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Transcript of The Lost Decade
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
2
Table of Contents
Disclosures 3Executive Summary 5
What went wrong? 5The good news for today’s retail investors and financial advisors 5A note of caution 6The purpose of this paper 6
Introduction 7The Lost Decade: Ten years of Disillusion for Buy & Hold Asset Allocation 7Why It Was So Bad for Investors (and Not for Institutions) 9Why Modern Portfolio Theory Has Been So Widely Accepted 9Why Didn’t Asset Allocation Work? 9The Difference Change Has Made 10How Institutional Investors Have Performed Better 11
Alternative Strategies for Retail Advisors and Investors 12Options to consider 12Different Investor Types 14Retail Investors Are Embracing Sophisticated Alternative Strategies 14Why change is needed 14Alternative-Strategy Mutual Funds 15Portfolio Manager for an Accounting and Advisory Firm: Allen Gillespie, CFA 16Registered Investment Advisor: Gary Clemmons 16
Tactical Trading Tools 18Leveraged funds 18Leveraged mutual funds 18Leveraged mutual fund advisor: Daniel Wiggins 19Leveraged ETFs 19Leveraged ETFs in action: Todd Bessey 20Leveraged ETFs in action: Paul Ingersoll 21A Self-Directed Investor 21High-Frequency Traders 22High-frequency trader profile 22Suitability 23
The Effects of Daily Rebalancing: The Key to Using Leveraged ETFs Effectively 24The Bottom Line: Monitor and Act When Necessary 24Leveraged ETF Myths 24Myth #1 24Myth #2 27Myth #3 27Myth #4 28Myth #5 28
Conclusion 29 A new perspective on investing 29Glossary of Terms 30
3
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Disclosures:
An investor should consider the investment objectives, risks, charges, and expenses of Direxion Shares carefully
before investing. The prospectus and summary prospectus contain this and other information about Direxion
Shares. To obtain a prospectus please visit www.direxionshares.com. The prospectus and summary prospectus
should be read carefully before investing.
Investing in the Funds may be more volatile than investing in broadly diversified funds. The use of leverage by a fund means
the Funds are riskier than alternatives which do not use leverage. These Funds are not designed to track the underlying index
for a longer period of time.
There is no guarantee that the funds will achieve their objectives. The ETFs are not suitable for all investors and should be
utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged investment
results and intend to actively monitor and manage their investments. Due to the daily nature of the leverage employed, there
is no guarantee of amplified long-term returns.
Risks:
An investment in the Funds involve risk, including the possible loss of principal. The Funds are non-diversified and include risks
associated with concentration risk that results from the Funds’ investments in a particular industry or sector which can increase
volatility. The use of derivatives such as futures contracts, forward contracts, options and swaps are subject to market risks that
may cause their price to fluctuate over time. The Fund does not attempt to, and should not be expected to, provide returns
which are a multiple of the return of the Index for periods other than a single day. For other risks including correlation, leverage,
compounding, market volatility and specific risks regarding each sector, please read the prospectus.
Distributor: Foreside Fund Services, LLC.
The Use of Testimonials in this White Paper
The testimonials used in this paper may not be representative of the experience of other customers, the testimonial may not
be indicative of future performance or success, and the testimonials were voluntary and unpaid.
Although information and analysis contained herein has been obtained from sources Direxionshares believes to be reliable, its
accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made
in this report may not be suitable for all investors. This should not be considered an offer to sell or a solicitation of an offer to
buy any securities.
4
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Disclosures:
An investor should consider the investment objectives, risks, charges and expenses of the funds carefully before
investing. The prospectus contains this and other information about the funds. To obtain a prospectus, please call
the Direxionfunds at 1-800-851-0511. The prospectus should be read carefully before investing.
Wilshire Funds Management is a business unit of Wilshire Associates Incorporated (“Wilshire®”). Wilshire® is a registered
service mark of Wilshire Associates Incorporated, Santa Monica, California. All other trade names, trademarks, and/or service
marks are the property of their respective holders. Wilshire is not affiliated with Direxion or any of its affiliates.
