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  • Eric Scharaga

How do Mortgage Notes Compare with Stocks, Bonds, and Annuities?



I want to make it clear that I’m not in favor of mortgage loans replacing traditional investments in an investor’s portfolio. Every investor has a complicated combination of risk tolerance, time horizon, accumulation goals, net worth, and income needs. Therefore, every investor, with the help of a seasoned advisor, needs to find their own appropriate and effective asset mix.


My goal in this section is not to tout mortgage loan investing as a superior option to any other kind of investing, but to help the reader understand how mortgage loan investments stack up against more traditional investments. Doing this will allow more investors and their advisors to determine the appropriate place for mortgage loans in their portfolio.


I view mortgage loan investing playing a complementary role in a portfolio. These assets help improve diversification and are noncorrelated, meaning they are not affected by swings in the stock market. They add balance for many investors and a source of strong, predictable income for those who need it. But again, I want to stress that mortgage loans are just one component of a diversified, well-balanced portfolio.


Too many financial advisors are discouraged or even prevented from researching alternative investments such as mortgage loans or mortgage loan funds. The pool of what they offer clients is a tiny slice of the investable universe. It often consists only of Wall Street–related investments too volatile for a large stake of client assets and which often don’t address the need for high-yield income generation.


The stigma that alternative investments are “too risky” to recommend makes little sense when you consider that stock investing success relies on a combination of consumer confidence, investor demand, and the willingness of corporations to act in their investors’ best interests. Switch over to high-yield corporate bonds, and you have to rely on the company to make the coupon payments and pay back the principal, something studies show might not be as reliable as you’ve been told.


Let’s take a closer look at some often-promoted investments to see how they stack up against mortgage loan investing. I’ll kick it off with the big one—stocks.

Stocks

I was first introduced to stocks, which represent shares of ownership in an underlying company, when I was sixteen. My grandfather, who was retired during my entire youth, was an active stock market investor before the internet age. He introduced me to Value Line, an equity research company with a series of hard-bound research and ratings books at the library, very similar to a set of encyclopedias.[1] He taught me what to look for in stocks and how to integrate a stockbroker’s advice. I still remember our experiments of picking stocks, pricing them out per share, and tracking our portfolios.


Trading stocks seemed, to me, overly complicated with no real assurance of success. The whole process seemed more like throwing darts at a board than it did controlled research resulting in successful returns. But my biggest problem with the market was that I didn’t like the stress of having to accept losses.


Take a look at almost any generic asset allocation pie chart and you will see that stocks are pushed as the primary investment for most people during their younger, income-earning years. Why? Because conventional wisdom tells us that stocks grow. And grow. Did you know that if you invested $100 in Amazon back in 1997, it would be worth about $196,635 today?[2] If you invested $100 in Microsoft in 1986, it would be worth about $26,100. That same $100 in Apple in 1980? It would be worth about $106,391 today!


These numbers aren’t untrue, but they are pretty optimistic. Because for every one Wall Street unicorn that’s grown exponentially in forty years, there are thousands of companies that have gone bust. So, sure, $300 spread between Amazon, Microsoft, and Apple between 1980 and 1997 could have given you more than $300,000 today, but $300 in Enron, Compaq, and WorldCom might have given you losses or, worse, nothing at all.


The Problem of Picking Winners

There’s no bright, blinking neon arrow flashing over the stocks that are going to grow over the years, and there’s no specter of doom standing over those that will not. As of 2020, there were roughly 2,800 stocks listed on the New York Stock Exchange and 3,300 on the NASDAQ.[3],[4] Which of the thousands are worth investing in? Probably not many. Just five stocks on the S&P 500, which lists 500 tech stocks, are pulling up the average of the whole index.[5] I don’t know about you, but when it comes to being an individual investor trying to pick winners out of pools that big, I don’t like my odds. And that inclination isn’t just a feeling—it’s backed by facts.


