Investors: Often Their Own Worst Enemy

The NYT small business blog by Jeff Brown wrote about the S+P SPIVA report I blogged about on August 20. It pointed out that the active management advocates found solace in one part of the report (my bolds, my comments in bold italics):

Still, the active-management boosters won’t cry “uncle,” falling back on a variety of arguments.

Lending some support to their view, S.&P. noted that on an “asset-weighted” basis, managed funds matched or beat their benchmarks in “most categories except mid-caps and emerging markets.” This analysis takes into account the amount of money investors have in each fund. A few large managed funds that beat the benchmarks can therefore pull up the managed-fund results, even if the average managed fund has trailed the index when assets are not taken into account.

To managed-fund advocates, this means investors are good at picking market-beating funds. But it may also mean that funds with lots of assets can afford to spend money — their investors’ money — to lure even more investors.

To managed-fund advocates, this means investors are good at picking market-beating funds. But it may also mean that funds with lots of assets can afford to spend money — their investors’ money — to lure even more investors.

Marketing on the basis of recent performance can be a dirty trick, drawing investors in too late to share in the big gains. Morningstar, the market-data firm, has worked hard to get insight into this problem, trying to distinguish investor’s actual gains and losses from apparent returns indicated by changes in fund share prices — the figures typically used in marketing materials. By looking at cash flows in and out of individual funds, Morningstar has detected a widespread pattern of investors chasing past results, pouring money in after a fund has done well and taking it out after the fund falters.

The average investor therefore does much worse than the investor who buys a block of shares and hangs on through thick and thin

.

Brown points to an interesting aspect of investing in actively managed fund that leads investors to succumb to many of the pitfalls recognized by those that study behavioral finance.

Investors who favor managed funds are more susceptible to this kind of self-destructive behavior because fads change fast. The whole idea of using active managers is to hitch your wagon to a hot stock-picking team, and a fund that loads up on a hot market sector — Internet stocks, for instance — can tumble when that sector falls out of favor, driving the active-management investor elsewhere.

In other words if an investor buys into the belief that there are genius fund managers that can beat the market through sector rotation, stock picking or market timing then they will be in constant search for the next "genius". As soon as their genius manager "under[erforms they will be off in search of the next genius. And how will they pick that genius ? based on the only data available to them = past performance. Yet we know that past performance is not a good predictor of future performance. So the believer in active management (as evidenced by the morningstar data) will constantly be buying funds high and selling low. Of course that doesn't stop Morningstar (and various other magazines websites and newsletters) from constantly publishing list of acte funds to "buy now" or "must dump now".

The same can be said of investors that believe they can consistently beat the market by market timing or shifting in and out of individual stocks. Their belief in these strategies will lead to overtrading often based on chasing past market performance.

as Charles Ellis wrote long ago: It's a Loser's Game.

Brokers and Registered Investment Advisors Are Not The Same...

graphic below from the WSJ. You can read here

Fiduciary Duty Hits the Street -- Sort Of
about proposed changes that would institute a fiduciary standard for stockbrokers.

More Fallout From the "Yale Model" at Harvard

WSJ: Harvard Regroups

The Wall Street Journal Gets It(Less Than) Half Right About ETF Costs

The WSJ today has an article on the what it calls the high hidden costs of etfs. It gets it right when it points out that some new etfs carry high fees noting the average etf now charges .56& compared to .40% at the of 2005.

But two comments on that number:
1. On an asset weighted number basis the average fee is far lower. Most of the assets in etfs are in broad asset classes from the leading providers and carry far lower fees, For example the vanguard small cap etf has a fee of .10% and the ishares s+p 500 etf has a fee of .09%.

2. In some but not all cases the higher priced etfs are in asset classes where the active funds carry higher fees. Thus the ishares emerging market etf carries a fee of .74%, the vanguard etf .25% but the average of the actively managed mutual funds for the category of emerging markets is 1.72% (for domestic funds it is 1.33%). So in some cases the higher fees for the etf is paralleled by higher fees in the same category in the active fund category.

