Some Absolutely Awful Investments
Wall Streeter Ray DeVoe called it the Crack of Doom.
It’s the point when you know for sure that not
only are you going to lose money, but you are going
to lose a lot more money than you can afford.
Quinn’s First Law of Investing is never to buy anything whose price you can’t follow online. An investment without a public marketplace attracts the fabulists the way picnics attract ants. Stockbrokers and financial planners can tell you anything they want because no one really knows what’s true.
The First Corollary to Quinn’s First Law says that even when the price is available online, you shouldn’t buy anything too complex to explain to the average 12-year-old.
These rules proscribe some of Wall Street’s most popular investments. They’re “popular” not because you’ve been dying to own them but because brokers and planners press them upon you. Not coincidentally, they all carry higher sales commissions than surer, simpler investments do. I wouldn’t touch any of them myself—and I hope that you’ll avoid them too.
I won’t even offer you “how-to” lists for finding gems among the dreck. Some gems exist, but they’re not worth the time it takes to do the research or the risk that your broker will talk you into buying something that you shouldn’t. What’s more, today’s diamonds may turn into zircons overnight.
The competition for “worst investment” is pretty stiff, but hedge funds definitely make the cut. Some hedge funds have earned spectacular returns, and naturally those are the ones you hear the most about. Thousands of other funds produce subpar gains or fail. Originally, these private investment funds were designed to “hedge” against different types of markets. They bought stocks “long” (to hold in case prices rose) and sold other stocks “short” (to make money if stocks declined). Both positions were held at once, in the hope of making money under any market scenario. That’s what a hedge is supposed to do.
Today the hedge fund universe has exploded into dozens of styles. Traditional long/short funds are generally called market neutral. Those that use unconventional assets such as commodities, to try to earn gains in any weather, say they seek absolute returns. Another group of funds specializes in arbitrage—using computers to find tiny differences in securities that are virtually alike, then buying one and selling the other at the same time to lock in risk-free returns. Yet others buy distressed securities—stocks or bonds in the toilet. Or they’re event driven—betting on certain types of corporate events such as mergers or spin-offs. 130/30 funds hold long positions worth 130 percent of the portfolio and shorts worth 30 percent of the total. Macro funds make big bets on anything they want anywhere in the world.
In none of these funds, however, can you find out what they’re really doing, because they don’t have to tell you. You do know that they’re taking high risks on borrowed money with virtually no government regulation.
Hedge funds peddle three ideas:
1. Because of their hedges, they’re not as risky as other funds. Wrong. See their subpar average market performance, below. They abandoned traditional hedging to take higher risks and often lost.
2. Their managers are smarter than anyone else in the market and hence will make more money for investors. Wrong. Again, just look at their average performance. Some smart managers succeed brilliantly, and others don’t. The brilliant managers may succeed in one market climate but not in another. Plenty of them aren’t as smart as they think they are.
3. They bring stability to a portfolio because they’re not correlated with other investments—they may hold steady while other parts of the market are going down. Wrong, wrong, wrong. Hedge fund prices swing wildly. Hundreds of funds went down in 1998 when Russia defaulted on its debt, and hundreds more vanished when the market plunged in 2007–2009. Without question, some funds succeed in their mission and swing against the market, or at least decline less than stocks as a whole, but then, “some funds” always do. There’s no magic to a hedge. A 2006 study by Bernstein Wealth Management Research concluded that if your objective is to stabilize your investments, skip hedge funds and buy bonds.
During bull markets, affluent investors love to buy hedge funds—not only in the hope of profit but for their mystique. That’s where the big boys play. Some brokerage firms put together “funds of hedge funds” and sell them in $15,000 or $20,000 lots to give bragging rights to wannabes.
Hedge funds may work for the superwealthy and large institutions that can spread millions of dollars over a group of managers they meet with and whose strategies they get to know. Large gains in a couple of their funds will (they hope) offset losses in the others.
Hedge funds do not work for the average affluent, and here’s why:
1. Fees, fees, fees. The funds typically charge 1 to 2 percent a year plus 20 percent of the annual profits, including “paper” profits that might evaporate next year. They don’t share in the losses—those are all yours. You pay yet another layer of fees if you diversify by buying a package of funds (a “fund of funds”)—maybe 1.75 percent of assets or 1 percent plus 10 percent of the profits. Then add administrative fees and trading fees. Your fund has to be a huge winner just for you to net Treasury bill returns! Bernstein Wealth Management Research found that the funds with higher fees produced lower returns. Duh.
2. Risk, risk, risk. Hedge funds may have highly concentrated positions. They earn outsize gains when they win and suffer outsize losses when they lose.
3. Subpar average returns. The HRRX Global Hedge Fund Index is one of the benchmarks for hedge fund performance. From 2003 through 2008—a period that covers a rising market and a steeply falling one—the index did worse than all the major investment classes: U.S. stocks, international stocks, emerging market stocks, and fixed-income vehicles.
4. Phony, inflated investment returns, including the data cited above. Hedge funds aren’t required to make their performance public. Disclosure is entirely voluntary. The funds that report are those trolling for investors or managing money for public pension funds. They typically stop reporting, however, if they’re not doing well and expect to go out of business within a few months. The worst performances don’t get into the public reports of average returns.
Furthermore—and this should amaze you—they’re free to play games with their reports. For example, a hedge fund can carry illiquid assets on its books at the price it paid, not the current, estimated market price, which makes the fund seem more stable than it really is. It may fudge the value of illiquid investments to hide losses and boost its annual fee. The management company may start several small “incubator” funds with in-house money to see how they perform. Those with low returns are closed; those with higher returns are launched as new funds. When they launch, they “backfill” their public records by reporting their performance from the days when they were small and not managed as public funds.
