Editor's note: This commentary was updated on Nov. 17, 2005 for clarity.
Let me ask you one question before we get started. Why did you want to read an article called "Bad Investment Advice"? I mean, why not just pop over to the "Ruin Your Life" article or the "Download a Computer-Killing Virus" site and make a day of it?
OK, just kidding. I'm actually quite pleased that you're here. Of course, I wrote this article not to give bad investment advice but to remedy it. I imagine many of you clicked on this article's headline because over the years you've received too much of what it describes. Let's see if we can change that -- and help out one of our readers at the same time.
On the heels of last week's article -- where I gave the skinny on exchange-traded funds (ETFs) such as the iShares Select Dividend Index
Dan Investor* is just your average fellow who's trying to make his way in the investment world, and that's why I was so taken with what he had to say. It seems that Dan has been led astray for most of his investing life -- largely by his broker, Jeff** -- and now he'd like to find his way home. Here is his situation, in his own words:
I feel like my broker just ripped me off and I am trying to understand my position. I am so sick of hearing sales pitches masquerading as investment advice. I've tolerated shabby service from Jeff because we had a social relationship, but no more. If I want a friend in the future, I'll buy a dog. (Even though, in a way, Jeff's advice has had me doing that already.)
I should tell you that I must invest in mutual or exchange-traded funds because I don't have the time, energy, or ability to manage a portfolio of individual stocks. (I have tried, and [I] lost a good deal of money in the process.) Overall, I am seeking income and capital preservation, and I would be thrilled with a minimal-risk 6% yield.
Wouldn't we all, my friend. However, that will be difficult in this market, and this focus could partly explain some of your troubles. But we'll talk about that a little later. Next, Dan got down to the nitty-gritty:
Given my yield requirement, my broker recently had me purchase the BlackRock Enhanced Dividend Achievers
My questions are these: Am I correct? Would I be significantly better off in an ETF? Does it make sense to buy BlackRock's funds after they have been issued and their prices have declined? And finally, what in the heck should I do?
Foolishly (unfortunately in the bad way),
Dan, I believe you know -- or at least suspect -- more about investing than your broker. You certainly know more than you give yourself credit for, which is probably your first mistake. I urge you to be confident in your own abilities and trust your instincts. If you've been advised to do something that doesn't feel right, there's a reasonable chance you shouldn't be doing it. In any case, speak up when you have reservations, and if your broker doesn't respect your feelings and address your concerns, give him his walking papers.
With that said, let's see if we can improve your situation while keeping some of your fellow investors from making the same mistakes. I'll start at the beginning, as I hear it's a good place to do so.
Unfortunately, bad advice abounds in the investment arena, and it sounds like Jeff has given you more than your fair share. Some folks say that too much of a good thing can cause trouble, but personally I believe it's too much of a bad thing that actually gets you. To be fair, Jeff is probably not so much a jerk as he is ignorant. In other words, I doubt he purposely shipwrecked you on a crummy-return island. It's more likely that he simply doesn't know much about investment research.
The thing is, people tend to forget an important aspect of the brokerage business: For most, this is a sales, not an investment, job -- and volume is key. (How do I know? I began my career as one, but fortunately escaped the business quickly with my integrity intact and my eyes open much wider than when I started.) Yes, many brokers out there try to serve both their clients and the interests of their firms, but the plain truth is that far too often the product being sold matters much less than the sale itself.
At the end of the day, most brokers simply push the investments that are recommended by their given firm's research department, and many times that firm has a cozy relationship with the investment's provider. Think that matters? You bet your assets it matters -- especially in the mutual fund arena, where fund companies have their own institutional marketing staffs and fees, commissions, and sales incentives are the rule of the day. Make no mistake: These relationships exist to enrich the brokerage firm first and you second.
If any of you still doubt that, I'll share another important part of Dan's letter:
... my broker has never sold me a no-fee product, and -- beyond commissions -- they charge me an annual fee equal to 1.5% of my account balance.
Lions and tigers and bears. Oh, my.
So what's the result of all this? Well, you can see it pretty clearly in Dan's portfolio: subpar returns. Tons of investors out there are being eaten alive by high-fee yet average-return investment products -- a combination that typically leaves you underperforming the market averages.
