Never, ever invest in this

When we meet new people and Papa ERN explains what he does and where he works (asset management for a large financial institution), people often want to chat about investing and show off their own investing prowess, here some actual quotes:

I made lots of money with a short silver ETF

I put a lot of money in oil ETFs

I use a VIX ETF to protect against the downside

Papa ERN has heard it all and would usually respond that at work he’s discouraged from actively trading in personal accounts and thus resorts to investing in index funds exclusively. Papa ERN is trying to enjoy a happy hour or cocktail party, and so he doesn’t want to get into arguments or talk people out of bad investment decisions. Most of the recent so-called financial innovations only make the issuers rich, not the retail investor. Of course, occasionally one could win and win big, just like in the casino, but over time the house wins.

Financial innovations play with the same emotions as all the other gimmicks, whether it’s cars that exude the feeling of a race car, downhill skis that make you go down the slopes like a gold medalist or designer clothes that make you look like a Hollywood celebrity. By trading this ETF or switching to that platform, or studying this chart pattern, ostensibly, you too can become a trader. Or at least feel like one. Intriguingly, the same people who now laugh about their parents and grandparents falling for the Marlboro Man many decades ago, now get suckered into an equally damaging scheme targeting their financial health. Here are some of the worst ideas:

Commodity ETFs

Note that commodity ETFs are different from equities that produce the commodities, such as Exxon Mobil (XOM), which you should already own in your equity index fund. Commodity ETFs invest in futures contracts, i.e., promises to buy physical commodities, such as oil, gold, copper, wheat, etc. at a later specified date. Why are they a bad investment?

1. Fees tend to be high, sometimes as high as 0.50% to 1.00% p.a. You could go and invest in the actual futures contracts yourself and save the fee, but see items 2-3 below for why that’s still a bad idea.
2. As Early Retirement fans we are all about passive income. Equities generate passive income because you own a share of the productive capital of the economy generating a cash flow and profit for the shareowners. Commodities are dead things that do not multiply. Oil molecules on the tanker ride over from Saudi Arabia do not multiply. Same for gold; as cozy as it may be in the vault at the New York Fed, there will be no mama and papa gold molecules getting together to make love and produce an offspring. Pigs do multiply, but by the time they become a commodity they are already dead and frozen. They are passive, yes, but zero income. Investing in these dead things will likely yield poor returns over time. Commodity spot prices roughly track the CPI inflation index over the very, very long-term, so real returns before fees should be about zero. After fees, you lose money in real terms.
3. As if issue #2 above wasn’t bad enough, commodity futures returns sometimes lag behind even the lousy spot returns (see item 2), due to a phenomenon called Contango. Futures prices are above the spot price, more so the further the futures expiration lies in the future. Since over time the futures price has to approach the spot price, you continuously lose money, selling existing futures contracts close to the spot price and buying more expensive contracts with a later expiration date. Sometimes this Contango problem can be a drag of 10% p.a. or more.

VIX ETFs

Sounds like a great idea: If the market drops, the volatility index (VIX) goes up. Almost a perfect negative correlation, then why not buy a VIX ETF as downside protection? Again, the high fees are only one of the problems. Most of the time, there is a constant drag from the Contango problem in VIX futures, so even if the VIX moves only sideways you stand to lose money.

Levered ETFs

The problems with these instruments is that they have very high fees and in some cases also the Contango problem mentioned above when trading leveraged commodities. Another disadvantage is that in choppy markets, the constant rebalancing inside the ETF will cause a drag on performance. DQYDJ had a piece on this and a nice example where after a few trading days the underlying index finished flat, but both the 2x long and 2x short ETF would have lost money. Apart from that, levered means more risk. We don’t need more risk so close to retirement, and certainly, once we’re in retirement we like even less risk.

Hedge Funds

Most hedge funds have lagged behind major equity benchmarks for the last few years. The few very successful funds are likely closed to new investors or would not be interested in our retail investor size investment. Hence, the funds that would actually accept $100K or $250K from me (remember to never invest your entire net worth in one single fund!) are no good.  In the best case they are not very successful and in the worst case, they are Ponzi Schemes. To use the wisdom of Groucho Marx: “I don’t want to belong to any club that would have me as a member”. Likewise, we would not want to invest in any hedge fund that would accept our money.

Any single name stock making up more than a few percentage points of our portfolio

If you buy the index fund you likely already have that stock. Then why buy more than you already have? If that stock is not already in the index fund, then why not? It’s probably too small. Do we seriously want to give a small illiquid stock the same weight in the portfolio as Apple or Exxon Mobil? It’s best to stick with index funds. If not, you will likely add unnecessary, undiversified idiosyncratic risk to your portfolio. Most importantly, while you are still in the accumulation phase and pulling a paycheck, the one stock that you most definitely want to stay away from is the company where you work. People working for Enron, Lehman Brothers and countless other firms learned first hand that you want a low correlation between your paycheck and your stock portfolio.

Day Trading

The problem with day trading is that it doesn’t work for pretty much 90% or more of all people that try it. Most people lose a lot of money, and some people lose even much more than money. Even for those lucky few who have been successful so far, business will get tougher and tougher thanks to High-Frequency Trading (HFT) algorithms that recognize trading patterns a million times faster than humans. To win in the HFT arms race takes multi-millions dollar investments from large hedge funds (see some fun facts about the HFT arms race here) and thus retail investors like us are better served with index funds.

Besides, the whole idea of early retirement is to generate passive income and to enjoy a stress-free life. Sitting in front of a computer screen for 6.5 hours every day does not fit into that lifestyle.

Investing in stuff we don’t understand

This goes without saying. We invest in assets that have an attractive risk vs. return profile. To make that assessment we need to determine expected return, expected risk and expected correlations to the other assets in my portfolio. If any of those are not available, we say no thank you.

Investing in stuff we do understand really, really well

Huh, how can that be, ERN? Let me explain: we know people who invest in individual stocks they know really well and they believe they have a great diversified portfolio; maybe 15-20 stocks. The only problem: these are all companies they know really well from their role as a consumer. Stop by at Starbucks every day? Buy SBUX. Love shopping on Amazon? Buy AMZN. Love the Starwood preferred reward program? Buy HOT. Do we see what’s the problem with this portfolio? They are all consumer discretionary stocks. Picking only stocks that you think you know well risks introducing significant biases into your portfolio. An even worse bias: load up on the equities in the sector where you work. In the worst case, the actual company where you work, see item above.

Another idiotic trend, furthered now by several companies, is the alert “investor” who spots a new trend and immediately trades based on it, as seen in this TV spot, “Opportunity is everywhere.” Do you really believe that such an observation gives you any incremental information about the expected returns of the stock not already priced in? Can this be worth more than the trade commission and bid/ask spread? Likely not. The only people making money on this are the brokerage and Kevin Spacey.

Any other financial get rich quick scheme

It’s so tempting: on the one hand, you are looking at living on just 25-40% of your net income for about a decade to reach financial independence. On the other hand, you blow 90% of your net income, save the other 10% for a few years, buy a book of some financial guru, attend some real estate investing workshops, and voila, you get fabulously rich in half the time. Don’t fall for it!