The article goes on to argue that the trading costs for some etfs are prohibitively high:

"Lower ETF assets generally mean higher trading costs for investors.

Consider the "bid-ask spread," or the gap between the price buyers are willing to pay and the price sellers are asking. Only about a dozen ETFs have more than $10 billion in assets. All have small spreads, amounting to less than 0.09% of the price that is midway between the bid and ask price, according to New York Stock Exchange data for the first seven months of this year.

By contrast, nearly 200 ETFs have spreads over the 0.5% mark. A spread that wide is "not acceptable," said IndexUniverse's Mr. Hougan. It means an investor who buys and sells the fund could lose more than 1% of his investment to the spread, which is more than most ETFs' expense ratios".

While it may be true that the bid ask spreads for etfs reflect trading costs, in most cases the bid/ask that appears on quote screens does not reflect actual transaction costs.

Making an assessment of trading costs based simply on the bid/ask spread that appears on a quote screen is incredibly simplistic for several reasons.

Firstly no one should ever put in market orders for any but the most liquid etfs. Simply putting in a limit offer in the middle of the bid ask spread will get the trade executed in most cases. I do this for all the etf trades I make for my client portfolios.

Why is this the case:

The posted bid ask spread for the etfs is really just an indication of where the market makers are willing to trade at minimum risk. It is important to remember that etfs are a form of derivative product. That means the price of the etf is derived from the price of the basket of underlying securities that make up the etf. The market makers in the etf have at their fingertips the value of the etf based on the stock prices and they will hedge their position with trades on those stocks. The posted bid ask is a wide spread around that value because initially there may be little price competition among market makers and the market maker posting the price is happy to collect the easy money from those unsophisticated enough to put in market orders (this phenomenon is common in many thinly traded derivative markets such as deep out of the money options on stocks or futures. But the market makers in most cases will be willing to trade inside that spread.



In fact the value of the underlying stocks--the intrinsic value is not some kind of deep secret held only buy a few wall street bigshots. It is readily available the symbol would be the ticker for the etf followed by .iv for instance EEM.IV for the ishares emerging market etf A good guideline for an order is to try to put in a limit order close to the intrinsic value. If one is trading close to intrinsic value the bid ask spread is pretty much irrelevant as a measure of your trading costs.

So if the real active market for the etf is "inside" of the bid/ask spread that initially appears on the computer screen, it only goes to reason it is a pretty poor measure of trading costs. It's akin to calculating car dealers' markups on autos based on the first price offered when you walk onto the dealer's lot, or measuring housing prices in the current market based on the offering price first quoted. Those numbers are irrelevant what matters is the price where the trade gets made.

In the case of foreign stock etfs a wider bid ask spread (although probably not .50%) is in my view justified given the risks undertaken by the etf market maker. Think about his situation: he is quoting a price on a basket of stocks for markets that are not open (certainly not during the entire US trading day)with price risk on the stock and on the currency movements. Yet as someone purchasing or selling the etf I get full transparency on my trade.

Consider the alternative of an actively traded mutual fund,for example in emerging markets. The purchaser or seller of the emerging market fund must buy or sell the fund at only one time: at the end of the US trading day. Yet the NAV of that fund is set based on the prices at the market close in the local markets. Talk about buying a blind item ! I would certainly prefer the opportunity to trade the etf throughout the day.

Furthermore, just because one buys an actively managed mutual fund the transaction costs don't disappear, they are just buried. A study by Vanguard (available on their financial advisor website) estimates transaction costs on emerging market trades at 1% in each direction (2% round trip) twice that of developed markets.

So there is probably less than meets the eye looking at that computer screen with the bid/ask spreads on etfs. That spread is not a true representation of the trading costs of etfs, certainly not for someone who takes even the most minimal step for reducing costs by using limit orders.

Style Purity and Actively Managed Mutual Funds....There May be Exploding Derivatives in That Portfolio...And You Likely Won't Know About It

I wrote earlier about the importance of style purity of one's holdings and that active funds often don't have that purity. I also noted that it is impossible to know the current holdings of a fund since the data is published in arrears.