In this instance, simplicity is your friend. Most investors who find themselves in this situation would do better by simply purchasing a low-cost index fund such as Vanguard's Total Market Index
With the general stuff out of the way, it's time to move on to addressing Dan's specific questions. First, both his suspicions and conclusions are correct: Basing financial relationships solely on friendship is asking for trouble. That doesn't mean you can't be friends with your advisor, but the decision must be based upon the person's financial skills first and personality second.
If you're certain you need advice, choose a fee-only advisor who has a professional designation from a respected source, such as a CFA or CFP, but is not affiliated with any particular family of mutual funds or investment products. You want unbiased advice, and the only way to ensure you'll get it is to avoid any conflicts of interest.
Next, let's address your yield expectations. Though we'd all like to simply choose the yield level we want based on our risk tolerance, that's just not how it works in practice -- as I mentioned in this article. Is it possible to achieve 6% yields? Absolutely. But in this market -- unless our definitions of the word differ -- there's no way you're going to do so with "minimal" risk.
The problem is that -- despite a year and a half of interest rate increases by the Fed -- the risk-free rate is still very low right now. The yield on both the five- and 10-year Treasury bonds is around 4.4%. So you can see how difficult it would be to get to 6% with "minimal" risk.
You're going to have to step up to what I'd refer to as average risk to get anywhere near this mark today. A few below-average risk opportunities may exist -- Income Investor recommendations and master limited partnerships (MLPs) Enterprise Products Partners
This is because a stock fund can probably only achieve this yield level by one of three ways: Either employing leverage (i.e., borrowing money at short-term rates and investing the proceeds in additional long-term securities), including a return of capital (ROC) in the dividend payment, or utilizing a covered call strategy (i.e., selling out-of-the-money calls on the fund's holdings to receive the options premium). None of these options would be considered a particularly low-risk strategy. In fact, in this environment of flat yields, one might call the first two approaches high risk.
This leads us to your question about BlackRock's closed-end mutual funds (CEFs). BlackRock is a well-respected investment company, and I have nothing against its funds. Indeed, overall the funds you mention appear fairly well managed. However, you need to be aware that the almost 7% yield on these funds is either a managed yield, or -- in the case of Enhanced Dividend Achievers (BDJ) -- is being boosted by an options strategy.
In other words, the dividend income from the companies themselves doesn't produce that yield level. (This will become apparent if you look at the funds' top holdings, none of which yields more than 5.4%.) Thus, if the yield is to be maintained over the long term at this higher level, at some point it will depend on either capital gains, borrowing, or the continuously successful execution of an options strategy. Now, this in itself is not necessarily a bad thing, as all of the approaches can be viable strategies. But again, they add risk.
Of course, you could seek your income from bond funds instead of stock funds, but even in this arena you'd be hard-pressed to find a 6% yield without average to above-average risk.
I suppose the bottom line is that -- in the current environment -- you're either going to have to lower your yield expectations or increase the risk level you're willing to accept in order to achieve your 6% target.
One thing that I can tell you -- which you seem to have noticed -- is that it almost never makes sense to buy closed-end mutual funds via an initial public offering (IPO). Like most stock IPOs, these investments nearly always trade lower shortly after their offerings, as the impact of sales loads and the normalizing of demand runs its course.
My next comments concern your 1.5% management fee. Honestly, given the general fund advice that you receive, this is an absurd amount. Many professional asset managers will customize a portfolio of individual stocks and bonds to suit your specific needs for far less than this figure. Based on the size of your account, I would never pay more than 1%, and even in that case I would expect a much greater level of service and customization than you're currently receiving.
Lastly, if you do have to buy a friend, consider cats. They're actually quite nice once you get to know them.
If you're looking for more information on ETFs, I explain these investments -- and recommend specific funds covering a broad range of asset classes -- in the special report, The ABCs of ETFs, which is gratis for free-trial members of my dividend-stock newsletter, Motley Fool Income Investor.
Good luck, Dan, and Fool on!
*Last name changed to protect the innocent
**First name unchanged to publicly flog the guilty
Mathew Emmert hates bad investment advice, but loves his cat. If you're interested in dividend-paying stocks, he recommends two per month in Motley Fool Income Investor. Try it absolutelyfree for 30 days. He owns none of the investments mentioned in this article. The Motley Fool is aboutinvestors helping investors.