Since prevention is cheaper than cure, here's a list of 10 investments you should avoid in 2010 and beyond.
1: Limited Partnerships
These are private deals sold to "sophisticated" investors who meet minimum net worth requirements. The pitch is you are investing with the "big boys" -- large brokerage firms with the inside track on elite investments.
The reality is that these partnerships are illiquid. Because they aren't subject to Securities and Exchange Commission oversight, there's no requirement for audited financial reports, so it is difficult to monitor them. They're characterized by high fees paid to the general partner and affiliates. And there's no evidence that the average returns of limited partnerships beat those of a broadly diversified stock portfolio.
Limited partnerships are great for the promoters and operators who shill them.
2: Any Offshore Investment
Many deals are based offshore, typically in locations like the Cayman Islands or the Turks and Caicos islands. Avoid them.
The U.S. is a large country with well-established laws and a comprehensive (albeit imperfect) regulatory system. The primary purpose of establishing an investment offshore is to avoid U.S. regulation. However, investors need more -- not less -- regulation.
Deals structured offshore have a much higher probability of engaging in questionable (if not fraudulent) conduct than deals subject to U.S. laws.
If you think investing abroad shields you from the IRS, think again. A recent agreement between Swiss banking giant UBS (UBS) and the U.S. and Swiss governments provided for the release of the names of wealthy Americans who thought they outsmarted the IRS by secreting money in Switzerland. Those folks are now scrambling to turn themselves in and hoping to avoid prison time for their conduct.
3: Hedge Funds
No guru is going to deliver outsize returns without taking commensurate risk. This includes hedge fund managers. (One pundit has correctly noted that hedge funds are for "stupid rich people.")
These funds are illiquid. When things go bad, the fund can prevent you from liquidating your investment for significant periods of time. And the fees are obscene. Usually 2% of the assets, plus 20% of the profits.
They're difficult to monitor. If the fund changes its investment strategy, you'll never figure it out in time to do anything about it.
And they're very risky. Since 2006, more than 117 hedge funds at 71 fund families have gone bust. The list includes funds from stellar names like Russell Investments, ING (ING), Carlyle Capital, Bear Stearns and Dillon Read.
4: "House" Funds
"House" funds are actively managed mutual funds created, owned and operated by brokerage firms. They can be sold only by brokers who work for that firm. The Morgan Stanley Emerging Markets Fund (MSF) is an example of a house fund.
Independent studies have shown that house funds usually underperform funds from major independent fund families, like Fidelity and Vanguard.
Brokers love them because they get paid a higher commission. You should avoid them.
5: Variable Annuities
Insurance companies sell variable annuities through brokers. The pitch is that you get the benefit of an investment and the protection of a death benefit. The reality is that these are high-commission products, which is why they're sold so aggressively.
The costs of an annuity are difficult to discern, but they frequently exceed 2% a year, which will erode your returns.
The big selling point is that profits are tax-deferred. However, what the broker may not tell you is that you'll be taxed at your marginal, ordinary income tax rate when you withdraw your funds. You're also subject to a 10% penalty for early withdrawal, prior to age 59 1/2.
A former SEC economist concluded that, instead of investing in a variable annuity, "in virtually every instance" investors would have been better off in a mutual fund or a portfolio of stocks.
6: Equity-Indexed Annuities
Have I got a deal for you! You get the benefit of the stock market when it goes up and the protection of an annuity when it goes down. That's the promise of equity-indexed annuities.
Sound too good to be true? It is.
This is really an insurance product so complicated it would take an actuary to figure out its true returns and costs. They are illiquid and saddled with significant penalties if you surrender the annuity prematurely. And the insurer can change the provisions even after you sign up.
The combination of nondisclosed costs and uncertain returns makes these investments a poor choice for investors.
7: Exchange-Traded Funds
I'm not opposed to all exchange-traded funds (ETFs). Some, like the iShares MSCI ACWI Index (ACWI), are a low-cost way to achieve a broadly diversified stock portfolio. However, you can achieve the same goal with low-cost index funds like the Vanguard Total World Stock Index Fund (VTWSX).
I prefer the use of low-cost index funds over ETFs because you don't need to open a brokerage account to buy index funds. This means you don't have to pay a commission that reduces your returns, especially if you buy regularly or over an extended period.
ETFs have "bid-ask" spreads, which further add to your costs. And you can't automatically reinvest dividends back into your ETF. But you can with an index fund.
You should avoid the niche ETFs that track small sectors like cancer research stocks. Your chance of selecting an outperforming sector of the market is very small.
On balance, I don't see the appeal of ETFs for most investors.
8: Individual Bonds and Most Bond Funds
The purpose of holding bonds is to stabilize the returns of your portfolio. If your bonds or bond fund defaults or loses significant value, you've failed in achieving that goal.
Most investors can't buy enough bonds to properly diversify. Brokers love to sell individual bonds because they make more money doing so. You should avoid individual bonds altogether.
The key to buying bond funds is to focus on low-cost, short-term, investment-grade (rated BBB- or higher) bond funds. Ignore comparisons of the returns of these bond funds to those boasting higher returns. They may produce higher yields, but they do so by taking greater risk. The Schwab YieldPlus Ultra-Short Bond Fund (SWYPX) is a perfect example. It was sold as a safe bond fund that gave investors extra yield. It performed as advertised for a couple of years before it dropped by more than 30% in late 2007 and early 2008.
You should confine your bond fund selection to a fund like the Vanguard Total Bond Market Index Mutual Fund (VBMFX) or comparable, low-cost, high-quality, bond index funds from other major fund families. Avoid most of the bond funds on the market.
9: Pooled Funds
Pooled funds are funds from different investors aggregated for purposes of investment. There's no evidence they perform better than publicly traded funds. They're often structured in a way to avoid SEC oversight, which is a major disadvantage because it's difficult to monitor their costs and investing style, and to verify their returns.
They're often illiquid and valued only periodically.
More than 14,000 publicly traded mutual funds have established track records and can be monitored daily. I see no benefit to pooled funds but many disadvantages for the investor. Like hedge funds, they're structured to benefit the advisers who sell them and the fund managers who run them. I would advise avoiding them.
10: Individual Stocks
Probably more money has been lost pursuing the latest "hot" stock than in any other area of investing. No one has ever proven to have Superior stock-picking skill. The price of any stock is determined by tomorrow's news. Since no one knows what tomorrow's news will be, picking a stock based on your instinct about its future price is simply gambling. The stock-pickers graveyard is littered with bad choices that once looked great: Lehman Brothers, Worldcom, Enron, Refco and General Motors are just some examples.
Holding individual stocks has another problem. You assume risks that are unique to that stock, like the death of its founder or embezzlement by its chief financial officer. When you hold a low-cost stock index fund, you diversify away almost all of this risk without sacrificing your likely return.
Individual stocks aren't suitable for the portfolios of most investors.
Avoiding these 10 investments won't eliminate the possibility of losses. But it will improve the quality of your portfolio and keep you from becoming another victim of the poor advice all too frequently dispensed by brokers and advisers.