Risks:
The risks associated with the funds are detailed in the prospectuses which include Adverse Market Conditions Risk, Adviser’s
Investment Strategy Risk, Aggressive Investment Techniques Risk, Commodities Risk, Concentration Risk, Counterparty Risk,
Credit Risk, Currency Exchange Rate Risk, Debt Instrument Risk, Depositary Receipt Risk, Early Close/Trading Halt Risk, Emerg-
ing Markets Risk, Equity Securities Risk, Foreign Securities Risk, Gain Limitation Risk, Geographic Concentration Risk, Interest
Rate Risk, Intra-Calendar Month Investment Risk, Inverse Correlation Risk, Leverage Risk, Lower-Quality Debt Securities, Mar-
ket Risk, Market Timing Activity and High Portfolio Turnover, Monthly Correlation Risk, and Negative Implications of Monthly
Goals in Volatile Market.
Date of first use: October 3, 2011
Distributor: Rafferty Capital Markets, LLC.
The Use of Testimonials in this White Paper
The testimonials used in this paper may not be representative of the experience of other customers, the testimonial may not
be indicative of future performance or success, and the testimonials were voluntary and unpaid.
Although information and analysis contained herein has been obtained from sources Direxionshares believes to be reliable, its
accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made
in this report may not be suitable for all investors. This should not be considered an offer to sell or a solicitation of an offer to
buy any securities.
5
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Executive Summary
The so-called Lost Decade and its final blow—the
Market Meltdown of 2008—have been a wake-up call
for retail investors and retail financial advisors. Their
steadfast adherence to the buy-and-hold asset allocation
advocated by Modern Portfolio Theory resulted in
portfolio losses of 50% or more in the 18 months from
November 2007 through April 2009, during which
most types of securities—with the exception of Treasury
bonds and gold—fell in lock step. Perhaps even more
devastating for long-term investors who were advised
that large-cap equities should comprise the majority of
their portfolios, for the decade ending December 31,
2009, the S&P 500® Index (S&P 500) posted a total
return of -9.1%.
What went wrong?
While market analysts and economists will debate the
causes for years to come, one thing seems certain:
The markets themselves have changed. Markowitz’s
Modern Portfolio Theory (MPT) is based on the notion
that traditional asset classes—made up of stocks and
bonds—are not correlated: Their values do not rise
and fall at the same time. Yet, today’s global network
of trading exchanges, computer-driven investment
algorithms, and “flash” trades of millions of shares
in seconds have combined to radically change the
investment environment. In short, it has increased
market volatility to levels unimagined by Harry
Markowitz, transforming the static correlations that
formed the core of MPT into fluctuating correlations,
which change under different market conditions. These
new markets have created the need for new investment
theories, ones that include new non-correlating asset
classes and strategies for managing the risk/reward
equation.
Of course, not all investors were devastated by the
events of the last decade. Many institutional investors,
who long ago recognized the shortcomings of traditional
portfolio theory, used so-called alternative investment
vehicles to avoid—and even profit from—the recent
turbulent markets. Hedge funds, for instance, managed
a 6.3% annualized return for the same 10 years (as of
December 31, 2009) when the S&P 500 took such a
beating, according to Hedge Fund Research’s Weighted
Composite Index. Furthermore, the Harvard Endowment
Fund returned 8.9% per year for the decade ending
December 31, 2009, with significantly less risk than even
a traditional 60/40 stock and bond portfolio.
To accomplish these returns even during challenging
markets, institutions and other sophisticated investors
use asset classes and strategies outside of traditional
models to manage high-risk situations and to take
advantage of low-risk opportunities. These include:
• Additional asset classes, including real estate,
commodities, and currencies;
• Short positions, to take advantage of overvalued
market segments;
• Hedging, in order to reduce a position’s risk,
without losing its upside potential, or to avoid an
inconvenient selling situation; and
• Leverage, to amplify exposure with an efficient use
of capital.
The good news for today’s retail investors and financial advisors
Today, there are a growing number of investment
vehicles that offer access to the aforementioned
strategies that have formerly been available only to the
largest of investors. For Do-it-Yourself investors and
financial advisors, there are now more than passive
index Exchange-Traded Funds (ETFs) and index-based
leveraged ETFs. These provide exposure to worldwide
markets, commodities, currencies, and various classes
6
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
of equities and debt securities. For those investors who
prefer to defer tactical investment decisions to others,
there are alternative-strategy mutual funds, managed
by institutional managers, which offer exposure to long/
short equities, market-neutral strategies, commodities,
and global currencies.
A note of caution
Of course, it’s essential for retail investors and financial
advisors to fully understand these investment vehicles.
The very differences that make alternative investments
beneficial to many portfolios also put them outside
the experience of most typical investors and advisors.