The problem is even worse. As Investment News reports investors seldom know if the mutual fund they hold makes use of leverage:(my bolds, my comments in bold italics)

An American Bar Association task force studying mutual funds' use of derivatives will likely recommend measures to ensure that investors and fund directors are better-informed about the risks associated with the use of the complex financial instruments. ...

Although the Investment Company Act of 1940 limits the amount of leverage a fund may carry, the SEC hasn't imposed specific limits on a fund's use of derivatives, in part because derivatives are often used by funds to hedge against risk.

“These limits were structured when derivatives didn't exist,” said Jay Baris, chairman of the task force and a partner in Kramer Levin Naftalis & Frankel LLP of New York.


“A whole world of derivatives has evolved,” he said. “The SEC is struggling to keep laws and regulations in sync with these developments.”


The task force expects to release its preliminary findings in November.

Simpler disclosures aimed at retail investors could be in-cluded in fund prospectuses, while more detailed, technical disclosures could go into the statement of additional information, he said.

“Disclosure is critical,” said Eric Jacobson, a mutual fund analyst at fund research firm Morningstar Inc. in Chicago. “Even though there's always been skeletal data in the reports that the fund companies make to the SEC, there hasn't been enough detail for the average investor or even the average intermediary like a financial planner or broker. [Regulators] need to come up with standards for what information has to be disclosed.”


The use of derivatives by mutual funds caught the eye of regulators last year after some fixed-income funds posted steep declines as a result of investments in derivatives. Such investments, for ex-ample, caused the Oppenheimer Core Bond A Fund (OPIGX) to lose 35.83% in 2008, compared with a 5.3% gain for its benchmark, the Barclays U.S. Aggregate Bond Total Return Index, according to Morningstar.


“Oppenheimer is the cautionary example of what can go wrong,” Mr. Jacobson said.

Here is an extreme example of you don't know what you own when you invest in an actively managed mutual fund. Imagine the impact on a portfolio for the investor that chose the Oppenheimer for his bond allocation. And the bond allocation is usually intended as the most conservative part of a portfolio.

No one at OppenheimerFunds Inc. of New York would be made available to comment last week, Katherine Herring, a spokeswoman for the firm, wrote in an e-mail.


In addition to improved disclosure of funds' use of derivatives, fund board oversight is an issue on which the task force is focusing, Mr. Hirsch said.


“It's a very important control,” he said. “The people overseeing the fund adviser must understand the trading technique.”


Mutual fund consultant Burton Greenwald agrees.


“There has to be some oversight in respect to consistency with the funds' investment charter and disclosure,” said Mr. Greenwald, the managing director of B.J. Greenwald Associates, a Philadelphia-based fund consulting firm.

The Fallout From The "Yale Investing Model" Continues This Time at The University of Chicago

I have a particular interest in the investment results now being reported by the major university endowments. I teach a course in investment management for not for profits and one of the major themes in the class is whether the "Yale Endowment Investment Strategy" is appropriate for smaller not for profits. It seems that after the model has been subject to the real world mega stress test of the past year many large endowments have been asking that question as well.

The Yale model outlined most clearly in the book by David Swensen the head of Yales's endowment: Pioneering Portfolio Management allocates large proportions of the portfolios to alternative asset classes:
hedge funds, private equity, and real assets such as timber with low allocations to more conventional asset classes(such as publicly traded bonds and stocks) with a far lower allocation to bonds than such endowments held in the past. Yale posted extremely high returns for over a decade prompting many other unversity endowments large and small to try to "be like Yale".

But as James Stewart of the WSJ wrote (and I blogged on ) the strategy includes a fatal flaw. The instruments generating those high returns are extremely illiquid. And those times when an institution would need access to funds often corresponds to when those illiquid vehicles (like hedge funds) close their gates.