The result of all this accounting hanky-panky? Returns that are highly overstated. The hedge fund industry claimed an average return of 13.5 percent from 1996 through 2003. A 2004 study* found that, subtracting the fudges and failures and adjusting for fees, they actually earned just 9.7 percent, compared with 12.3 percent for Standard & Poor’s stock average.
5. Disaster in falling markets. Hundreds of funds failed in 2008–2009 when the markets dropped, global credit dried up, and investors screamed for their money back. Many survived the storm, of course, including some of those specializing in short selling. But their gains failed to outweigh the losses in the rest of the industry. Some of the largest players had to fold. Various multiyear studies have found that over whole business cycles, hedge funds in general have underperformed the major stock averages.
6. High death rates. Of all the hedge funds active in 1996, fewer than 25 percent were still alive nine years later, according to a study published in 2005. These wipeouts don’t show up in the performance averages either, but billions of investor dollars have gone down the tubes. The average life of hedge funds is only about five years. When you look at their reported records on Morningstar, it’s unusual to see returns for more than two or three years.
7. Deceptive guarantees. You may think you’re protected by a “high-water mark.” If the fund’s value drops, the managers don’t get their 20 percent until the value recovers and rises past its previous high. Only problem: if the fund stays under water for a couple of years, the managers may decide it will never recover and shut it down. While you’re nursing your losses, they’ll move to a new fund—probably one of several they’ve been incubating privately. They’ll pick one with hot performance, natch, open it to investors, and start raking in their 20 percent. This game helps explain why so many funds fail: their managers don’t want to bother keeping them open in years when they can’t rip the investors for anything more than management fees.
8. Locked-up money. You might not be able to withdraw your cash for six months, one year, or even more. Quarterly results may not be reported for several weeks. When you ask for the money, you may have to wait 30 to 90 days for the check. Favored investors may get “side letters” letting them get their money earlier—but that’s not likely to include you. In a run on the funds, as happened during the 2008 credit collapse, the managers may suspend redemptions.
9. Extra taxes. Their trading practices can create a lot of short-term capital gains, taxable as ordinary income. Long/short funds might be managed for tax efficiency, but that’s not so easy for other types of funds. Anyway, most hedge fund managers, including the long/shorts, don’t pay much attention to taxes.
10. Dirty dealing. For a short period of time in 2006, the Securities and Exchange Commission required hedge funds to register, like other funds, and submit to SEC audits. The funds sued, and a court concluded that the SEC didn’t have the authority to peek. So all is dark again. But during those few months of sunshine, the government found dirty practices all over the place: false asset valuations, reporting the results only of their better investments to the fund databases, and trading on inside information, to name just three. I can guarantee that those practices are still going on.
Some hedge funds turn into private-equity funds—pools of cash that buy and manage companies. They’re for high rollers only.
A slew of mutual funds mimic hedge fund strategies (130/30, long/short, and so on and so forth) because that’s the sexy thing to do. Like ladies of the night, they’ll follow money anywhere. Don’t buy hedge fund mimics, either.
Most of the penny stocks come from mystery companies, with an untested business, that sell for $3 or less per share. Not all cheap stocks are bad. Some are respectable companies that have fallen on really hard times. But almost all the rotten issues are cheap. They’re peddled by phone by Hole-in-the-Wall Gangs who transfix their victims with the claim that the investment “cannot lose.” Or they buy Google search words to con you on the Internet. If you type in “hot stocks” and sign up for one of the investment-tip services, you deserve all the losses you’re going to take.
The “research” they give you on penny stock companies is usually paid for by the company itself. It writes a wonderful fairy tale about its future and hires an apparently “disinterested” print or online newsletter to pitch it to suckers. You’ll read about a fabulous project under development, important patents pending, plans to partner with a major (unnamed) company, $1 billion markets that the company expects to get a share of. All baloney. Favorite types of “new products” deal with balding, erectile dysfunction, aging, weight loss, and other health issues—stuff you’d like to buy yourself if it were on the market and actually worked. You’re blinded not only by your dreams of money but your dreams of being young and gorgeous all over again!
The online tip sheets deceive you in other ways. They boast about stocks they say they backed that subsequently rose in value 1,000 percent—but they pick the stocks after they rise and pretend that they recommended them all along. They get you excited about a subpenny stock worth $0.0004 cent a share that went to 0.72 cent, raising a $1,000 investment to $1.8 million in one month. (Do you really believe you could have sold your shares for that price? To whom?)
That brings me to pump-and-dump schemes. You buy a stock that the broker or the newsletter tipped, and it goes up! You buy another, and that goes up too! These guys, you tell yourself, really know what they’re doing. Well … they do, but not in the way you think. What’s really happening is that the market makers—all insiders—are selling their own stock to you at higher and higher prices that they pick out of thin air (the pump). They might even let you make some money on a small buy to get you to buy some more. After you’ve racked up larger “profits” and want to sell, you’ll discover that no one wants to buy except at a price that’s even less than the pennies you paid (the dump). Pump-and-dump stocks are also showing up as text messages and cell phone spam. You might get a phony “wrong number” call on your voice mail (“Hi, it’s me, I just want to say that that stock I mentioned, Jumping Cow, got its government contract and will go through the moon when that’s announced. But don’t tell anyone, this is for your ears only”), or a similar “wrong address” e-mail.
Some investors think they’re wise to these games and can make money by being first in, first out. Online scams take advantage of that attitude too. They tell you that a small company is preparing a big publicity campaign and that the buzz will drive up the price. Buy now, buy now, before “the public” hears! But who, I ask you, do you think “the public” is? Why would you imagine that something on the Internet is somehow secret? The whole pitch is false.
