One of the great challenges of getting consumers to believe in basic index portfolios lies in the prejudice that something so simple must be a “dumbed down” version of good advice. The academic research over the past thirty years has been highly rigorous and anything but simple. However, the conclusion that a simple index portfolio provides the best solution just seems implausible to many consumers. Remember that indexing isn’t the best choice because it’s simple; it’s the best choice because the results have been so superior. It also happens to offer the added benefit of being simple both to understand and to implement.

On the other side of the complexity spectrum, I sometimes get questions that are beyond the scope of this blog and more appropriate for discussion among researchers in academic finance. It’s not that such topics aren’t quite interesting, it’s just that they’re not necessarily appropriate for general investors since they can be pretty arcane. (Warning: arcane content ahead!)

For example, recently a reader of this blog posted a question on an approach to retirement investing proposed by Zvi Bodie, a well-respected finance professor at Boston University. Bodie suggests a portfolio with a mixture of inflation-adjusted bonds and stock index call options. For many investors saving for their retirement, Bodie claims that such an approach can offer a superior outcome when measured by investor utility, a fancy way of saying how happy it’s going to make those investors.

Bodie is really raising two separate issues, one about the concept he labels “human capital risk” and the other about the mixture of call options and inflation bonds as the best portfolio for certain types of investors. The idea behind human capital risk is that your investment choice should depend not only on your risk tolerance and time horizon but also your industry’s exposure to the stock market and to job loss in general. For more details, see his article “Making Investment Choices as Simple as Possible: An Analysis of Target Date Retirement Funds” at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=900005. Bodie’s application of human capital risk may eventually become more widely accepted, but as of now it’s still pretty new and untested.

As for the mixture of calls and inflation bonds, keep in mind that in any such portfolio you’re merely trading one payoff distribution for another. Bodie shows some good graphs on page seven of another article: “Retirement Investing: A New Approach,” http://prc.wharton.upenn.edu/prc/PRC/WP/wp2001-8.pdf. Such portfolios can be perfectly good alternatives to a standard long index holding, but remember that there are no magic bullets here, only different distributions of payoffs. Bodie's proposal does offer one subtle benefit over straight indexing: no one would condescendingly describe a mixture of long-term out-of-the money equity index call options plus inflation bonds to be a "dumbed down" portfolio suitable only for beginners.

A blog reader posted a question recently asking my views on buying stocks on margin. Since margin loans are simply another form of investment borrowing, the question for me really boils down to being about asset allocation. Let’s start with two basic asset classes, 1) risky assets (stocks, real estate, commodities, etc.) and  2) less risky assets like bonds and cash. Of course the two always have to add up to 100 percent. Take the example of a simple portfolio for someone with a long-term time horizon who holds 80% stocks and 20% cash. We can drive up both the expected return and risk of the portfolio by instead choosing 100% stocks and 0% cash. Most investors understand this relationship between risk and return. However, we can become even more aggressive by aiming for a still higher return and commensurate higher risk by allocating 110% stocks and ‑10% cash. The negative cash balance is really just borrowing, which investors can achieve through means like a margin loan.

So what are my views on borrowing on margin? For the right situation, margin loans can be a perfectly acceptable way to increase the expected return and risk of a portfolio. Based on historical data, an investor with a very long time horizon and a high risk tolerance will earn a higher return than just the market’s return by borrowing. However, it’s critical to remember the inherent risk and the challenge of staying invested during inevitable downturns, when leverage like margin borrowing exaggerates the downward swings the same way it does the upward swings. Furthermore, your overall asset allocation can affect the wisdom of margin borrowing, e.g. it can be foolish to borrow on margin if you have part of your portfolio in cash (money market funds) since for that portion you’re simply borrowing at margin rates in order to invest at money market rates, almost always a negative carry.

Margin borrowing offers only one approach to increasing the leverage of a portfolio. Another method is to use derivatives like index futures contracts, which allow investors to create an asset allocation of greater than 100% in stocks. The ideal source of leverage will depend on which rate provides the lowest implicit or explicit borrowing rate, including tax impact, if any. Keep in mind that for both futures contracts and margin loans, an investor enters a world where losses can potentially exceed the original amount invested. Another perspective to remember is that in the long term such leverage may be advantageous, but you need to make sure you can survive until that long term arrives. In any game of chance with a positive expected return, the players with the deepest pockets have an advantage since they can outlast others in bad times while waiting for the law of averages eventually to swing back to their favor.

A reader of this blog posted a question recently about exchange funds, inquiring, like any savvy consumer, as to whether or not there’s a catch of some sort with this type of product. I’ll try to give a thumbnail sketch on exchange funds and their advantages and disadvantages. Warning: for novice investors, this discussion will focus on a somewhat specialized and complex part of investing. If you’re not facing the challenge of a concentrated position in a low-basis asset, then this discussion may not be applicable to you.