Risk parameters can differ, time horizons can vary, and
some investment objectives—such as the concept of
daily objectives for most leveraged ETFs —can seem
unnatural to investors who have a traditional long-term
mindset. In addition, many of these types of alternative
investment vehicles can require more active monitoring
and management than those typically used by buy-and-
hold investors.
The purpose of this paper
In this paper, we take a close look at some of the
various types of alternative-strategy investment vehicles
that exist today—and which types are appropriate for
which types of investors or traders, as the case may be.
Investment professional user profiles have also been
included to provide context for some of the strategies in
action.
We also take a specific look at the common
misconceptions that exist regarding leveraged ETFs, and
seek to set the record straight. Consider the following:
• Leveraged ETFs are designed to meet daily
investment objectives, not to provide compounding
of returns beyond one day (as is commonly
expected in buy-and-hold investing);
• Leveraged ETFs serve as an effective way to gain
short exposure without the need to be subjected
to margin rules and limit investors’ losses to the
amount of their initial investments; and
• There is no quantifiable evidence that leveraged
ETFs can generate downward pressure on their
respective asset class or sector or introduce any
measurable volatility or systematic risk to the
markets.
The truth is that more investors and financial advisors
than ever before are questioning the wisdom of the old
long-only buy-and-hold investment approach, and are
looking for ways to profit from the new highly volatile
markets, whether they are going up or down. In fact,
advisors who are not offering risk management through
un-correlated investment strategies may be in danger
of losing new assets to the competition. The growing
number of alternative investment products is providing
retail investors and advisors with the tools they need to
create and manage far more sophisticated portfolios—
like the ones with which institutional managers have
succeeded for years. These tools are designed to enable
sophisticated investors to generate higher returns with
less risk in today’s highly volatile markets—and attempt
to help them avoid future Lost Decades and Market
Meltdowns.
7
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Introduction
The Lost Decade: Ten years of Disillusion for Buy & Hold Asset Allocation
In the 18 months from November 2007 through April
2009, the Dow Jones Industrial AverageSM (DJIA) lost
more than half its value (53%), the second-worst
18-month drop in U.S. history (from September 1, 1929,
to April 1, 1930, the DJIA fell 55%), and the third-worst
bear market on record.
Chart
10 Worst Major U.S. Bear Markets
DateDuration
(mos.)Loss
1929 34 -90%
2000 32 -78%
2008 18 -53%
1937 56 -51.8%
1973 24 -47%
1919 21 -46.6%
1907 10 -45%
1917 13 -40.1%
1903 10 -37.3%
1968 18 -37%
Source: Bloomberg
For retail investors in particular, the 2008 losses
were devastating: Every asset class sustained losses
except two—Treasury bonds and gold—and even
“conservative” investments like municipal bonds fell
roughly 15%. Many seemingly “diversified” portfolios
lost from 20% to 50% of their value during the year.
People who depended on their retirement portfolios, as
well as advisors whose livelihoods were based on assets
under management, were financially devastated.
Unfortunately, the financial damage wasn’t limited to
the aftermath of the Sub-Prime Meltdown. Due in large
part to the meltdown, December 31, 2009, ended what
was, by all measures, the worst decade for stocks since
The Great Depression: Over the preceding 10 years, the
nominal S&P 500 Index lost 20% from its high at the
end of 1999, with a total return of -9.1%.
For retail investors, the new millennium started almost as
badly. According to Morningstar, the average annualized
return for U.S. equity mutual funds was 1.7% during
the first decade—culminating with only one fund out
of the total 3,833 mutual fund universe posting a gain
for calendar-year 2008: Forester Value Fund rose a mere
0.4%.
Source: Bloomberg
With virtually all asset classes used by retail investors
down during the past two years, those “diversified”
portfolios, which appeared so conservative, offered little
protection from the market maelstrom. For the majority
0
200
400
600
800
1000
1200
1400
S&P 500®
NASDAQ®
Major US Stock Indices Total Returns 12/31/99 - 12/31/2009
Co
rrel
atio
n
IndexAverage Annualized Returns 12/31/00-12/31/10
Total Return 12/31/00-12/31/10
S&P 500® Index 1.41% 15.07%
NASDAQ Composite Index -0.14% -1.41%
Past performance is not an indicator of future results. Index performance is not representative of a specific fund or products. One cannot invest directly in an index.
8
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
of retail investors, especially those Baby Boomers who
are in their peak earning years leading up to retirement,
those 10 years with little or no portfolio growth marked
disaster for their retirement plan strategies.