Some penny stock hustles are “blank checks” or “blind pools.” (One state securities commissioner calls them “deaf pools,” as in “Give me your money, and you’ll never hear from me again.”) You buy shares in a hollow company, or “shell,” that does no business of its own. When it gets your money, it goes looking for small private companies to buy. Some of these companies are legitimate, such as a printer or a bakery. Others are frauds.
Always hang up on high-pressure penny stock brokers. Ignore stocks that don’t trade on a major exchange (the exchanges set financial requirements for the stocks they list). Never hunt for hot-stock sites on the Internet. If this advice comes too late, sell your shares and rescue whatever money you can.
Imagine a house with an elephant in the basement. It’s been said that the animal holds up the house. Grateful for the constant support, the householders feed their elephant lavishly. But they never go down with a flashlight to see if the beast is as big as they thought.
That pretty much defines the bizarre faith engendered by unit investment trusts, a multibillion-dollar industry directed especially to conservative investors. You buy bond unit trusts for their “steady income” and “locked-in yields” and stock unit trusts because you believe in a particular investment strategy. Stockbrokers like to claim, based on no independent evidence, that the trusts do better than comparable mutual funds.
But no one has ever gone down with a flashlight to look. One academic study that tried to make the comparison gave up, because virtually no performance data are available for unit trusts. I know of no other major investment with so complete a blackout on how well (or poorly) participants are doing. Trust sponsors claim “transparency” because you get a list of the securities in the trust. But that’s very different from having daily data on how that particular mix of securities is doing. There’s simply no hard information on whether unit trusts are better than, the same as, or worse than competing mutual funds. Because of this blackout, and the temptation it offers to put weak securities in the trusts, I suspect the worst.
A unit trust is a fixed portfolio of stocks, bonds, or other securities. The sponsor assembles a package of them and sells them as new offerings. You buy an interest in the package for a minimum of $1,000 or $2,000. The trust is held, virtually unchanged, for anywhere from 6 months to 30 years. Securities are occasionally sold out of the trust, but normally, no new ones are added. At the end of the term, the remaining securities are sold and the proceeds distributed to the investors.
Unit trusts aren’t cheap. The up-front sales commission runs in the area of 3 percent, with another 1.5 percent in the second year, plus an 0.5 percent “creation fee”—5 percent in all. Annual fees run in the 0.4 to 1 percent range. Brokers tell you that trusts are cheaper than mutual funds because they carry a lower annual fee. But the sales commissions on the trusts are generally higher, so this is a dubious claim.
Investors in a unit trust receive a pro rata share of its interest or dividends, mailed to them monthly, quarterly, or semiannually.
In a bond unit trust, you also receive a pro rata share of the proceeds as the bonds mature. For example, take a $20,000 investment in a municipal bond unit trust. Initially you might earn $50 a month in bond interest. Five years later, a block of those bonds may mature. You’d receive a $2,000 check representing your share of the proceeds. That $2,000 is a return of some of the capital you invested. After that, your monthly check might drop to $45 because there are fewer bonds in the trust. Each check specifies how much is interest and how much is principal.
Ginnie Mae unit trusts are a little more complicated. They invest in mortgages, so every check you get is a combination of mortgage interest and principal, the latter being a partial return of your own capital. Every time a home owner prepays a mortgage, the proceeds are distributed to the trust’s investors (for more on Ginnie Maes, see page 931). Your entire investment plus interest will be gradually paid out over the term of the trust.
The distributions you receive from bond unit trusts usually cannot be reinvested in the trust itself. The sponsor arranges for them to be invested in a mutual fund. Distributions from equity unit trusts are generally reinvested in the trust itself.
You can switch to another trust within the same family, generally at a reduced sales charge. You may be able to sell your units back to the sponsor before maturity, at whatever it considers market price. If the sponsor isn’t buying, you can redeem your shares from the trustee—in which case, shares may have to be sold to pay you off. After fees, you’ll probably get less than the portfolio’s net asset value.
If your trust mimics the performance of a stock index, you are overpaying big-time. You can get index mutual funds from Vanguard or Fidelity for 0.2 percent a year or less, and with no up-front sales charge. If you buy index performance through a unit trust, you’re throwing away money.
If your trust holds stocks chosen by a manager, you’re stuck with those decisions for the trust’s entire term. A bad stock won’t be sold, it will just sit there and rot. Better stocks won’t be substituted. Some unit trusts follow short-term investment theories, such as Dow Dogs: buying the 10 highest-yielding Dow stocks at the end of each year.* In theory, these stocks outperform the general market average. In practice, sometimes they do, sometimes they don’t. But notice the genius of the pitch: you have to buy a new unit trust, with a new sales charge, every year. Those costs will be hard for even good Dogs to overcome. You also have to pay taxes on your annual gains, unless you hold the Dogs in a tax-deferred account.
With either type of trust, your return depends on what happens in the market over a fixed period of time. If your trust matures during a downturn, tough luck. You don’t have the option of holding on. If you want to stay invested when the portfolio terminates, you can move your money into a new trust—again, paying a new sales charge and paying taxes on any gain. Why would you do that? Why not buy a regular mutual fund that you can hold as long as you like?
Finally, if your unit trust faces a lot of redemptions and securities have to be sold, the investors remaining in the trust could get hurt. The sales may lock in market losses or reduce the likelihood of future gains.
When you buy, you’re quoted an “estimated current return,” based on the bonds in the portfolio. The bonds aren’t changed over the life of the trust, so you assume that that’s what you’ll get for the entire term.
Not likely.