The demand for exchange funds arises out of a problem facing many taxable high-net worth investors: how to address a concentrated position that creates excessive risk in a portfolio but would trigger capital gains in order to sell the asset and diversify. Such a situation can commonly arise due to an entrepreneur or executive receiving stock (through acquisition, grants or options) in a single company that represents a high percentage of an individual’s wealth. For example, newly-minted dot com millionaires might be worth $20 million in stock of a company that bought their firm, which might comprise 100% of their portfolio.

Investors in such situations have usually faced the choices of 1) selling the stock and paying the capital gains,  2) using derivatives such as variable pre-paid forwards to alleviate temporarily some of the extra risk, 3) continuing to hold the stock and just bearing the extra risk or 4) contributing the stock to an exchange fund, and receiving a more diversified holding in return. These choices provide various advantages and disadvantages. Selling the stock can offer a great way to diversify instantaneously, and for a high-volatility stock the upfront tax penalty is usually more than worthwhile. Derivatives tend to be a very expensive way to diversify, though they’re very popular with brokers since they can generate so much profit for those selling them. Continuing to hold the stock avoids the pain of an immediate tax penalty, which is less of a problem for less volatile stocks than for high-flyers.

Exchange funds provide a unique tax treatment for investors with concentrated positions since they allow for the contribution of undiversified assets and then the withdrawal of more diversified assets, typically seven years later. The advantage lies in the ability to defer capital gains while achieving some level of diversification. The disadvantages include 1) the high fees, both initial placement fee and ongoing annual fee, 2) the lack of liquidity, i.e. tying up funds for up to seven years, 3) the lack of control of the other assets in the fund and extent of diversification (based on what actually gets contributed rather than what’s necessarily ideal), 4) the requirement that exchange funds hold 20% in illiquid assets, which is fine if that fits your asset allocation and a problem if it doesn’t.

Even with all of those disadvantages, exchange funds can still be beneficial for investors with high tax rates and a long time horizon who will not be liquidating the assets in question for a long time, if ever. The sooner an investor might sell, the less advantageous an exchange fund will be, even if it’s selling beyond the typical seven-year holding period. Furthermore, the lower an investor’s tax rate, the less advantageous will the fund be.

To answer the blog reader’s question, you should be careful about the high fees in an exchange fund and the true diversification achieved, but the tax advantages can be real nonetheless, especially if you face a high tax rate. This discussion applies to a situation faced by a typical high-net worth taxable investor, and may not apply to all situations. Please seek specific advice on tax or portfolio issues you may face. As a bit of further disclosure, Eaton Vance, one of the leaders in exchange funds and mentioned by the blog reader, owns a competitor of my employer, so if you’re a truly cynical skeptic, you might need to take that fact into account. Unfortunately for consumers, the investment industry has acted in a way that makes some cynical skepticism a healthy thing.

At the end of July I offered another free workshop in San Francisco, again following up with all of the people who had responded to the article in San Francisco magazine. I was particularly tickled by the story of a woman who before attending the workshop told her husband that there wasn’t going to be any sales pitch. Her husband assured her that she was most definitely going to hear at least some sort of disguised sales message. I was amused to hear that the woman told her surprised husband afterwards that in fact the entire presentation had been educational, along with some consumer advocacy. I then realized that if my wife had told me she was going to attend a free three-hour investment workshop I too would have assured her that it could only be some sort of effort to get clients to sign up for a product or service. 

Unfortunately for consumers, the husband’s skepticism was well-founded, as the financial services industry has justifiably earned a reputation for being less than forthcoming with honest information about the products and services it offers. An interesting challenge to getting a pro-consumer message out is that it so easily gets lost amid the deluge of marketing hype. The problem facing consumers remains how to get the investment advice and services truly needed without signing on for the useless and overpriced.

In addition to the challenge of whom to believe, the material itself can be overwhelming to a beginner. After the second workshop a number of people approached me who had also attended the first one in February. They all echoed the same sentiment, namely that they had really understood the simple approach of a collection of index funds only after hearing it a second time. I think part of the challenge comes from the messiness of the existing landscape in terms the buried fees and the difference between asset allocation (the broad picture) and choosing securities (the best way to deliver an asset class). If you’re a beginner and you find the Full Story section of the web site intimidating, you’re not alone.

Another challenge lies in just how major a shift in belief system is required to embrace indexing. If you’ve been living in a world where the assumption is that you should pay a professional to pick managers that will perform better than the market, then it’s quite jarring to shift to a world where the smartest approach is no longer to pay high fees either to wealth advisors or the stock pickers they hire in order to beat the market. While indexing sounds too much like settling for average, in fact the costs are so much lower that you end up settling for the 80^th or 90^th percentile of stock performance, and that’s even before you add in the extra cost of a wealth advisor.

Just to clarify and repeat a point from the web site, I’m not saying that it’s a bad idea as a consumer to hire a wealth advisor. I am saying that it’s a bad idea to assume you need to hire a wealth advisor to beat the stock market. There are lots of good reasons to hire an investment professional. I’m just saying that consumers should understand clearly what they’re buying and how much they’re paying, which in many other parts of our commercial lives, say grocery stores, wouldn’t be as radical and threatening a concept as it is for the financial services industry.

If you have any feedback on the site or requests for particular topics or clarification of any points, please feel free to post a comment.