kodak, Polaroid and BlackBerry taught us, things can go wrong even for well-run companies. But when an investment is complicated, it’s that much harder to assess how things might go.
Consider, for example, an exchange-traded fund called the Box ETF (ticker: BOXX). It’s designed to deliver performance comparable to U.S. Treasury bills but in a more tax-efficient manner. For that reason, it’s quite popular, and I’m asked about it frequently. Despite the clear tax advantage, though, I advise against it. That’s because of its complex structure, which involves a strategy known as a box spread. This is how it’s described on the BOXX website: “A box spread is an options trading strategy that combines a long call and short put at one strike price with a short call and long put at a different strike price.”
Another question about BOXX is whether the IRS might challenge the tax strategies it’s employing.
BOXX could work out just fine, but in my view, the complexity and IRS risk just aren’t necessary. And even though it’s worked well so far, the hardest part about complex instruments is that we can’t know in advance how they’ll perform through various market cycles. Times of stress could cause an otherwise successful strategy to fail. That was the lesson of Lehman Brothers.
Management style. For decades, there’s been a debate between advocates of active and passive investing. That debate is an important one, but it isn’t the only one. Within the world of actively-managed funds, there are also important distinctions. Funds like the Magellan Fund, for example, are straightforward. The manager’s aim is to choose a group of stocks that he thinks will outperform. That’s one type of actively-managed fund and is the most common one, but there are many others.
Some funds take a tactical approach, trading in and out of different asset classes in response to the managers’ sense of where markets are headed. Morningstar analyst Jeffrey Ptak analyzed these funds a few years back and concluded that they “would have earned twice as much if their managers didn’t trade over the past decade.” The funds’ managers, in other words, only subtracted value.
The lesson: The investment world is much more nuanced than the simple distinction between active and passive, and the passive realm isn’t immune to potholes either. So be sure to look carefully under the hood of any fund you’re considering.
Tax-efficiency. Mutual funds and exchange-traded funds offer a number of advantages, but they can also carry risk in the form of higher tax bills because funds are required to distribute the bulk of their gains to shareholders on a pro rata basis.
Careful due diligence is required on this point because there’s a misconception that a fund’s turnover ratio—which measures the amount of trading inside a fund—is the best proxy for tax efficiency. Turnover can be an imprecise measure, though. Consider a fund like the PIMCO Total Return Fund (ticker: PTTRX). It has thousands of holdings—everything from bonds to currencies to interest rate swaps, credit default swaps, reverse repurchase agreements, and more. As a result of this diverse mix, it has an extremely high turnover rate, north of 600%. With so much trading, you might expect this fund to be massively tax-inefficient. But surprisingly, it isn’t. It hasn’t generated any capital gains distributions at all in the past four years.
In contrast, a fund like Magellan might appear to be more tax-efficient, with a much lower turnover ratio of 49%. But Magellan has generated significant capital gains for its investors in each of the past several years.
The lesson: When assessing a fund’s tax efficiency, be sure to study its distribution history. That’s the metric that’s most meaningful.
Concentration. With the rise of the so-called Magnificent Seven stocks, there’s been increasing hand-wringing over the concentration level of the S&P 500. The top 10 stocks today account for nearly 40% of the entire index. On the one hand, this is unprecedented and potentially cause for concern. But as The Wall Street Journal’s Jason Zweig pointed out recently, there’s more than one way to look at market concentration. At one point, for example, AT&T accounted for nearly 13% of the entire market. Today, the market’s largest stock, Nvidia, poses a risk but nonetheless has a more modest weighting of less than 7%.
The bottom line: Concentration may or may not turn out to be a problem in the coming years. But since we don’t have the benefit of hindsight, this is another area where you could be defensive with your portfolio. If concentration is a potential risk, it’s one that’s easy to avoid. To diversify away from the S&P 500, you could allocate to value stocks, to small- and mid-cap stocks and to international stocks.
Other factors. How else can you play defense with your portfolio? In evaluating prospective funds, I’d also consider the length of its track record, the firm behind it, and, as discussed last week, the fund’s withdrawal policies.
Investment risk may be unavoidable. But that doesn’t mean it can’t be managed.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Adam, great article as always. Concentration risk is, in my view, the issue most everyday investors are most exposed to right now — and the worrying part is that an awful lot of them have no idea just how concentrated their plain, safe, boring S&P 500 tracker actually is.
When a severe wobble comes, many will be every bit as surprised and disappointed as investors were during the bond fund crash of 2022. Products they believed were safe simply didn’t behave the way they expected.
The best defence against that is education. Understanding the risks inside your investments before something goes wrong makes all the difference.