To begin with, bond unit trusts rarely last until their maturity date. When the trust’s principal value has shrunk to perhaps 25 or 20 percent of its opening value, the sponsor often sells the remaining securities and distributes the proceeds. That shag-end sale may bring a profit or a loss, depending on market conditions at the time. Some unit trusts have been dumping grounds for bonds that the sponsors otherwise couldn’t sell. At liquidation, investors in these trusts would almost certainly take a loss.
Furthermore, you probably won’t get the promised “steady stream of income,” for the following reasons:
1. Some of the higher-interest bonds will probably be called before maturity or retired through a sinking fund. This usually lowers your final yield. The trusts try for call protection on their bonds of at least 5 years and sometimes 10. But that’s a far cry from a “steady stream of income” on a 30-year trust. If long-term, guaranteed income is your objective, buy noncallable Treasury bonds instead.
2. Some securities will be sold out of the trust in order to cover early redemptions. If the amount of bonds sold exceeds the sum redeemed (as sometimes happens), the leftover money will be distributed to investors, returning a small share of their principal whether they want it or not. In choosing which securities to sell, the trusts try to hold your yield steady. Sometimes they can; sometimes they can’t.
3. The credit quality of some bonds will slide. If a bad bond has to be sold out of the portfolio, you lose some of your principal. If a bond defaults, you lose interest and, generally, part of your principal (although some residual value will remain). Junk bond unit trusts are double trouble. Their better-quality bonds get called because those issuers will be able to borrow at lower rates. The poorer bonds remain in the trust. After the calls, you lose some of your “steady” income, and you’re stuck with the issues most likely to default. Because of the trust’s opaque structure, you’ll never know.
4. Some trusts are smoke and mirrors (S&M). They pay a higher income than you’d get from other bond investments, which makes you think that you’re earning a superior yield. But, in fact, you’re earning a normal yield and are running an abnormal risk of loss. That happens because the trust buys a lot of older bonds that carry higher interest rates than are available today. You get more current income, but to get those high rates, the trust had to pay more than the $1,000 face value for the bonds—say, $1,100. They will almost certainly be called before maturity at their $1,000 value, leaving the trust with a $100 loss. After the call, your yield will drop.
But that’s only step one in the deception. Step two is to disguise the loss. The trust does that by buying zero-coupon bonds. Zeros pay no current income; each year’s interest is added to the value of the bond itself. The gains from the zeros are supposed to balance the losses you take on the bonds that are called.
That’s the theory, anyway. In practice, these S&M trusts are time bombs. Follow what is going to happen: (1) You will lose some of your income when your high-rate bonds are called. (2) You will take a capital loss on the money used to buy those bonds. (3) The zeros will eventually cover that loss, but you’ll have to wait until they mature 20 years from now. (4) If you sell early, you’ll probably lose money. To be sure of coming out whole, you have to wait for the trust to liquidate. So much for the “high-yield” unit trust that was supposed to pay a steady income!
Shares in older bond unit trusts, which are widely sold, can run you into a similar trap. You’re attracted by the high current income. But when those bonds are called, your income will drop, and you’ll be left with a capital loss. You can spot this risk by asking the broker for two numbers: the trust’s current yield and its estimated long-term return. If the long-term return is lower, it has been packed with older, higher-rate bonds.
Anytime a broker offers you a unit trust that apparently yields markedly more than the new bonds coming to market, laugh hysterically and change the subject. “If you want a high yield real bad, that’s what you’ll get,” a friend of mine says. “A real bad high yield.”
You’ll get a check when the trust is cashed out but no information on what your yield turned out to be. The sponsors say that the brokers have the tools to compute it if you ask. So ask—but who knows if your broker can actually figure it out? The sponsors should disclose it as a matter of course, but maybe they’d rather you didn’t know.
They buy high-quality, new-issue, intermediate-term bonds instead. There’s no up-front sales commission on these bonds, some are noncallable, you pay no annual management fee, and the income really is steady. Unit trusts, with their misleading yields, are pitched to smaller investors who know less about how the bond market works.
A unit trust invested in Treasury bonds (as some are) is a pure con. You’re paying a 1 to 5 percent sales commission to buy securities that you can get yourself, commission free, through TreasuryDirect.
Exchange-traded notes track an underlying investment of any sort—typically a commodity index or obscure stock index. You trade them as if they were stocks. When you sell, you’re paid by the sponsoring institution. So ETNs are basically IOUs: a particular sponsor’s promise to pay. They’re unsecured. When Lehman Brothers Holdings failed in 2008, the three ETNs it had created failed, too.
Sponsors tout ETNs as better than exchange-traded funds (ETFs) because your profits are taxed at the low capital gains rate rather than as ordinary income. But the IRS is examining that question, so lower taxes aren’t a sure thing. How does stuff like this get sold? you wonder. Stockbrokers and commissioned planners, of course. Complex new investments always look like great ideas until the day they aren’t.
With these notes, your money is said to be safe, and there’s supposedly an upside: the investment is linked to some sort of index that can grow. When the notes mature, typically in 6 to 10 years, you get your money back plus any growth that has accrued. In short, the usual fantasy—total safety plus stocklike gains.
So here’s the downside: You pay hidden fees. You earn no current interest or dividends. You’ll lose money if you have to cash in the investment before the term is up. There’s usually a cap on how much you’re allowed to earn. You earn nothing if the index happens to be down on the day your note matures. The company backing these notes might fail. Any gains are taxed as ordinary income, not capital gains. Why bother with something like this? If you want safety plus growth, put some of your money into a bond or certificate of deposit and some of it into a stock-owning mutual fund.