Exceptions to “the rule”
Yet, all investors didn’t suffer equally during the past
two tough years or even in the past flat decade. That’s
because while most popular asset classes were taken
down with the markets, ALL asset classes weren’t.
Consider that:
• Investors who put $10,000 into S&P 500 stocks on
Dec. 31, 1999, had $9,090 10 years later, at the
end of 2009. The same amount invested in 10-
year Treasury notes would have grown to about
$18,000 (a 6.1% annualized return);
• The Reuters/Jefferies CRB Index of 19 raw materials
increased 3.3% per year, to $13,803;
• Gold futures, which rose 14% per year, would have
yielded $37,852.
Those who benefited during the decade were short-
term, tactical investors who were able to take advantage
of the volatility in the stock market. Who were the
investors using these classes for portfolio protection
and profit? One group was hedge fund investors:
Their average annualized return was about 6.3% over
the same 10-year period, according to Hedge Fund
Research’s HFRI Fund Weighted Composite Index.
Another group managed to beat the Lost Decade—
the large Institutional Investors. For example, the
endowment funds for Harvard and Yale Universities
have been using alternative asset classes and strategies
to produce higher, more consistent returns with less
volatility for decades. The two multi-billion-dollar funds
have consistently produced a track record of high
risk-adjusted returns. Over the long haul, including the
most tumultuous market since the Great Depression—
from July 2008 through June 2009—these institutions
have carved out very strong, long-term performance.
Consider that from 1985 to 2008, the combined
Harvard and Yale Endowments posted a 15.95% annual
compound rate of return versus the S&P’ 500’s 11.98%,
with far lower risk: a standard deviation of 9.75 versus
15.6 for the S&P 500.
Source: The Ivy Portfolio by Mebane T. Faber & Eric W.
Richardson © 2009 John Wiley & Sons Inc.
Specifically, the Harvard Endowment Fund has delivered
annualized returns that have consistently outperformed
a typical 60% stock-/40% bond-allocated portfolio
over time. During the past 10 years, the Harvard
Management Company (HMC) managed an average
annual return of 8.9%, while the S&P 500 Index was
losing 0.99% a year and a 60/40 portfolio was returning
1.4% annually. HMC has generated significant alpha, in
great part through the use of alternative strategies and
asset classes. Financial advisors have been preaching the
commandments of diversification and asset allocation to
their clients for decades. Today, in hindsight, reality may
cause many to consider a more active solution.
Sources: Harvard Gazette, January 2010, Bloomberg
Results of the Endowment Approach to Investing
1985-2008 Annual Compound Rate of Return
Volatility (measured by Standard Deviation)
Yale and Harvard Endowments Combined
15.95% 9.75σ
S&P 500® Index 11.98% 15.6σ
Results of the Endowment Approach to Investing
10 Year Annual Returns
20 Year Annual Returns
Harvard Endowment Fund 8.9% 11.7%
S&P 500® Index -0.99% 8.23%
Typical 60%stock/40% bond portfolio
1.4% 7.8%
Past performance is not an indicator of future results. Index performance is not representative of a specific fund or products. One cannot invest directly in an index.
9
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Why It Was So Bad for Investors (and Not for Institutions)
In 1952, a 25-year-old, future Economics professor
named Harry Markowitz first published his Modern
Portfolio Theory under the title “Portfolio Selection”
in The Journal of FINANCE. Markowitz considered
the effects of asset risk (as measured by the historic
range of returns or “volatility” of a specific stock) on
probable investment portfolio returns. He was the first
to postulate the now widely held view that a well-
diversified portfolio of individual stocks will be less
risky than holding any individual stock. The risk in such
a diversified portfolio, he said, comes not from the
volatility of each stock, but from the covariance—the
difference or similarity—between the stocks’ returns. He
concluded that portfolios get the highest returns with
the least amount of risk if they combine stocks with
historically “low-correlated” returns: that is, if the stocks
have a history of going up and down at different times.
