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Why Don’t We Use Short or Margin?

The title is one of the most frequently asked questions of our portfolios.

The simple answer we usually use is that over 90% of our managed accounts are IRA accounts, and we just can’t short stocks or use margin in IRA accounts.

Following is the actual elaborate answer for more sophisicated clients. Since risk is unlimited using short or margin and they could result in total account loss, it does not match our long term investment goal. Mathematically, as we can see from formula below, since Ls could be infinitely large with short or margin on stocks, over the long term (i.e, f is large) it is unlikely to make money if one keeps using short or margin.

Investment Gain = f * (Wp * Ws – Lp * Ls) where,
f = frequency of trades, e.g., trades/year
Wp/Lp = win/loss percentage
Ws/Ls = average win/loss size, Ls = R (i.e., Risk)

Over a smaller sample size, i.e., in the short term, it is possible to make money using short or margin with a few bets, but this is entirely different from our goal to use the same strategy over and over again for long term growth.

It may be easier to understand using a real life example. Let’s use GSIC to illustrate issue. As the chart below shown, in March, 2011, GSIC chart broke down a decenting triangle, has formed a series of head and shoulder, and was retraced back to $19 resistance level. Its fundamental valulation ratio is expensive (e.g., P/E at 47), earning is on the decline, so it looked like a perfect short setup, and stop loss can be placed at $20, with profit targets at $18, $16, and $14. The reward/risk ratio seems very favorable.

Assume one trader with a $5000 account, decided to take $500 risk to short 500 shares of GSIC at $19 and place a stop loss at $20. The trader also placed braket orders to cover 200 shares at the first profit target $18, and cover 200 shares at next profit target $16, and cover the last 100 shares at $14.

Right after the trader shorted GSIC with the perfect setup and placed all necessary orders to control risk, GSIC gapped up open at $29.41 next day with pending acquisition news, see chart below. So stop loss order was triggerd and 500 shares was covered at $29.41, with total loss more than $5200, resulting in total account loss.

It will probably take a long time to recover from such a trade.

True Cost of 401k and 403b

Due to continuous bleeding of many defined contribution retirement plans for the past 10 years, hidden fees in these plans becomes a hot topic in many financial publications. These discussions rarely address the fundamental problem with many retirement plans: lack of risk management and lack of investment performance. Nonetheless, disclosure of layers of hidden fees charged by all retirement plans probably can slow down the bleeding a bit.

How outrageous are these hidden fees after all? It is estimated that Bernie Madoff’s Ponzi scheme victims lost $20 to $30 billion over the period of 40+ years. With $3 to $4 trillion dollar of asset in defined contribution retirement plans today, each 1% hidden fees would cost retirement plan participants $30 to $40 billion dollars each year.

Edward Siedle, a former attorney with the SEC, says it very well in Forbes article 401ks: the America’s Biggest Investment Fraud Was Foreseen and Preventable.

The following 2008 video clips from Bloomberg has in-depth investigations on the hidden 401k fees.

(1) The part 1 of the video has an 401k plan expert review a John Hancock 401k plan participant’s account to show all hidden fees combined (wrap fees, soft dollars, revenue sharing, finder fees, shelf space, surrender charges, 12B-1 fees, etc) can be 3000% more than the 0.1% fee disclosed by the plan administrator. In many 401k plans Edward Siedle audits, he says investors are paying 3% to 5% hidden fees.

(2) The part 2 of the video reveals an union 403b plan with a shocking 12.17% hidden fee. It also shows a Walmart’s agreement with its 401k provider Merrill Lynch to withold fee information from employee in its 401k plan with $9.5 billion in asset.

(3) The third video clip has an expert examine the hidden cost of one of the largest 401k plans in the nation – Ford’s 401k plan administratored by Fidelity with $12 billion in asset. The video also have retirement plan specialists show some complicated charts demostrating even plan advisors can’t figure out where the fees go.