When the dollar plunges, investors get hot for foreign currency bets. The forex (foreign exchange) market lets you trade one currency for another: dollars for euros, euros for yen, yen for pounds, pounds for Icelandic kronur. It’s the largest market in the world, open all the time, where prices change fast and by large amounts. As I write, there are pitches to newbies all over the Web: Buy a currency trading platform! Sign up for training courses! Free practice accounts! Just $500 to start investing, and then borrow to increase your stake! Wow!
No market is more unpredictable than currencies. You may be right that the dollar is dropping (or rising) over the long term, but the forex is a one-minute market where your stake can be slashed almost as soon as you’ve put up the money. You’re betting against the world’s most sophisticated traders, so any profits are dumb luck. Costs are high, both to buy and to unwind trades. You have to be watching your computer screen all the time.
If you love losing money, trade the forex. If you love making it, diversify away from the dollar by buying international stock and bond mutual funds.
For those of you eager to make a hopeful bet on commodities, let me steer you to mutual funds (chapter 22). If losing money is your objective, try commodities futures.
Many an innocent has lost his or her life savings by hearing or seeing an infomercial touting futures. If winter is coming, the pitch is for oil (“prices will rise!”). These soulless opportunists seize the weather, the season, or the news and use it to separate unsophisticates from their money.
Those are the innocents. What shall I say about the guilty—experienced investors who open commodity futures accounts in the nutty belief that they can beat the game? They’re on the road to learning Quinn’s Second Rule of Investing: never buy anything that trades in a pit.
The “pits” are the arenas where futures contracts are bought and sold: a contract on June gold, a contract on December wheat, a contract on March soybeans. You put up perhaps 5 or 10 percent of the cost of the contract to bet on the price of a specific commodity on a specific future date. Prices are moved by rumor, politics, war, scientific discoveries, business announcements, economic developments, and international weather and crop reports, and they move fast. You can “go long” (a gamble that prices will rise) or “go short” (a gamble that prices will fall). Winners may earn many times their investment. But if prices run against you, you can lose far more money than you put up—perhaps tens of thousands of dollars more. In fact, you are liable for up to the contract’s full value. Fortunes can be lost or made within a few days or even a few hours.
End of lesson. The only other thing you need to know is that an estimated 75 percent of commodities speculators lose money. I would bet that 99.9 percent of amateur commodities speculators lose money.
The record is probably no better for plungers who buy options on futures. A call option gives the holder the right to buy the underlying futures contract at a specified price within a specified time; it’s a bet that the price will rise. A put option gives the holder the right to sell and is a bet that the price will fall. If you pay, say, $1,000 to buy an option and prices move in your direction, the value of your option will rise. But if prices run against you, you can never lose more than the $1,000 you put up.
There are two main differences between options on futures and futures themselves:
1. When you buy or sell a future, you are contracting to buy or sell the actual commodity. If you don’t close out a purchase (at a profit, you hope) before the contract’s delivery date, you’ll literally have bought the farm. You’ll own warehouse receipts for a silo full of soybeans or wheat. By contrast, when you buy an option on a future, you are buying the right to the contract’s change in value over a limited period of time. If you don’t sell or exercise your option, it will expire worthless.
2. With futures, you can lose much more than the money you put up. The same is true if you sell an option. Both carry unlimited risk. If you buy an option, however, your losses can’t exceed your original investment. For this reason, brokers say that buying options is “safer,” although the risk of losing 100 percent of my investment isn’t on my comfort list. (Any kind of options trading is terrific for brokers. They earn up to 10 percent of your principal, depending on what commodity you buy, how many contracts, and the price per contract. How are you going to beat costs like that?)
You don’t have a prayer of winning if you buy through the slickies who tout options on get-rich-quick radio and TV shows or online. (For information, call 800-555-GYPP.) The investments they sell are real enough, but their prices are grossly inflated. As much as 40 percent of your “investment” may be sliced off the top in sales commissions and hidden costs. Any price moves in your commodity would have to be huge to cover these expenses and yield a profit.
Any customer with a modest income and few assets who was fast-talked into buying options on futures has a good chance of winning a reparations case against the broker. There’s no way these investments are suitable for anyone with a low net worth. For reparations and arbitration procedures, see page 828.
You can book bets on stocks without ever owning one by buying and selling stock-index options and futures. They’re a speculation on the future prices of some of the major market averages. If you know where the Standard & Poor’s 500-stock index will be next month, here’s the place to make your fortune. But, of course, you don’t know, and there’s the rub.
During the early years of the Great Bull Market, options players made astonishing profits on very small amounts of cash. But the morning after the 1987 crash, those same investors woke up to learn that they’d lost many times their original stake. An Indiana teacher who thought he was risking only $5,000 found himself $100,000 in debt (the firm settled this case in arbitration). A stockbroker in Oklahoma, after losing a large arbitration case, admitted to his clients that options confused him. “I never should have messed with them,” he said. A Florida broker who suffered huge losses in his own account took his brokerage firm to arbitration, arguing that he was in over his head and his boss should have realized it. We got a rerun when the stock market bubble burst in January 2000.
Here’s a glimpse of the complexities of stock-index trading, just to show you what you’re up against.
Stock-Index Options, Defined: When you buy or sell these options, you’re hoping to profit from the changing price of stocks. You’re betting that a specific stock index will rise or fall by a specified amount within a limited period, typically one to four months. The cost of the option is known as its premium. You also have to pay brokerage commissions.
Buying a call is betting that the index will rise by at least a certain amount. Buying a put is betting that the index will fall by a certain amount. When you buy an option, your risk is limited to the money you put up.
When you sell an option, however, your risk is unlimited! Many investors and brokers fail to grasp this crucial difference. So, in their innocence, they hit on what seems like a “safer” way of playing a strong market than buying calls. They decide to sell puts, which are a bet that stocks won’t fall over a specified period of time. But if you’re wrong, you can lose far more than your original investment.
