Avner Mandelman is president and chief investment officer of Giraffe Capital Corp. and the author of The Sleuth Investor
amandelman@giraffecapital.com
In the early 80s when I worked at Gordon Securities, it merged with R.A. Daley. It eventually became Gordon Capital, but for a brief period it was called Gordon, Daley - which created confusion, because there was also another brokerage company by the name of Daley, Gordon, whose business was mainly risky mining financing.
Why am I mentioning this? Because right after the Gordon merger, our receptionist ran to the trading desk in a panic and said there was an irate gentleman at the front who wanted his money back and would someone please, please go talk to him?
A damsel in distress cannot be refused, and so I and a hefty trader went to check it out. There, in the waiting room, was a large gentleman in a checkered jacket and a feathered fedora, shouting that his mining shares went to zero and he wanted his money back or there would be repercussions. The trader asked the complainer gently whether he had meant Daley, Gordon. The gentleman looked at us both, asked whether there was a difference, and finally departed, mouthing terrible oaths.
After the intruder had left, the trader turned to me and said: "Remember this guy - that's the public. They buy what they don't understand from those whom they've never met, and that's why it's always profitable to do the opposite of what they do."
Sounds simple? In theory, perhaps, but in practice it's harder than you think. Most investors are nice conformists - they try to make money for retirement and to send kids to college, yes, but also to impress their neighbours and colleagues, which is good: That's how society stays civil. But because of such conformity, doing the opposite of what the neighbours and colleagues do is uncomfortable - even for mild non-conformists such as the gent in the fedora. So, just imagine how hard it is for good, civilized investors like you and me.
To make it clear, let me bring a current example - double and triple exchange-traded funds - some of which are called bull- or bear-plus funds.
ETFs are closed-end funds that mimic the behaviour of market segments such as gold, technology and energy, or even whole indexes such as the Dow, S&P or Nasdaq, which can be used instead of index funds. But for the fast-money crowd this was not good enough. So out came double and triple ETFs, which move every day twice or three times the daily movement of the underlying index (or commodity).
With these came trouble, because most "investors" who bought such ETFs (both bull and bear ones) had no clue what they were buying: Many assumed they could now lever their long-term indexed portfolio without borrowing: Instead of buying, say, $10,000 worth of the Nasdaq, they'd buy $5,000 worth of the QLD (two-times the daily Nasdaq movement); or, instead of shorting the Nasdaq with that $10,000, they'd buy $5,000 worth of the QID (two-times the opposite of the daily movement). This way they'd get twice the long-term movement for half the capital invested, right?
Wrong. The double ETF provides twice the daily movement, not twice the long-term one. What the public did not realize was that when buying a double or a triple ETF, they were going long (twice or thrice) the underlying index, yes, but they were also going inadvertently short the volatility. This meant that if the underlying market went sideways but meanwhile fluctuated - which it always does - the index single ETF indeed went sideways, but the double or triple ETF went down.
When we realized this six months ago, the conclusion was not just to avoid buying double or triple ETFs altogether, but of course to short them in pairs.
At that time you could borrow and sell short several double and triple ETFs - bull and bear ones together, to hedge out the underlying market - and so pick up the volatility gains freely handed out by "investors" ignorant of what they were really buying.
For a while this provided big, steady returns; but then the returns began to shrink, it became difficult to borrow the underlying ETFs - even those trading millions of shares a day - and the borrowing fees went way up. That meant large hedge funds and trading desks had probably discovered the opportunity and were doing it in volume; so the game was over.
Now, you may ask, are there other such opportunities today where going against the public would be profitable?
Well, you won't find them in the press - after all, it caters to the public; so by revealing such anomalies to everyone, it would alert the losers and the opportunity would vanish. But you could seek such opportunities yourself: Just look for the most popular, most complicated investment shtick of the moment - chances are it is not fully understood by those who buy it. Then spend some time understanding it fully, to see whether it's worth your while doing the opposite.
In the meantime, to avoid losing money, don't use double and triple ETFs as long-term investments. You are unlikely to do well there.
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© 2007 The Globe and Mail. All rights reserved.