Markowitz’s now 60-year-old theory was further
advanced in 1986 by the Brinson Hood Beebower study,
which concluded that only 10% of a portfolio’s risk and
returns comes from the individual stocks in it, while the
remaining 90% results from the asset classes that the
portfolio’s stocks fall into. Put another way, Brinson et al
found that the gains or losses of each stock matter very
little to the overall performance of a portfolio, while the
relative weightings of classes into which the stocks fall
(small-cap value, large-cap growth, corporate bonds,
etc.) matter a great deal. Brinson’s findings redefined
Modern Portfolio Theory to mean that the allocation of
assets among different types of investments with unique
characteristics reduces the probability of sustaining a
large loss. This change launched an entire generation
of financial advisors who eschew picking individual
stocks in favor of constructing portfolios out of diverse
allocations of mutual funds.
Why Modern Portfolio Theory Has Been So Widely Accepted
MPT’s orderliness and simplicity make it easy to
understand: A portfolio constructed of a well-diversified
basket of stocks (mutual funds) allocated between
various non-correlating asset classes will offer investors
the highest possible returns for the lowest possible risk.
Ideas like this that are easy to understand are easily
sold—and bought. Its conclusion leads to an elementary
methodology of investment management: “Set it.
Rebalance every quarter. Repeat.”
Financial advisors have been preaching the
“commandments” of diversification and asset
allocation to their clients for decades. Real
market performance over the last few years,
however, forces investors to challenge this
theory. Disparate asset classes, with distinct
risk profiles, all went down together in 2008
and early 2009, taking trillions of dollars of
investors’ assets with them.
Why Didn’t Asset Allocation Work?
It all makes sense in theory. But theories, by definition,
must rely on assumptions. MPT and Asset Allocation
were born and bred in academia, an environment
where assumptions can be made, controlled, isolated,
and plotted on graphs. It’s simple and elegant, and can
lead into various mathematical proofs and equations,
which may help to explain why it has become so widely
accepted. Books will be written on why buy-and-hold
strategic asset allocation has failed for more than a
decade. But some causes seem obvious if we look at the
realities of today’s financial markets.
10
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Traditional asset allocation relies on diversification
into asset classes that are not correlated; that is, their
returns rise and fall at different times. Many financial
advisors and retail investors have assumed diversification
from holding say, International Large Cap Blend stocks
and U.S. Large Cap Blend stocks. Are they really that
different in terms of risk and correlation? The answer
is that correlations between asset classes in today’s
markets aren’t static—they’re fluid: Assets that once
were correlating can become non-correlating under
certain market conditions, and vice versa. Most notably,
from July 2008 through June 2009—a period in the
decade when true diversification would have been most
valuable—the traditional eight asset classes fell in lock
step (except for Treasuries, as noted earlier). When
non-correlating assets become correlating, portfolio
diversification disappears, and risk goes up—sometimes,
way up.
The Difference Change Has Made
10-Years of Market Volatility
S&P 500® Index Barclays Capital US Bond Index Volatility Index (VIX) 10 Year VIX Average
0
10
20
30
40
50
60
70
80
90
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
$16,000
$18,000
$20,000
12/31/99 12/31/00 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08 12/31/09
$18,475
$9,090
Gro
wth
of
$10,
000
VIX
Source: Bloomberg
1.00 0.990.93 0.92 0.90 0.90
-0.24-0.27
1.00 0.990.94 0.95
0.85
0.94
0.05
-0.25
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
1.20
S&P 500 Index
DOW JONES INDUS. AVG
RUSSELL 2000
GROWTH IDX
RUSSELL 2000 VALUE
IDX
FTSE 100 MSCI EAFE Citigroup Non USD WGBI All
Mat
BarCap US Agg Total
Return Val
Correlation of Indices to the S&P 500 Index
2008 2009
These fluctuations in correlation
are at least in part due to dramatic
changes in the way markets work.
Gone are the 1950s style “open
outcry” trading pits filled with
face-to-face buyers and sellers,
replaced by a complex web of
electronic exchanges driven by
computer-trading algorithms.
Proprietary traders use high-speed
computers to execute “flash”
trades of millions of shares in a
hundredth of a second, thousands
of times a day, on exchanges all over the world. All this speed means a great deal more volatility in the markets. One of
the reasons for the market’s 10 years of negative returns was this new level of volatility. As measured by the S&P 500
Index, U.S. equities from 1999 through 2009 experienced two major volatility shifts: First, the 2000 to 2002 technology
bubble, when the index lost 37.5%, and volatility climbed to 46% in August of 2002. Second, in 2008 and 2009, the
market experienced the highest-level volatility ever recorded.
Source Bloomberg. Diversification does not protect against a
loss or ensure a gain.
Past performance is not an indicator of future results. Index performance is not representative of a specific fund or products. One cannot invest directly in an index.
