Steer clear of Wall Street

Just a few days ago I wrote in this blog about my intention to publicly “walk-the-talk” as far as my investing theories were concerned. I fully intend to honour this commitment and publicly put some of my hard-earned cash to work in the markets sooner rather than later.

However, and as they say in sporting parlance, the kick-off may be delayed somewhat. Accustomed readers will surely by now be familiar with my sceptical views on the investment industry. I have previously pointed out its perverse incentives (seeking to earn volume-based fees as opposed to net performance commissions), its use of intentionally obscure terminology and most of all, its appalling track record as a source of wealth creation for all but a few of those that choose to take part in it.

Recent reading has nonetheless only aggravated my already sceptical mind-set and highlighted for me a new set of potential “investing landmines” in what already looks like a barren patch of exposed "no-man’s land". I am referring here to the apparently blessed and increasingly popular Exchange Traded Funds (ETFs), and more precisely to a dangerous off-shoot referred to as Ultra Short ETFs. “Ultra” is but a fancy euphemism for leverage and “Short” merely indicates that the performance of this investing vehicle will be inverse to that of the index or benchmark it is designed to track.

So far so good I hear you say… I, for one can see the genuine appeal of a low cost, liquid fund, that can deliver returns at a time when uncertainty rules and markets are just as likely to turn bearish as they are to rise. However, and this is a maxim one would be foolish to ignore, when Wall Street concocts a “new, exciting and sophisticated product that will enhance returns whilst lowering risk” as these ETFs are branded, you’d be wise to at least, thoroughly analyse the product, if not simply to walk away from it.

Don’t believe me?. Take some time to reflect on the outcomes from the following list of once-loved and much publicised Wall Street invetions:

1. Junk bonds (think Michael Milken and his time in jail)
2. Portfolio Insurance in the 1980s (major contributor to ’87 crash)
3. Long-only high P/E tech-heavy funds in late 1990s (resulting in 70% Nasdaq drop between ‘00 and ’02)
4. Securitization or any type of structured prodcuts in ‘00s (we all know how this ended in ’08 and beyond)

In any case, the above examples are nothing new (even if people don’t actually learn anything from their mistakes). What is new however, is the remarkable and fundamental flaws in an investment fad that is happening as we speak, and that is Levered (Ultra) Short ETFs.

These products are sold as a a form of hedge or protection against a general market loss. Their performance is “guaranteed” to be the double the inverse of that of the index it tracks. In short if you expect the S&P 500 will suffer a 5% loss in 2010, buying an Ultra Short ETF will yield a 10% positive return in the same period.

Now, this sounds great, but it is in fact simply not true. Allow me to borrow from an example cited in Jason Zweig’s excellent 2010 title: “The Little Book of Safe Assets” and show you why this is the case:

Below is the actual performance of a Ultra Short ETF over 1 trading year as its benchamrk index. (this example assumes a bumpy ride made up of positive days and negative ones over the course of a full year...)

Trading days	Months	Index	Ultra Short ETF	Variation
	0	100,00	100,00
20	1	99,60	98,41	-1,19%
40	2	99,20	96,85	-2,35%
60	3	98,81	95,31	-3,50%
80	4	98,41	93,80	-4,62%
100	5	98,02	92,31	-5,71%
120	6	97,63	90,84	-6,79%
140	7	97,24	89,40	-7,84%
160	8	96,85	87,98	-8,87%
180	9	96,46	86,58	-9,88%
200	10	96,08	85,20	-10,87%
220	11	95,69	83,85	-11,84%
240	12	95,31	82,52	-12,79%

After a year when the market average drops by under 5% (see table above), it is nothing short of shocking to witness the Utra Short ETF, whose sole purpose is to perform inversely, lose around 17,5% of its value thus reducing 100 $ to 82,52 $! .

It seems that the field of potential investment tools, is becoming more constrained as we speak. The UF Portoflio will hence tread carefully not just in terms of asset classes and specific securities but also vehicles of choice.

As Paul Volcker , former Fed Chairman in ‘80s rightly stated on December 8^th , 2009:

“ The biggest innovation in the financial services industry of the past 20 years has been the cash machine (ATM)”…”