Yale Professor David F. Swensen’s words in page 294 of his 2005 book “Unconventional Success” is probably the best conclusion of all these hidden fees: “For the vast majority of mutual-fund investors, the future appears dim. Regulators identify abuses, deal superficially with the most high-profile issues, and move on to other matters. Meanwhile, the mutual-fund industry find new ways to place profits above investor interests. Even if the SEC eliminates pay-to-play revenue sharing, enforces fair-value pricing mechanisms and bans soft dollars, the mutual-fund industry, as it has from its beginning in 1924, will employ its endless creativity to find visible and less visible means to take advantage of individual investors.”

Fund Ownership of Mutual Fund Managers

Have you wondered why the mutual funds you owned in your 401k account continued to hold on to Lehman Brothers stock all the way from $65 on Jan 1, 2008 to $0 on September 15, 2008, even though there were plenty of time to get out at $50, $40, $30, or even $20, etc prior to it filed bankruptcy?

Morningstar recently published a great article on fund managers’ ownership of their own funds (https://news.morningstar.com/articlenet/article.aspx?id=372678), which may explain why most fund managers do not feel the pains fund shareholders are feeling:

“Fully 4,347 funds out of about 6,557 have at least one manager who isn’t investing in the fund. And of the 1,126 funds where there is just one manager, there is no manager ownership. On the plus side, 564 funds have at least one manager with more than $1 million at stake in the fund they run.”

4,347 funds out of about 6,557 is a shocking 66.29%! On the other hand, Warren E. Buffett, the most successful investor and money manager in the world, has invested almost all his money along with share holders of Berkshire Hathaway Inc.

Things to Consider Before Signing an Annuity Contract

We frequently see investors’ accounts stuck in inappropriate annuity contracts with insurance companies, facing the dilemma to choose between taking the huge surrender charge penalty or continuing to hold on until surrender period expires. Before signing an annuity contract, here are the tips that may help you avoid the most expensive investment mistake:

(1) Think twice before putting IRA accounts into annuity contracts. IRA accounts are tax deferred or tax free vehicles, is it necessary to put them into another tax deferred vehicles?

(2) Think twice if annuitization is mandatory in the annuity contract. By annuitization, annuitants are betting insurance companies under-estimate annuitants’ life expectancy. Are Insurance companies really that dumb?

(3) Variable annuity has very limited choice of investment options, typically limited to at most a few hundreds of mutual funds. If money is not in an annuity contract, 15,000 mutual funds, 1000 ETF’s, 10,000 stocks, real estates, separately managed accounts, and thousands of alternative investments are available to compete for your business. Which will be more cost effective?

(4) Annuity can be used as a tax deferred vehicle. But if you are paying 2% fee on 5% return, you are paying tax to insurance companies instead of IRS. Paying tax to IRS may not a bad thing after all if you really make money from investment.

(5) Annuity surrender charge is used to pay sales commission. Why not choose an annuity without surrender charge if you really want to buy a contract?

Take Advantage of US Stock Market Changes Since 2001

Three major positive changes in US stock market at the beginning of 21st century bring tremendous investing opportunities to individual investors, leveling the playing field of once institution-dominated arena:

(1) The U.S. Securities and Exchange Commission, the federal agency that oversees the nation’s stock markets, ordered all U.S. stock markets to convert to decimals by April 9, 2001. With this change, the spread for individual investors to trade stocks plunged and resulted in huge increase in market liquidity.

(2) US federal law Sarbanes–Oxley Act of 2002 was a enacted on July 30, 2002, which set new or enhanced standards for all U.S. public company boards, management and public accounting firms. Since then, financial restatements from public companies declined significantly, and individual investors can reliably count on public financial statements to analyze stock fundamental factors without the need to hire an army of accounting investigators for the job.

(3) With the rapid advance of information technologies, individual investors can trade stocks at sub-penny level commission, the same (if not lower) rate as institutions, with the same direct access the trading venues.

With all above, individual investors no longer have to limit their investment needs to the investment products sold by Wall Street companies that are full of conflict-of-interests.