11
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Unfortunately, Asset Allocation worked better in
the old, less volatile, predictably correlating markets
for which it was designed. In today’s more volatile
markets, asset allocators actually “steer” into down
trends and away from up trends in order to maintain
their allocations. By selling the “winners” and buying
the “losers” at arbitrarily predetermined times (e.g.,
quarterly), advisors and investors often lose a portion
of the ride up, and then gain an extra portion of the
ride down. For example, an investor may have good
reason to believe that International Large Cap stocks will
under-perform for a period of time, but would continue
to hold them, and in fact, may buy more if negative
returns in that class (or positive returns in another asset
class) shift the allocation of the portfolio. Conversely,
if the fundamentals of small caps still look great after
a quarter of stellar returns, strict MPT followers will still
sell the winners even if all signs point to more gains for
the next quarter, and beyond.
How Institutional Investors Have Performed Better
One of the reasons that institutional investors such
as Harvard Management Corporation fared better in
recent years than retail portfolios is that they understand
that risk management—protecting the assets that they
manage—is a critical component of their investment
strategy. Risk management, as these institutional
investors see it, involves two components: minimizing
exposure to high-risk situations, and increasing their
participation when the risk is low. To accomplish this
within their portfolios, savvy institutions use alternative
investment products and strategies that fall outside of
a traditional asset allocator’s menu of mutual funds. In
light of their investment experience during the past 10
years and more, it seems reasonable to ask: If some of
the most successful long-term investors have been using
alternative strategies and asset classes to manage risk
for decades, why isn’t everyone following their lead?
First, there is the perception of higher risk associated
with alternative asset classes and strategies. These
institutional fund managers use leveraging and other
speculative investment practices that average investors
typically associate with higher risk. Some classes of
alternatives can also be highly illiquid, and, often,
alternative investment funds are not subject to the same
regulatory requirements as, say, mutual funds. While
there are additional risks associated with alternative
strategies, sophisticated financial professionals
implement programs to offset, manage, and monitor
these risks. In fact, most institutional managers would
say that they use alternatives to lower standard deviation
and offset the risks associated with other holdings.
Not everyone has access to the resources that the
managers of a $30 billion endowment or hedge fund
have at their disposal. At that asset level, resources,
staff, technology, and infrastructure abound. Institutions
may even designate a Chief Risk Manager, overseeing a
department dedicated to examining the best ways to use
alternative strategies and asset classes to hedge portfolio
risk. Implementing those strategies and managing them
day in and day out, requires 100% hands-on attention
by experts. Fundamental and technical analysis, short
strategies, leverage, counterparty risk and illiquidity
require very sophisticated management expertise. These
realities have all tilted the playing field in favor of the
largest players—until now.
12
The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Alternative Strategies for Retail Advisors and Investors
As we’ve seen, during the recent financial crisis, almost
anywhere you were invested would have been highly
correlated, leading to disastrous investment results,
which is why many people today have largely retreated
away from the equity markets and are looking for a new
approach. Investment advisors and retail investors who
believe in managing risk by diversifying portfolios but
aren’t satisfied with how it’s been working for the last
decade or more may want to consider adding alternative
asset allocation strategies like the ones detailed below,
to their overall portfolio management toolkit. As you’re
probably aware, these asset allocation strategies aren’t
“new,” but they are more sophisticated versions of the
strategies with which you’re probably familiar, bringing
them closer to the strategies that institutional investors
have been using successfully for many years.
Options to consider
By either applying active management or using
alternative-class or alternative-strategy mutual funds,
here are a few possible ways that well-allocated MPT
portfolios can be updated to mitigate—and indeed,
profit from—today’s increased market volatility and
inefficiencies:
1. Incorporate additional asset classes, including real
estate and commodities. These alternative asset classes
may have the potential to:
• provide greater diversification and enhance all asset
allocation models;
• offer low correlation to stocks and bonds;
• serve as an effective hedge against inflation; and
• provide additional risk-adjusted returns over time to
a diversified portfolio.
2. Consider short positions (in addition to long
positions) in order to take advantage of trends or to
hedge risk. Traditional asset allocation only allows for
long positions, which provide returns when stocks
appreciate. If investors have learned anything over the
past 10 years, it’s that markets move in both directions.
Whether using margin, or securities with built-in short
exposure, the ability to profit—or to hedge against
losses—in down markets is what separates the most
successful institutional and retail investors from the rest
of the pack.