For fifty-five years, the Center for Research in Security Prices (CRSP) has maintained a database tracking historical security prices and returns.[6] Studies analyzing that database have found that between 1926 and 2016, the median length of time securities stayed listed was just seven-and-a-half years before disappearing into obscurity, taking investor cash with them.[7] That’s overwhelming to think about, so let’s go smaller and look at the S&P 500. Between 1980 and 2014, 320 listings had been removed from this list due to “business distress.”[8] And according to J.P. Morgan, a steady stream of these companies faced their distress during times of economic expansion, not recession. The year this book was written, we saw massive volatility thanks to an election, a pandemic, and massive unemployment. Imagine trying to pick a winner with this level of volatility.[9]


All this should help you see that the odds are against you when you try to pick stocks, but I want to throw one research paper quote at you to help drive this point home. When researching whether stocks outperform treasury bills, researchers found that:


“… the best-performing 4% of listed companies explain the net gain for the entire US stock market since 1926, as other stocks collectively matched Treasury bills.”

—“Do Stocks Outperform Treasury Bills?” Department of Finance, W. P. Carey School of Business, Arizona State University, May 2018


It doesn’t take a virus, housing market collapse, or dotcom bubble burst to create losses for individual investors like you and me. Attempting to pick winning stocks is like betting against the house in Vegas. The odds are not in our favor, and most people are going to lose, most of the time. So much so that even highly trained, experienced financial professionals have a poor record of picking stocks that beat the market.[10]


Maybe It’s All In the Timing

Another current stock investors fight against is timing. Let’s look at a portfolio at the tail end of 1997 holding Microsoft, Bank of the Ozarks, and Mattel, all purchased from a broker, using a cell phone with a retractable antenna. But let’s up the ante. Let’s say the investor was fifty-five years old, just ten years away from retirement, and threw $100,000 into those positions. Now, we reach the year 2007, the cell phone has been replaced by a Blackberry, and our investor has a portfolio balance of $366,427 the day they retire.


Almost two years after retiring, in February 2009, just as our investor needed to start liquidating their portfolio to take some income distributions, the market crashed and the value of all their investments fell to $220,841.[11] Now, our investor has to liquidate a higher number of shares early on in their retirement just to get the amount they need for a distribution. This leaves fewer shares in their portfolio, which means less opportunity for recovery and growth when the market rebounds.


The above situation is an example of sequence of returns risk, and it causes lasting damage. Just as compounding interest and returns can drive accumulation, selling a large chunk of shares at a low price (or a loss) early in your retirement can devastate your ability to maintain distributions and live out a comfortable retirement.


Time is touted as a great friend to the stock investor, when it can just as easily be the enemy. Proponents of stock market investing hold out 10 percent as a reasonable expectation for returns, a number that’s often based on growth of an entire index during a historical period.[12] Please tell that to investors who lost their savings with WorldCom, Pets.com, Enron, and the thousands of delisted stocks removed from the NYSE over the years.


Stocks may have a place in your portfolio. That’s for you and your advisor to determine. For my part, I am uncomfortable with the idea that hardworking Americans can have a large portion of their retirement savings wiped out during one major market correction, and it can take years to regain those losses—if they can at all.


While we do know where the market has been, we don’t know where it’s headed. Of the crashes that have occurred during my lifetime, the one thing they all had in common was that very few of us saw them coming. The stakes are too high to take chances when an investor’s retirement is at risk.


Can we—or should we—expect an average 10 percent stock market return in the future? I don’t know, but if there’s any doubt, I would argue that investors should look at putting a small amount of their portfolio into alternative investments, such as mortgage loans, both to hedge against loss and to provide some steady income security.


Let’s look at yet another not-so-nice gift that time brings to stock investors: volatility.

Volatility and Returns

Most people accept the volatility of the stock market as a natural, unavoidable part of investing. Some even embrace it, under the strategy of dollar-cost averaging. This strategy involves investing a specified amount periodically into a certain stock, ensuring that the investor buys both when the stock price is up and when it’s down. Since the market is impossible to time, dollar-cost averaging ensures the investor buys both during highs and lows, thus averaging out their cost basis and better managing volatility.


It might sound like a great strategy, but the truth is that the more volatile an investment is, the less successful a portfolio will be over the long term.


Many people don’t realize how seriously volatility can diminish returns. If I asked you whether you’d rather have an investment that had a fixed annual return of 3 percent over six years or a volatile investment with an average annual return of 6 percent over six years, you’d probably choose the more volatile but seemingly higher return. But let’s look at the overall performance of both investments:


The more volatile investment earns far less than the slow, steady, lower-return investment. By the end of the six-year period, the volatile position has earned just $76,184, while the steady return has earned $180,000.