A winning option can be held until maturity and settled for cash, or it can be sold at a profit ahead of time. To cut your losses on a losing option, try to dispose of it before it expires. If you don’t or can’t, that money is gone. Options are offered on a variety of stock market indexes. The most popular is the Standard & Poor’s 500, followed by Standard & Poor’s 100 (100 blue-chip stocks).
Stock Futures, Defined: When you buy or sell futures, you are contracting to buy a particular commodity. In this case, the “commodity” is a stock market index, the most popular being the E-mini S&P 500-stock index—a contract one-fifth the size of the index as a whole. You put up about 10 percent of the contract as collateral. If stock prices move in the right direction (either up or down, depending on your bet), you can sell the contract at a profit. Or you can take a cash settlement at the end of the contract’s term. Either way, you get your collateral back. If the market runs against you, you will be asked for more collateral. Your losses could be substantially more than you put up.
Options on Stock Futures, Defined: Here you’re betting on whether the price of a stock futures contract will rise or fall. You can buy or sell calls (if you’re expecting a rise) or puts (if you’re expecting a decline). Either way, you will own a piece of paper that speculates on the changing worth of another piece of paper. If you’re not with me, that’s proof that you shouldn’t be with an options broker, either.
The prices of options on futures swing more widely and wildly than the prices of options on the stock indexes themselves. So of these three super-risky investments, buying futures options combines the highest potential for gain with “limited” losses (only 100 percent of your investment could go down the drain).
If you own a large and diversified stock portfolio but don’t want to sell for tax or other reasons, you can buy puts on an index that resembles your holdings. In a market decline, you’ll lose on your stocks but make money on your puts. Your losses may not be fully covered by your gains, but at least you’ll have limited the shock. If the market doesn’t fall, you’ll have paid a pretty penny for peace of mind.
Minor changes in the stock index produce big percentage gains or losses on the index options. But to win this game, you have to get three things right: (1) the market has to move in the right direction; (2) the index has to rise or fall by more than enough to cover your costs; and (3) the change has to come within a short and specified period. That’s market timing with a vengeance. It shouldn’t surprise you to hear that the majority of options buyers lose. But their brokers win. At a full-service firm, your combined buying and selling commissions generally run in the area of 5 to 8 percent of your invested capital, although they can go both lower and higher.
Just as you can speculate in puts and calls on the market as a whole, you can do so on individual stocks, such as General Electric or Microsoft.
A conservative use of options is to sell calls against blue-chip stocks you own—an action known as writing covered calls. If you own GE, for example, you can sell someone the right to buy it from you at a specified higher price (the “strike price”). The money you collect is called a premium. If GE doesn’t rise above the strike price, you keep the premium and the stock—so you eat your cake and have it too. If the price does go up, your GE stock will be called away, costing you the capital gain. So you earn extra taxable income by writing options (after paying sales commissions) but will give up a lot of stock profits over time. You also pay additional commissions when you buy more stock to replace the shares that were called away.
A hugely high-risk use of options is to sell them against stocks you don’t own, a strategy known as writing naked calls. Suppose that you write such a call against Microsoft. As long as the price of Microsoft doesn’t rise above the strike price, you win. If it does, you lose. You would have to buy Microsoft in the open market, whatever its price, to deliver to the person who bought the call. Alternatively, you might write naked puts. As long as the stock doesn’t drop below the strike price, you win. If it does, you will have to buy the stock for something more than its market price.
Some speculators substitute options for stocks. If you feel in your gut that GE will go up pretty soon, it’s cheaper (and potentially more profitable) to buy a three-month call on the stock than to buy the stock itself. If the price rises enough, you win. If your gut was just registering indigestion, however, you’ll be out the money. One popular game: buying calls on companies that announce stock splits in hope that the stock will jump in price.
To give your bet more time to work, speculators might consider buying LEAPS—long-term equity anticipation securities. These are options that can last for up to three years, giving you more time for the stock price to move your way. Longer-term options cost more than the short-term kind.
When the speculators are Wall Street pros, I couldn’t care less. Professional investors are action junkies, and options are an easy fix. Ditto for economists and other interest rate experts who often gamble on Treasury bond futures. But no individual seriously trying to build net worth should use options, period. Even if you win at the start, you will lose in the end.
Chicken funds (structured as unit trusts, principal-protected notes, and other packaged investments) flourish after any stock market scare. Sponsors package a “safe” zero-coupon bond (page 945) with a speculative or growth investment such as stocks or real estate. Part of your money buys the zero, which returns your original investment after a specified period of time. The rest goes into the riskier side of the package. The pitch is “Come back to the market, my dear departed ones. I’m positive that your money will grow. To calm your nerves, I will guarantee that, whatever happens, you will get your money back.”
Salespeople call chicken funds “balanced investments.” I call them humbug. The zeros don’t lower your investment risk.
Here’s what’s wrong with chicken funds:
Over five to eight years, the zero will mature—eventually repaying the money you originally put in. But it will have lost a lot of purchasing power. Also, you may have paid taxes every year on the interest building up inside the bond. To keep up with inflation and taxes and earn a real return on your money, you are counting on the other part of your investment—the stocks, commodities, or real estate—to succeed. So the zero hasn’t shielded you from risk at all.
You’re at double jeopardy if you want to sell. You’ll lose money unless both parts of your packaged investment did well. Had you held, say, your stocks and your zeros separately, you’d be able to sell just one or the other, as market conditions dictate.