From the WSJ article on the University of Chicago endowment:(my highlights in bold my comments in bold italics)


The WSJ reported on the University of Chicago and the story seems to be repeating itself elsewhere as well as these institutions may rethink their investment approach (my bolds, my comments in bold italics)

More such judgments will be passed beginning later this month, when colleges begin disclosing how their portfolios fared over the fiscal year that ended June 30. Northern Trust Corp. estimates that, over the period, the average U.S. college endowment has a 20% decline.

Harvard University has predicted the asset value of its endowment, the nation's largest, would drop as much as 30%. Yale University and Princeton University have projected declines of about 25% each. The University of Chicago has predicted a 25% decline in its portfolio value for the fiscal year.

Though loath to discuss their money-management strategies, many universities appear to have considered moving to more conservative investments. Harvard tried last year to sell a chunk of its private-equity portfolio but didn't receive an acceptable offer; it has been cashing out some of its hedge-fund investments, say people with knowledge of the situation.

Most college endowments used to favor stocks and bonds. David Swensen, hired in 1985 as Yale chief investment officer, argued that endowments -- long-term investors that were unconcerned about redemptions or short-term market fluctuations -- were ideal for the likes of real estate, leveraged buyouts and distressed debt. Yale beat markets by a wide margin.

But the stock market's nosedive last year showed what some see as flaws in the model. "The endowment model contained a colossal intellectual error in thinking -- that long-term investors don't need short-term liquidity," says Robert Jaeger of BNY Mellon Asset Management, a unit of Bank of New York Mellon, who advises endowments on how to structure their portfolios.

Some endowments maintain that, despite steep losses, they aren't second-guessing themselves. "That would require moving away from equity-oriented investments that have served institutions with long time-horizons well," Mr. Swensen said in an interview earlier this year.


I have great respect for Mr Swensen but the above statement is more than a little disingenuous. The major achilles heel of the Yale model as reveal last year was not related simply because of a significant allocation to "equity oriented investments."And a strategy other than the "Yale Model" could easily include a significant allocation to equity oriented investments. The distinctive aspect of the Yale model was not it's use of equity oriented investments, it was the large use of illiquid and leverage equity oriented investments.

As others have pointed out, while hedge funds and private equity may seem like asset classes that are not driven by the same market forces, in fact both are crucially dependent on access to capital (creating leverage). During a credit crunch they both suffer severely. In addition the level of leverage is often the main reason for the high returns which of course increases the risk. If a hedge fund is leveraged 10 or 15:1 and generates returns far in excess of the S+P 500 is the fund really generating alpha (higher risk adjusted returns) or just leveraging up both the risk and return. In fact Swensen himself has expressed skepticism at the risk adjusted returns of some investment vehicles.

Warren Buffett has written that when the tide goes out we find out who is naked. Could it be that in the market crash of 2008 the Yale model has proven to be not all it seemed to be ? It certainly seems that in evaluating the model one must in fact expect a significantly higher than a traditional portfolio in order to compensate for the higher risk and lower liquidity in these portfolios.

And it is not the case as Swensen seems to assert that abandoning the Yale model means moving out of equity like investments. As an alternative one could create a liquid portfolio of etds that covered the broad range of asset classes. In fact it seems we may have come full circle. In the most recent edition of Pioneering Portfolio Investments and in his book for individuals. Swensen advocates just that type of more simple liquid portfolio.

In addition to the liquidity issue another factor is our old friend behavioral finance. Swensen may well have educated folk at Yale (and he has a strong track record behind him) to weather the volatility of the portfolio with large allocations to illiquid alternative investments. But it may be that many university endowments found, just like many individuals, they are less able to weather large falls in the value of their portfolio than they previously thought.

Ironically enough one can see this played out in the recent episode concerning the University of Chicago's endowment. In a little bit of inside baseball the episode must strike those of us in the finance field as a bit ironic. The Univesity of Chicago Finance and Economics department are considered the cornerstones of the efficient markets school and modern portfolio theory which preach strongly (to say the least) against market timing. Over the last few years though, even this bastion of the rational has been breached with scholars of the behavioral finance school like Richard Thaler joining the faculty.

I think this experience will be taught (certainly in my class) as a case study in the problems with the "Yale Model" when subject to the stress test.

