An Investor's Best Protection: Understanding

A fundamental issue -- or flaw -- in the investment industry today is a lack of good communication around investing. Obscure wording, labels that don't reflect reality and more all add to the proliferation of myths. This contributes to a lack of understanding of investing principles and is a real scourge for investors, in both dollars and sense.

-- Thomas Ek, Fisher Investments vice president

NEW YORK ( TheStreet) -- Simplicity and understanding are two cornerstones of successful long-term investing, yet it truly seems much of the investment industry hasn't grasped this, doesn't agree or otherwise prefers not to operate transparently.

While one might suggest the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 targets this, we'd suggest there's ample evidence already it's wide of the mark. Communication and clarity are no more common in the law's wake, and simplicity is still often overlooked by Wall Street as being too "basic" to be of value -- despite the fact the best real protection from flawed products, bizarre strategies with no real track record of success and, yes, villains like Bernie Madoff generally isn't anything regulatory. It's common sense.

Take, for example, Mr. Madoff. Here was a man showing returns that were consistently high (equity-like) and positive, with no negativity throughout his tenure. His strategy underpinning this was based on options (anyone who's spent time in the industry knows these are likely the least understood broad investment option -- no pun intended) and stocks -- split-strike conversion -- in which a call and put were simultaneously sold around a stock or index.

Someone possessing a high degree of investment acumen would likely know simultaneously selling puts and calls around a stock or index (straddling) is unlikely to result in equity-like returns. Which was one way to know Mr. Madoff's strategy was mumbo-jumbo, a front for his illegal activities behind. But an individual investor needn't know any of that to be wary of Madoff.

All you need to see is the long history of no negativity and outsized returns. At this, your ears should perk not out of greed and attraction, but fear. You should have to be convinced beyond a shadow of a doubt the numbers are real because virtually any manager or investor, no matter how great, is going to have both good and bad years in the marketplace. (See Warren Buffett, late 1990s.)

But while Madoff's con made huge headlines, there are other ways the investment industry and press have yet to embrace clarity and simplicity. Consider: One major media outlet ranks various mutual funds on a scale called the "Riskless Return Index."

Which sounds great, until you remember there are a grand total of zero riskless funds in the world. (See "Break the Buck, Reserve Primary Fund" for an extreme example.) To earn any return over any length of time, you must accept some degree of risk.

Now, the ranking really aims to report the funds with the best returns adjusted for volatility. In theory, this seems a perfectly fine thing to study -- it tells us which funds have historically offered a higher return with a smoother path. Problem is, volatility isn't the same thing as risk. Moreover, the "riskless" moniker doesn't reflect how the funds actually invest.

Case in point: The fund placing first in August 2012's report was a bond fund composed largely of government bonds. It may have had fine returns (though what to measure that against is a matter not discussed in the "Riskless Return Index"), but there is no way to really see the fund as "riskless." At bare minimum, it's subject to interest rate risk. As interest rates rise, bond prices tend to fall.

But in this specific case, the trouble doesn't stop there. You see, this so-called "riskless" fund used a heavy dose of leverage to achieve its outsized returns--the very opposite of "riskless." In fact, leverage increases risk--it magnifies volatility and potential declines. As of June 30, Morningstar reports the fund was 178% invested in bonds, meaning you're actually making a substantial bet on interest rates' direction.

While we don't expect rates to surge higher in the near future, the fact long-term bond rates are at or near generational lows suggests the longer-term trend ahead is likely higher, not lower (see Exhibit 1). That makes the "riskless" label especially dubious at this juncture.

These are merely two examples of many where unclear communication and complexity could work against you as an investor. Ultimately, Vice President Ek's comments at the top -- delivered recently to an audience at our headquarters -- highlight an important point for investors: The only real way to arm yourself against flawed strategies and products is understanding. If the product is too complex to yield that, our suggestion is to keep looking.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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