When you buy a zero combined with any other kind of investment, you are really making a three-part bet: that your growth investments will succeed; that you will hold to maturity; or that interest rates will fall, so that if you sell before maturity, the zero will show a profit, not a loss. That’s a lot of ifs. Furthermore, you pay a higher commission to buy zeros packaged with growth investments than if you bought them separately through a mutual fund or discount broker.
CMOs have been touted to people who might otherwise buy Ginnie Maes. They’re packages of AAA-rated mortgages, either government insured or privately insured. They offer higher rates of interest than Ginnie Maes and are supposed to pay out in a certain number of years. In fact, you can’t count on receiving your money over the stated period of time—the payback period is always longer or shorter, depending on the rate at which home owners prepay their loans. Starting in 2008, you couldn’t count on receiving your money at all, because of the high rate of defaults and foreclosures. In the previous edition of this book, I wrote that I was skeptical of fancy new ways of holding investments that worked okay the old way. I still am. For mortgage investments, stick with a Ginnie Mae or Ginnie Mae mutual fund.
1. Any new investment touted as “safe” with a higher-than-normal yield.
2. Any mutual fund calling itself Something Plus—as in Government Plus. Such a name implies high yields at no increase in risk. That’s never true. There is always risk. “Plus” means “We’ll try to squeeze out some extra money by hedging with index options, zloty futures, and puts on silver shower curtains.” That might work. Then again, it might not. Mark these mutual funds a minus. Ditto any fund calling itself “enhanced.”
3. Anything hyped on late-night get-rich-quick TV shows. No-money-down real estate deals. Options on grain or oil futures. Penny stocks. Investment tapes and seminars of any kind.
4. Anything hyped online—by spam or in ads that turn up when you’re surfing for something else.
5. Anything hyped by phone, by a salesperson you don’t know. Even if the firm is honest, this is no way to pick an investment. If the firm is dishonest, you’re being set up to lose serious money. The bigger the profit the broker promises and the greater the pressure to make a decision, the worse the investment is going to be.
6. Diamonds and other precious gems. Wholesale prices are rigged. Markups are huge, as are discounts when you try to sell. Published price indexes are unreliable. The price of any individual stone depends on subjective judgments about its “quality grade,” which is an invitation to cheat. Even if the dealers all agree on a stone’s grading and it’s backed by a certificate from the Gemological Institute of America, you could still get burned by paying too much. True investment-grade stones are kept in their own soft bags, in vaults. Stones made into jewelry generally are of lesser grade and don’t fluctuate so much in price. By the time a stone is set, it may retail for more than double the value of the gem itself.
7. Smaller stocks that trade over the counter in limited amounts. Brokers may take huge markups on these issues. You may need a 20 percent increase in price just to cover the overt and hidden costs. Buy a smaller OTC stock only for a sound, fundamental reason and plan to hold it a long, long time.
8. Rare, or numismatic, coins. These are strictly for specialists. Among coin collectors, the condition of a coin is critical, and you’re in no position to judge. Two coins of the same apparent grade could sell for different prices, depending on who graded them. A coin might be graded up when you buy in order to make it more expensive. When you sell, a different dealer might grade it down, which lowers its price. Even the price of an “MS65” (MS meaning “mint state”), which is just about tops, will vary according to who certified it. Some quite ordinary coins are sold to the credulous at excessive prices. To buy well, you have to know your way around.
By all means, collect rare coins as a hobby. Start visiting dealers and auctions. Subscribe to Coin World at www.coinworld.com, which has reasonably good coin price indexes. If you really get smart about your hobby, your passion could become your investment. But plunge into it only for the interest, not for gain.
9. Collectibles of all kinds—stamps, art, porcelain, rare books, maps, antiques, rare wines, Oriental rugs, baseball cards, Mickey Mouse ears. None is worth a moment of your time, except for fun. They yield their treasure only to dedicated collectors or dealers, who study them, admire them, and understand their value. Buy a lithograph because you love it, not because you think it will make you rich.
For some, it’s a trauma defense. Let the Middle East mushroom into darkest night, let terrorists nuke downtown New York, there will be gold.
For others, it’s the supreme inflation hedge. If the U.S. dollar is ever carted off in wheelbarrows, there will be gold.
But in practice, gold doesn’t always work out so well. Take the trauma defense. Back when Lebanon first fell apart, rich people rushed to their banks to retrieve their gold, only to be robbed of it by gunmen at the door. The gold hoards of many Kuwaitis were similarly seized by Iraqi troops.
Gold can also be a bust as an inflation hedge, depending on the years you hold it. In 1974, with gold at $200 an ounce, it became legal again for Americans to own it. The price ran up to a peak of $873 in 1980, then collapsed to $253 in 1999. Over those years, gold bugs saw their investment fall well behind the inflation rate. Then the price moved up again, topping $1,000 in 2007 and again in 2008 before falling back. Only you, the reader, know where it is today. Maybe way up. But you can’t rely on it as a handy defense against rising prices over specific time periods.
Gold will protect you against hyperinflation and a U.S. currency collapse. The question is whether you want to hedge against that risk.
The rich usually say yes. They can afford to sequester money in an asset that earns no interest and is subject to buying and selling panics. If the global economy fails to right itself and U.S. dollars lose their status and value, gold will be precious indeed. Those who share these fears might put 5 percent of their savings into gold ETFs (page 972) and treat it as a permanent holding.
Alternatively, you might treat gold as an ordinary investment—sometimes good, sometimes not. Opportunists buy when the price declines. They sell when a rising price catches public attention and folks line up to buy gold coins.