Alternative investments like mortgage loans are a great complement to a portfolio because they are not correlated to the stock market and can be effective at strengthening a portfolio by reducing volatility.


A common strategy that I see repeated is investors removing some of their stock market gains during a bull market and placing them into either mortgage loans or mortgage loan funds. Then, during a bear market, they remain confident that a portion of their portfolio that is invested in mortgage loans will continue to provide income.


While I am not condoning an attempt to time markets, which is futile, let’s look at how devastating volatility can be to an investment portfolio over time, and how reducing volatility ultimately means much larger gains.


Issues with Income

Stock market investments are not ideal for income generation; stocks are generally bought for growth and speculation. Worse, you can’t control how the market is doing when you start liquidating stocks for income. That is when sequence of returns risk becomes a very big problem.


In the last section, we talked about the difference between a steady return and a volatile return. Let’s see how that same $1 million investment is impacted when the investor needs to take a $25,000 annual income from it.


You can see that while we still have our $1 million principal in our “steady” investment and we’ve been taking out $25,000 in income, we’ve also been accumulating an additional $5,000 per year. Yet in our volatile investment, we’ve tapped into the principal and our balance has dropped below $900,000, despite an average annual return of 6 percent.

But, you may be thinking, what about stocks that pay a dividend? Wouldn’t those be good for income? Well, that depends.


One of the biggest issues I have with dividends is that companies are not required to pay them and can revoke them at any time. For many years, Microsoft was under fire for deciding not to offer a dividend, despite having a profit.[13] While they reinvested this money into the business and the value of the stock grew, investors who were hoping for a dividend were out of luck. Not only are dividends not guaranteed, but dividend-paying stocks can go bust, or companies can simply suspend dividends, like Dunkin’ Donuts and General Motors did in 2020.[14]


When investors look for dividend stocks to create regular income, they often change the parameters around their assessment of a stock. Instead of measuring risk and potential the same way they would a growth stock, they instead consider only the dividend potential. Worse, evaluating stocks this way can actually hurt overall returns as dividends can reduce stock prices.[15]


The most common way for investors to make money in the stock market is to sell shares for a higher price than the price at purchase. Sounds simple enough, but without the ability to time the market and without any meaningful control over company decisions, we have no way to create a positive environment for stock ownership. Worse, we, just as everyone else, are victims of the whims of the market—which means that even if a company is doing well by all measures, if consumer sentiment is against it, the price of its shares can plummet, just when we most need them to rise.


Stocks have their place in the portfolios of many. They offer opportunities for growth, intermittent income, and—when you’re lucky—meteoric rises, if you’re willing to take on some pretty major risks. Mortgage loan investments, on the other hand, remove the instability and costs of volatility while generating a predictable income/yield, with no exposure to market risks.


Funds

When you’re looking toward the stock market to earn money, but want to play it safe, mutual or index funds might seem like a great compromise. With a mutual fund, instead of trying to find ways to pick the right stocks, you rely on a manager to buy and sell stocks to (hopefully) maintain fund performance. And that is where the problems begin.

Mutual Funds

The truth is, mutual fund performance generally underperforms the S&P 500.[16] That means the active managers who move positions in and out of the fund with the goal of creating a profitable fund have a performance that lags behind the S&P 500 index.


Making matters worse, mutual funds have fees that you pay, whether the fund is profitable or not. For many mutual funds, the fees include front-end and/or back-end loads, which are fees you pay when you buy or sell a stake in the fund. Even if you choose a fund with no buying or selling fee, also called a no-load fund, you still have what’s called an expense ratio. This is a fund management fee, charged as a percentage against the fund’s total assets.


Mutual fund fees can be especially egregious when they are held in a retirement account that has its own fees on top of the mutual fund fees. One of my biggest criticisms of the limited mutual funds that I was offered by my financial advisor were all the hidden fees and costs that I was paying to invest in those funds. This was within a 403(b) retirement account designed for teachers, which itself had high fees, which I was paying on top of the fees for the actual products within my plan.[17] Shouldn’t teachers, who don’t make much money to begin with, have access to the best funds with the lowest cost options available? Sadly, that wasn’t the case, and one of the reasons I decided that I needed to take more control over my own wealth building for retirement.


