Book of Wise Investors

There is increasing popularity of indexing investing as Internet breaks down the informational advantage that the high priests of finance once have. People start to realize the premise that professional fund managers can beat the market is false, at least for the majority because they are the market. Even in index investing, which is basically buying into index mutual funds and/or exchanged-traded funds that tracks certain indexes, there is still a need for an average investor to acquire knowledge in this area of index investing to prevent being screwed by salesman in expensive suits.

However, though index funds and ETFs are good for the masses in the long run, names that sound similar to them are most probably not. In fact, I wonder if the creation of this type of funds is to associates a bad reputation to index investing, talking about the conspiracy of the rich! People who lose money in them will end up reaching the conclusion that index investing is not good and better to turn over money to professional money managers. Associations are used in online ponzi schemes where the websites names sound similar to famous and well known financial institutions.

There are mainly three types of funds attaching the word index to them that are as good as gambling.

The definition of gambling is playing a statistical game of chance in which the odds are highly not in your flavor and achieve a negative return on invested capital in the long run.

Most of them existed in exchange-traded funds form, but got a relatively few in mutual funds form. Proshares and Rydex got quite a number of them.

1. Leveraged funds

The word leverage in finance means using debt, but debt is a double edged sword, if the outcome is what you want, there is greater return on equity compared to not using debt at all, but if it is not, such as sell a house for less than purchase price and house is being bought preciously and financed using mortgages, need to pay back the difference to the financial institutions, and be made a bankrupt if don’t have money to pay back.

How the leveraged funds burrow money to increase returns is not known and what mechanisms they use to achieve leverage effect is not known to public. As such it is difficult to estimate the odds and hence expected returns in the long run.

2. Inverse funds

The word inverse already suggests to you that the returns will be inversed to something. In this case, the return of an inverse fund will be such that if the index that the fund tracks goes down 10%, then the inverse fund will go up 10% minus away the fund expenses of course.

Firstly, there is a problem of how “inverse” the inverse fund will be, like if the fund is exactly negatively correlated to the index that it claims to track. This will need to check the fund past records and superimposed that on the relevant indexes. How they achieve this and what mechanisms they use, I don’t know.

Secondly, the original purpose of index investing is to buy and hold, or at least does contrarian market cycle investing in years, like buying and selling every 5 years. In other words, turning over your money to mutual funds, be it active managed by fund managers or passive managed like index funds, is to avoid spending your life watching stock tickers and yet have the safety of capital from diversifications together with returns from stock market at large in the long run.

In the long run, stock market as a whole goes up due to inflation and increases in income of the population and the amount of population at large which allows businesses to increase prices for its goods and services together with increased demand, and hence revenue together with profits. As a result, the long run trend line is going up, buy and hold inverse funds will be in a losing proposition. That will be the case for stock market as a whole, not necessarily for individual stocks, even blue chips, think Enron, Bear Sterns and Lehman Brothers. They may be volatility from day to day but still mostly goes up for macroeconomic reasons as mentioned above.

3. Leveraged inverse funds

Combined the elements of the above two types of funds and you will get leveraged inverse funds, the return of this fund is simply if the index tracked goes down 10%, the fund goes up 20% minus away the fund expenses.

Problems with this leverage, inverse or a combination of both,

1. No dividends.

This is no good, normal ETFs got give dividends and stability of dividends to pay for MacDonald’s happy meals every now and then, what is better than sleep and grow rich? For professionals like doctors, lawyers and engineers, the main advantage with usual index fund/ETFs is that they can focus their minds on what they like doing or exceptionally talented at to earn the cash rather than mentally bothered with the daily ups and downs of stock market.

2. Higher fund expenses

Though they tag on the names of index investing, but their fund expenses are not cheap compared to normal ones, at least 0.70%.

3. More risk but much lower expected returns

Just take a look at the past performance of every leveraged, inverse and leveraged inverse funds, see their annualized returns over a period of just one year or more, like between one to ten years. I think the results speak for itself.

Investing in them is like taking on higher risk without higher expected return, as you can see; there will be investments that provide lesser returns from a given level of risk which went against the commonly accepted finance notion of equal risk and equal return. In other words, if you can take this level of risk, you should invest in an index fund of small caps as there are higher expected returns.

Related posts:

1. Deciding between actively managed mutual funds and passive index funds
2. How to choose from among so many Index funds and exchanged traded funds?
3. Neglected risk when invest in stocks and bonds through mutual funds and ETFs
4. What is a good index for index investing?