It shows that:

As is well known (certainly to practitioners) "the only thing that goes up in a down market is correlation (among all risky assets).

In calm periods investors often overlook the issue of liquidity in their portfolio Yet in periods of turmoil the non traditional vehicles (hedge funds, private equity, direct investment in real estate) become the least liquid if not totally illiquid. Furthermore many of the strategies in these asset classes are dependent on leverage and ready access to credit. When that credit dries up the funds themselves may be obliged to enter into forced liquidations. Furthermore with many of these funds following similar strategies (momentum long/short) they all wind up liquidating at the same time, aggravating losses. What this means is that looked at from a risk/reward basis many of these asset classes were not really outperforming traditional asset classes. Adjusting for the leverage and lack of liquidity the risk adjusted returns were not so outstanding. Only in a crisis is this clear. An excellent academic paper (which I hope to blog on) on these issues is here.

Investor behavior: As many in the field of behavioral finance (and most people in my field) have experienced, people overestimate their risk tolerance when asked in the abstract, hence in my view making most questionnaires on risk tolerance useless. People have a strong loss avoidance and faced with large losses many who stated on a questionnaire that they would ride out such losses wind up selling (sell low buy high). It seems even the investment professionals at the University of Chicago experienced this. And the consequence was they had to sell the more liquid assets leaving the portfolio with even a higher portion of their investments in the illiquid assets.

The episode is described below from the WSJ ( Again my bolds my comments in bold italics.


The crisis of confidence has been playing out at the University of Chicago, in a previously unreported battle that divided the overseers of the nation's 10th-largest university endowment, a committee that included hedge-fund managers Sanford "Sandy" Grossman and Cliff Asness. Amid last fall's market turmoil, the committee argued over whether their portfolio's assets, $6.6 billion in June 2008 but falling fast, were too risky and volatile.

The endowment's managers staged a $600 million share selloff to buy safer instruments, an unusually abrupt no-confidence vote in its portfolio model. In a late October email to committee members, Kathryn Gould, a venture capitalist who heads the college's endowment committee, and Chief Investment Officer Peter Stein, wrote: "We will no doubt look like heroes AND idiots in the next couple of months."....

In 2005, the University of Chicago hired Mr. Stein from Princeton, where he had worked under a protégé of Mr. Swensen. In June 2008, the university's endowment had 77% of assets in "equity-like investments" -- foreign and domestic stocks, private equity and hedge funds -- according to the 2008 annual report.


That September, around the time that Lehman Brothers collapsed, members of the investment committee took a hard look at their mix.

"We had underestimated the value of liquidity and overestimated our degree of diversification," said Andrew Alper, chairman of the university's board of trustees and a committee member. He says the committee hoped to change the portfolio's long-term exposure to risk and volatility, and would have preferred to unload its stakes in private-equity firms.

But with the market in these illiquid assets essentially frozen and hedge-fund redemptions coming slowly, they began to talk about selling stock.

In early October, the Dow tumbled 18% in one week. In an Oct. 28 email viewed by The Wall Street Journal, Ms. Gould and Mr. Stein told committee members they were considering "an outright sale" of $500 million in stocks -- "virtually all the immediately saleable equities."

By early November, according to people familiar with the matter, Ms. Gould had instructed Mr. Stein to sell $200 million of equities.

James Crown, a trustee and a general partner at Henry Crown & Co., a Chicago investment firm, expressed confusion. "Where are we going with the endowment and why?" he wrote to committee members in a Nov. 2 email viewed by the Journal.

A force behind the sales push was Mr. Grossman, a Greenwich, Conn., hedge-fund manager and economist, say those familiar with the situation. On Nov. 6, during a three-hour committee meeting at university's business school, Mr. Grossman sketched out formulas on an easel to explain the portfolio's relationship to market risk. Other times he referred to the 2008 returns at his own hedge fund, QFS Asset Management -- some were ahead double-digits that year -- to make a case for selling, these people say.

They say some of Mr. Grossman's points were challenged by Martin Leibowitz, a managing director at Morgan Stanley, and by top trustee Mr. Alper.