If you plan on holding your mutual funds outside of a qualified account, you have another headache headed your way: unexpected taxes. At the end of each year, funds distribute a portion of the proceeds from trading on to their investors. These gains, which can be wildly unpredictable, are taxable to the investor when the fund is outside a retirement account. Because these gains can’t be planned for in advance, they can easily result in higher tax implications, and less net profit.[18]


Index Funds

Index funds have grown in popularity in recent years. These are mutual funds with holdings that match or are similar to those of a chosen benchmark index. For example, an S&P 500 index fund might hold all the same positions that are on the S&P 500 index. Our recently ended, eleven-year bull market run made index funds seem like a great deal.


But index funds are a lot riskier than investors believe. First, many indices, which are the underlying benchmarks steering the positions in the fund, are heavily invested in a particular sector, such as the Vanguard Information Technology index fund, which follows MSCI IMI/Info Tech 25-50 GR index.[19] So while investors with an index fund that has MSCI IMI/Info Tech 25-50 GR index as the benchmark might feel like they’re well diversified, their holdings are actually all within one sector. As that sector loses value, so, too, will their portfolio, often without enough hedging against the losses.


Index fund investors also face the issue of rebalancing. In a normal portfolio, your asset allocation would be based on many factors, including your risk tolerance. The weight of each position within your portfolio changes every time the investments move up or down in value or you liquidate some portion of them. This means that your portfolio needs to be regularly rebalanced to ensure that the weight of each investment stays within the range it should be, based on your unique risk tolerance and other factors.


With an index fund, you can easily find that one underlying holding, as it grows within the fund, takes a much higher percentage of asset allocation than you would otherwise be comfortable with.


And of course, we should talk about the elephant in the room, which is the fact that index funds are extremely vulnerable to systemic risk. Some research has found that index funds may even contribute to systemic instability.[20]When you have a mix of assets, including equities, from a wide variety of industries, it is possible that some of your investments can hedge against losses when the market begins to decline or when an index falls in value. But what happens if your investments are modeled against the very index that’s falling?

Imagine buying an index fund in the 1990s. The fund you chose? One modeled after a precious metals index, which had seen an 82 percent gain the prior year. But by the end of the 1990s, the fund was worth less than half of what it was.[21] The same could happen with many of the index funds available today.


Where mortgage loans offer a steady stream of income, minimal fees for loan maintenance, a noncorrelated asset, and an asset “backed” by a home that’s lived in by the owner, funds offer more risk, higher potential fees, and risks from improper diversification.


Bonds

Bonds are debt instruments that represent a loan the investor gives to a government or municipality. Through the bond, the issuer promises to repay the loan by a set maturity date and pay interest at the coupon rate.


Bonds are probably the most similar investment to mortgage loans, and the motivation between both bonds and mortgage loans is stable income that an investor can receive over time that is completely passive. Both are considered lower volatility (even though bonds are certainly not without risk), and the risk profile can be judged at purchase.


The problem I have found with bonds, including mortgage bonds, is that unless you are willing to purchase higher-risk junk bonds, it is hard to obtain low-risk yields above 5 percent.[22] As of the writing of this book, bond yields are averaging only 2 percent.


Another risk with bonds in the current ultralow yield environment is that investors essentially have two choices: commit to hold the bond to maturity for a very low interest rate, or sell it early. If you sell early during a rising yield environment, which we are undoubtedly entering, you can end up having to take a huge loss on your investment.


For example: You buy a thirty-year bond at 2 percent, and rates go up to 4 percent any time during your ownership period. If you decide you want to sell that bond, you would have to take a loss of up to 50 percent to match the yields in the bond market at the time you want to sell. I don’t know about you, but that’s not a loss I can stomach.

Annuities

Another investment that has followed bonds in popularity during recent years are annuities, contracts issued by insurance companies that guarantee a specific fixed income to annuitants after principal is paid to the insurance company. Let’s take a closer look at how they work.


Guaranteed Income: When and for How Long?

