Investing

Investing for Retirement: Asset Classes That Individual Investors Should Avoid

Introduction

For individual investors, these asset classes fail at least one of David Swenson’s rules. There are a number of actively managed asset classes that are only suitable for extremely sophisticated institutional investors capable of investing in illiquid markets, possessing very long time horizons, and generating enough volume to negotiate cost discounts. Moreover, there are a number of fixed income investments that serve no valuable portfolio role for almost any investor. Bottom line: these are the assets in which individual investors should not invest.

Absolute Return

Coming soon…

Investment-Grade Corporate Bonds

Bonds have limited upside potential: the best outcome for a corporate bondholder is to timely receive interest and return of their principal. Even that isn’t guaranteed: potential downsides include default, call of the bond when interest rates rise, and–compared to U.S. Treasury bonds–relatively limited liquidity. This asymmetrical relationship benefits the corporation more than the bondholder. Swenson questions whether the yield spread over comparable U.S. Treasury bonds adequately compensates corporate bond investors for these risks.

Credit risk includes the possibility that a company won’t be able to timely pay its debt in full. The lower rated a bond is, the higher the potential credit risk of corporation. A portfolio of equities can more easily absorb a loss than a portfolio of corporate bonds. Stocks can rise considerably, offsetting losses of individual stocks. High quality bonds, by contrast, have little opportunity for appreciation.

When interest rates decline and existing bonds are most valuable to investors, corporations are most likely to call bonds with higher-than-market interest rates and refinance the debt at lower prevailing interest rates. Conversely, when interest rates rise, the bondholder holds debt at below-market rates.

Individual investors should never own individual bonds. Like stocks, bond funds provide greater diversification. Corporate bonds are far less liquid than U.S. Treasury bonds. Many bondholders buy bonds at their initial offering. Then, they hold them for an extended period of time.

Stockholders and bondholders have very different interests. Equity holders gain by imposing losses on bondholders. This includes both the ability to change a corporation’s capital structure and the desire to borrow at the lowest cost with the most flexible terms. Assuming corporate management is aligned with the stockholders, management can not be aligned with bondholders.

High-Yield Bonds

High-yield bonds are even worse than corporate bonds:

  • the credit risk with “junk bonds” is far worse than investment-grade bonds
  • if the credit rating of an issuer of high-yield bonds does improve, the corporation will exercise call provisions to take advantage of lower interest rates associated with their improved credit
  • liquidity is far worse than investment-grade bonds, and
  • high yield bondholder interests are even less aligned with corporate management than investment-grade bonds. One of the greatest imperatives of management is reducing the cost and value of high-yield debt financing in order to improve the value of shareholder equity

For these reasons, high-yield bonds are even less valuable than investment-grade bonds when building a diversified portfolio. They provide neither protection from financial catastrophe nor protection from deflation. Swenson points out that high-yield bonds produced lower annual returns than both U.S. Treasury bonds and investment-grade corporate bonds.

Tax-Exempt Bonds

Coming soon…

Foreign Bonds

Coming soon…

Asset Backed Securities

Coming soon…

Hedge Funds

Hedge funds are illiquid: investors must keep their money in the fund for a predetermined period of time.

Hedge funds average only 3.5 years. This makes it very difficult to assess their long term performance.

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Leveraged Buyouts

Coming soon…

Venture Capital

Coming soon…

Commodities

Commodity pricing is based on supply and demand. In contrast to stocks and bonds, they have no internal rate of return. Therefore they are speculations, not investments.

Managed Payout

Coming soon…

Summary

Coming soon!

For More on this Topic

    1. By contrast–and precisely because it is differently situated from individual investors–Yale’s endowment seeks to allocate one-half of its portfolio to the illiquid asset classes of leveraged buyouts, venture capital, real estate, and natural resources.↩

 



Updated on January 14th, 2019