Mr. Grossman says he advocated reducing risk and volatility but doesn't remember whether he pushed to sell stocks.

The night of the committee meeting, Ms. Gould wrote several members that Mr. Stein was preparing to sell $300 million in stocks. A sale of another $100 million followed. Some proceeds went into fixed-income funds.

Mr. Asness, co-founder of Greenwich, Conn., hedge-fund firm AQR Capital Management, expressed dismay at the response to Mr. Grossman's presentation. "Was Sandy that convincing?" he wrote in an email the next day. "I felt a consensus was building not to be so short-term."

University of Chicago officials won't say when they sold their stock, so it is impossible to calculate returns. Mr. Alper says the proceeds weren't invested into other stocks but that the endowment continues to hold equities. (which means to me the portfolio must consist mostly of cash or bonds + illiquid investments...just the asset allocation that got them into trouble in the first place)

Fallout continues. "We cannot time the market to this degree and should not be trying," Mr. Asness wrote in a January email to members of the committee.

Last year, the university changed its policy so only trustees could serve on its investment committee. That led three nontrustee members, including Messrs. Asness and Leibowitz, to step down in June.

Endowment CIO Mr. Stein announced his resignation in January. Mr. Stein said in a statement at the time that he left for family reasons.

Now This is Scary .....People Just Never learn

From behavioral economist Meir Statman’s great article in yesterday's wsj on the mistakes individuals make in their investing:

Investment success stories are as misleading as lottery success stories.
Have you ever seen a lottery commercial showing a man muttering "lost again" as he tears his ticket in disgust? Of course not. What you see instead are smiling winners holding giant checks.
Lottery promoters tilt the scales by making the handful of winners available to our memory while obscuring the many millions of losers. Then, once we have settled on a belief, such as "I'm going to win the lottery," we tend to look for evidence that confirms our belief rather than evidence that might refute it. So we figure our favorite lottery number is due for a win because it has not won in years. Or we try to divine—through dreams, horoscopes, fortune cookies—the next winning numbers. But we neglect to note evidence that hardly anybody ever wins the lottery, and that lottery numbers can go for decades without winning. This is the work of the "confirmation" error.
What is true for lottery tickets is true for investments as well. Investment companies tilt the scales by touting how well they have done over a pre-selected period. Then, confirmation error misleads us into focusing on investments that have done well in 2008.
Lottery players who overcome the confirmation error conclude that winning lottery numbers are random. Investors who overcome the confirmation error conclude that winning investments are almost as random. Don't chase last year's investment winners. Your ability to predict next year's investment winner is no better than your ability to predict next week's lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.

From today’s Los Angeles Times (my bolds, my comments in bold italics)

Buy-and-hold strategy losing grip on investors
Bear market losses are causing some individual investors to embrace risky moves.

By Walter Hamilton

August 25, 2009

Stung by punishing losses in the bear market, some individual investors are souring on traditional buy-and-hold investing in favor of aggressive trading aimed at scoring big gains. Trading at online brokerages has soared in recent months as investors have tried to capitalize on rising securities markets. But individual investors increasingly are embracing strategies that carry outsized risks. In some cases, for example, investors have ventured into a relatively new type of investment product designed to magnify the movement of the underlying markets. That can sometimes yield big gains if investors bet correctly but bruising losses if they don't. To critics, the push into aggressive trading is the equivalent of doubling down at a casino to recoup earlier losses. "It would be a terrible tragedy if people try to recover from the devastation of the financial crisis by creating even more devastation in their personal investment accounts by taking on risks they don't understand and can't afford," said Barbara Roper, director of investor protection for the Consumer Federation of America.

Financial experts have long preached portfolio diversification, caution and patience when it comes to long-term investing. Still, some individuals feel they have no choice but to take matters into their own hands.

Two brutal bear markets -- after the bursting of the dot-com bubble in 2000 and the housing bubble two years ago -- have decimated portfolios and left many people poorer than a decade ago.