Annuities designed for ongoing income can pay that income in different ways. Some pay a guaranteed income for a limited term, some pay a guaranteed income until death of the annuitant, and some pay an ongoing income until the death of the last surviving joint annuitant.


The payment of this income comes after the annuity owner pays a premium, which is a lump sum of money paid in either a single contribution or in multiple payments.


In many ways, annuities are similar to mortgage loan investment, in terms of getting a steady, ongoing income. But unlike mortgage loan investments, annuity yields are very low and payments can vary, based on when you trigger them. For example, when you have a guaranteed minimum income benefit rider, the longer you wait to start the income, the higher your periodic payments will be.[23] Annuities also have administration and investment management fees as well as commissions.[24] Finally, annuity payments only occur when the insurance company is able to fulfill its promise of payment, a risk that some investors might not be willing to take.


Annuities have many built-in protections, such as inflation riders, which help to increase your future income to combat inflation. But many of these benefits come at an additional cost, which lowers the investment power of your principal.


Annuity Investments

Unless you buy a fixed annuity with a guaranteed return, you’re likely to choose either a variable annuity or an indexed annuity. A variable annuity allows you the choice of an underlying mutual fund for your annuity premium to be invested in.

An indexed annuity requires you to choose an index, such as the Dow Jones Industrial Average or the S&P 500, and will credit your account with a return based on the performance of that index.[25]


General Liquidity

When buying an immediate annuity, payments can begin as soon as one month after purchase. Should you need more money from the annuity, you could find yourself paying a penalty if it’s during the annuity’s surrender period. With a mortgage loan, however, you could get additional liquidity either by selling the loan or by selling a partial interest in one or more of your loans.

[1]https://www.valueline.com/ [2]Yahoo! Finance. Prices accessed 8/30/2020. [3]https://www.advfn.com/nyse/newyorkstockexchange.asp [4]https://www.advfn.com/nasdaq/nasdaq.asp [5]https://www.washingtonpost.com/business/2020/08/19/tech-stocks-markets/ [6]http://www.crsp.org/ [7]https://poseidon01.ssrn.com/delivery.php?ID=586024090004104077089103018119114105036053067045062087091089084119013068085098082104033016012031048048013081085017099088114018009094094009064094095018102026036012097127107111109120126086096127069015089067029090067021065005008124085024025000&EXT=pdf [8]https://www.jpmorgan.com/cm/BlobServer/Eye_on_the_Market_September_2014_-_Executive_Summary.pdf [9]https://www.forbes.com/sites/sergeiklebnikov/2020/09/30/stocks-close-a-dismal-september-as-investors-prepare-for-an-even-rockier-october/#50e1caf7e4b2 [10]https://www.aei.org/carpe-diem/more-evidence-that-its-really-hard-to-beat-the-market-over-time-95-of-finance-professionals-cant-do-it/ [11]https://www.portfoliovisualizer.com/backtest-portfolio [12]https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp#:~:text=The%20S%26P%20500%20index%20is,since%20its%20inception%20through%202019. [13]http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/Microsoftdividends.htm [14]https://www.nasdaq.com/articles/here-is-a-list-of-companies-that-have-suspended-dividends-or-stopped-stock-buybacks-in [15]https://finance.zacks.com/dangers-buying-highdividend-stocks-1419.html [16]https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html [17]https://www.fool.com/investing/2019/10/13/why-403b-plans-are-so-awful-so-often.aspx [18]https://www.morningstar.com/articles/945237/stop-the-mutual-fund-capital-gains-distribution-madness [19]https://money.usnews.com/funds/mutual-funds/technology/vanguard-information-technology-index-fd/vitax#:~:text=The%20Vanguard%20Information%20Technology%20Index,the%20majority%20of%20its%20performance. [20]https://www.cfainstitute.org/-/media/documents/article/rf-brief/etfs-and-systemic-risks.ashx [21]https://www.morningstar.com/articles/1927/mutual-fund-notables-of-the-1990s [22]https://www.thinkadvisor.com/2020/08/14/low-rates-arent-going-anywhere-heres-what-that-means-for-retirement-planning/ [23]https://www.annuity.org/annuities/riders/gmib/ [24]https://www.fidelity.com/viewpoints/retirement/shoppers-guide-to-annuity-fees [25]https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities

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