What moves the price of gold? Who knows? Demand may suddenly explode for a wide variety of geopolitical reasons, none of them predictable. In recent years, it has moved with the oil price, but that’s not a fixed relationship. It often rises when the dollar plunges in value against various currencies, but again, not always. It’s thought to move up on the expectation of higher inflation and move down on the expectation of level to lower inflation—that is, unless there’s a competing inflation investment that looks even better. Investors may be perfectly happy in Treasury TIPS rather than gold.
Gold is a reasonable investment, unlike the rest of the things in this chapter. But neither is it an essential part of your portfolio unless you have substantial wealth. If you’re still interested in owning gold—as a long-term “safety” holding or short-term speculation—here are the various ways to buy:
There are two ways of using these funds, one aggressive, one conservative:
Gunslingers swing into equities when they think that gold prices are going to rise. The stocks of gold-mining companies move up faster than gold itself. Conversely, the stocks suffer deeper losses when gold prices drop, so speculators may not own them long.
Conservative buyers might own a gold mutual fund or ETF for diversification. Gold stocks often go up when the rest of the market is going down, and vice versa. And unlike gold itself, the stocks pay dividends. To avoid the funds’ roller-coaster price risks, invest a fixed amount of money regularly, every month, for several years. You’ll wind up with a long-term precious-metals position at a reasonable average cost.
This is the investment of choice, for both speculators and long-term hoarders. A sponsor holds large gold bars in various international banks and sells shares against them. The shares, in the form of ETFs, trade on a stock exchange and are expected to track the gold price minus the sponsor’s costs. The two major ETFs: State Street Global Advisors’ SPDR Gold Shares and Barclays iShares COMEX Gold Trust. Note that you don’t own gold itself, you own a promise to pay backed by State Street or Barclays. If their credit rating were to decline, the value of your ETF would probably decline as well, even if the gold price was going up. On the other hand, if you want to own an interest in gold itself rather than in gold stocks, it’s much cheaper and more convenient to buy an ETF than to invest in coins.
These are for trauma strategists, who—not trusting ETFs—want to own gold itself, stored in a safe deposit box or private vault. Bullion coins have no numismatic interest. They’re traded on the value of their gold content plus a small premium to cover distribution, manufacturing costs, and profits. Premiums depend on the weight of your coin and the size of your order. For a small order of one-ounce coins, you might pay 2 to 6 percent over the spot gold price, depending on the dealer, plus a 1 percent sales commission. There may also be a shipping charge. For spot prices, go to the Web site of the New York Mercantile Exchange (www.nymex.com) or sites such as TheBullionDesk.com (www.thebulliondesk.com).
Investors should stick with one-ounce coins. The smaller coins (half-ounce, quarter-ounce, and so on) are more heavily freighted with sales and manufacturing expenses, making it hard for buyers to earn a profit. You’ll see small coins in jewelry, not in safe-deposit boxes. Of the many bullion coins now on the market, the most widely sold are the U.S.-minted American Eagle and American Buffalo, the Canadian Maple Leaf, the South African Krugerrand, the Australian Kangaroo, and the Chinese Panda.
Here are some rough cost data to help you gauge the fairness of the prices you’re offered on a purchase of 5 to 10 gold coins: The U.S. and Canadian mints sell coins to primary wholesale dealers for the current auction price of gold plus 3 percent. The primary wholesalers mark up the price by about a half percentage point and sell to retailers. The lowest-cost retailers add another half point, so their coins sell at the price of gold plus 4 percent. Other retailers price up from there. So gold prices have to rise by 4 percent or more for you to break even after costs.
Costs are typically higher if you buy just one coin and lower on orders of 20 coins or more. You may owe sales taxes unless you can legally store your gold hoard out of state.
When you resell a coin, you might be offered 2 to 3 percentage points over the auction market price minus a 1 percent sales commission—but bids vary, so shop the online dealers such as Bullion Direct (www.bulliondirect.com), Goldmasters USA (www.goldmastersusa.com), Kitco (www.kitco.com), Monex Precious Metals (www.monex.com), and OnlyGold (www.onlygold.com). Besides price, compare the shipping charge and any other fees.
Bullion bars are generally fabricated for wealthy investors who buy their gold in major-league amounts. Small bars are poured too, sometimes by little-known companies whose bars may or may not be readily accepted for resale. To protect your investment, stick with the majors. The dominant small bars traded in the United States are made by Credit Suisse and PAMP SA, sealed in plastic, and sold with a certificate of authenticity (you’ll need them in their original condition for resale). One-ounce bars sell for the gold price plus a premium of $7 to $10.
The price may indeed go up in times of rising inflation and high political risk. But silver more often trades as an industrial metal, responsive to changes in industries such as photography, dentistry, and electronics. The coin of choice for silver investors is the one-ounce American Eagle. Investors can also buy silver bars.
Platinum coins have a modest following. Like silver, platinum is used primarily in jewelry and for industrial purposes (especially in auto antipollution devices). Prices jump around a lot. The jury is out on whether this metal will ever be considered a store of value. The commonest platinum coins are the American Eagle Platinum and Canadian Maple Leaf Platinum.
I’m mentioning them here to be sure you know that they’re on the list. For tax-deferred variable annuities and equity indexed annuities, see chapter 29. For life settlements, see page 398. For initial public offerings, see page 880.
Bad investments pretend to be all things to all people. “Buy me,” they whisper, “and you’ll get your three wishes: high growth, high income, and no risk of loss.” Some throw in a fourth wish, tax avoidance, just for spice.
But no single investment fulfills all those hopes. When you go for high income, you give up some safety and growth. When you go for high growth, you give up some safety and income. When you go for safety, you lose growth and income. Any investment that promises all three is a fraud of some sort.
The financial press is loaded with warnings from saddened investors who fell for one slick promise too many. Study their stories. Better an object lesson than a learning experience.