Some have grown disillusioned with losses incurred by mutual funds and stock brokers, and figure they can't do any worse on their own by darting in and out based on market conditions....



.....Susan York was fed up with the dismal performance of her 401(k) retirement account. Then her husband saw a Sunday morning infomercial in January touting the benefits of trading options, which give an investor the right to buy or sell stocks and other securities at pre-determined prices.

The 50-year-old from Naples, Fla., had limited investment knowledge but attended several seminars before starting to trade in May. So far, York said, she's up an average of 40% a month and is trading full time.

Here's a suggestion before joining this woman in her trading career.

1 Reread the section above about lottery stories quoted at the top of this post.
2 Think about this one: Why is the originator of this 40% a month option strategy peddling it on late night tv commercials instead of managing money for billionaires?

"It's the best job I've ever had, not just for the enjoyment but from the compensation standpoint," said York, who previously sold telecom equipment. "I've replaced a significant six-figure income."...


Among individuals, activity is picking up in some risky areas.

Currency trading by so-called retail investors, for example, is expected to jump to $125 billion a day this year from $100 billion last year, according to Aite Group, a research firm. It has risen steadily from $10 billion in 2001.

Some individuals recently have jumped into one of the newest and riskiest investment products, known as leveraged exchange-traded funds. ETFs are mutual funds that trade like stocks and can be bought and sold throughout the day. A leveraged ETF is like a regular fund on steroids. It gives two to three times the return of an underlying stock index. For example, if financial shares rise 2% on a given day, a fund could jump as much as 6%. Some leveraged funds move in the opposite direction of an index. If an index rose 2%, an inverse fund could fall up to 6%.

Leveraged funds are one of the fastest-growing products on Wall Street. Total assets surged to $32 billion at the end of June from $11 billion 18 months earlier, according to State Street Global Advisors. The first leveraged fund debuted three years ago. There are now 126.

However, there is mounting concern that small investors don't understand the risks of leveraged funds.....

I have written before about the leveraged funds and how individual investors and even "professionals" don't understand how these works. Here is another example of a scarily uninformed finance professional (and a lawsuit that should be thrown at on day one)


According to a lawsuit filed this month by a Connecticut stock broker, one fund was supposed to return two times the inverse performance of an index of real-estate stocks. Thus, the ProShare Advisors' UltraShort Real Estate Fund should have risen if the index declined, according to the suit.

But even though the index sank 39% through much of last year, the fund also fell, by 48%, according to the suit.

"This should have been an extraordinary home run, and yet he lost money," said the stock broker's lawyer, Thomas Grady. "It's just preposterous."

It's not"preposterous" at all the broker should have read something about the etf before he bought it. The inverse funds are designed to give the inverse of the DAILY movement in the index. A simple knowledge of math would lead one to conclude that the long term return of this etf will not be the inverse of the long term return of the index.

The article notes this:

.

.Many other funds have suffered similar fates, according to researcher Morningstar Inc.

Over the last year, 55% of leveraged ETFs have gone in the opposite direction from what would have been expected, said Scott Burns, a Morningstar analyst.

The reason is that the funds are designed to track daily market moves but can fluctuate wildly over longer periods.

ProShare "touts the simplicity" of the funds when there are actually enormous risks, the suit said.

ProShare said in a statement that the allegations are "wholly without merit."

Fund companies say they warn investors about the danger in holding the funds for extended periods. "I think we've done a very good job in disclosing what these funds are, what they're not, and what they do and don't do," said Michael Sapir, chairman of ProShare Advisors....


.... experts worry that some individuals, in their haste to recover bear-market losses, are rushing in blindly.

"People shouldn't be messing around with stuff they don't understand," Burns said.

But individuals such as York believe that doing nothing is riskier than taking action themselves. She has devoted a lot of time, she said, to understanding how options trading works and believes she can prosper in good markets or bad. "I saw with my 401(k)," she said, "that buying and holding was just not working out."

So investors are reacting to the market downturn caused in large measure by overconfident finance professionals underestimating the riskiness of their leveraged trading.....doesn't sound like a strategy aimed for success.