3. Incorporate hedging techniques. Suppose an investor
is happy with the recent performance of her portfolio;
however, she is now anticipating a market correction
and is concerned about losing recent gains. She may
initially be inclined to sell portfolio holdings and move to
a cash position, but is well aware of the disadvantages
of this market-timing approach—including the possibility
of incurring capital gains taxes and the prospect of
missing out on future rallies. One solution? Apply
a hedge. Hedging is the strategy of purchasing an
inversely correlated investment to reduce the risk of
adverse price movements. A hedge can help to protect
your gains and reduce volatility in a declining or volatile
market. In the above instance, it can provide an investor
with the ability to stay long and still profit if the market
continues to rally without having to incur taxable gains.
In the illustration on the next page, the short position
is acquired using a leveraged monthly bear 2x (inverse)
mutual fund.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
4. Apply leverage to make tactical shifts between asset
classes to seek better returns, reduce risk or both—without
applying more capital. Here’s an example: Suppose an
investor has a bullish one-year outlook on stocks in the S&P
500. He currently has a diversified portfolio containing a
modest allocation to a popular S&P 500 mutual fund. He
would like to increase his exposure to the index, but does
not want to commit additional capital to invest. How may
he accomplish this? By repositioning $20,000 of $100,000
in the S&P 500 fund into a Leveraged S&P 500 Bull 2x Fund,
$40,000 of additional exposure is created, increasing his
total exposure to the S&P 500 from $100,000 to $120,000,
without adding more capital.
The use of leveraged funds provides the opportunity to
improve portfolio diversification because it generates beta in
excess of allocated assets. Put another way: Leverage frees
capital that can be used to make higher allocations to asset
classes already in the portfolio which have low correlations
to equities and fixed income securities; and/or to allocate
capital to asset classes that were not previously represented.
This use of leverage is one that has increasingly found favor
with institutional investors. The additional diversification
is used to seek improvements in risk-adjusted returns—
extending, changing, and improving the expected returns of
the portfolio without a commensurate increase in risk.
Symbol Fund Name 1 Yr 5 Yr S/I Inception date
DXSSX Direxion Monthly S&P 2x Fund -41.05 - -21.65 5/1/2006
SPY SPDR S&P 500 14.89 2.25 8.03 1/29/1993
IWN I Shares Russell 2000 Value Index 24.30 3.42 9.14 7/24/2000
IWS I Shares Russell Mid Cap Index 24.44 3.95 8.06 7/17/2001
EFA iShares MSCI EAFE 7.53 2.35 5.61 8/14/2001
-16
-14
-12
-10
-8
-6
-4
-2
0
2
4
Portfolio A Portfolio BUlcer Beta Stdev Total Return
Portfolio A 10.01 1.18 34.67 -13.89
Portfolio B 4.56 0.49 14.68 -5.59
Strategy in Action
The chart to below illustrates performance of two
portfolios, one long only and one hedged during then
period of 4/30/10 - 6/30/10 - A particularly volatile period in
the equity markets.
Portfolio A Holdings: Long Only Portfolio
SPDR S&P 500 25%
iShares Russell 2000 Value Index Fund 25%
iShares Russell MidCap Index Fund 25%
iShares MSCI EAFE Index Fund 25%
Portfolio B Holdings: Hedged Portfolio
SPDR S&P 500 20%
iShares Russell 2000 Value Index Fund 20%
iShares Russell MidCap Index Fund 20%
iShares MSCI EAFE Index Fund 20%
Direxion S&P 500 Monthly Bear 2.0x* 20%
*As of 9/30/2009, the investment objective of Direxion S&P 500 Monthly Bear 2.0x has changed from seeking daily investment results, before fees and expenses, of -250% of the price performance of its benchmark to seeking monthly investment results, before fees and expenses, of -200% of the price performance of its benchmark. The fund’s gross/net expense ratio is 1.90%/1.90%.The performance data quoted represents past performance through 12/31/10; past performance does not guarantee future results; the investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost; current performance may be lower or higher than the performance quoted. Please call 800-851-0511 to obtain current month-end performance information. For additional information, see the fund’s prospectus.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Different Investor Types
In the most basic sense, all investors can be divided into two
categories:
• Do-it-Yourselfers—Those who have a true passion
for the markets, have an interest in gaining a deep
understanding of the markets and the various
security types and why they behave the way they
do, and want to take the reins to make their own
investment decisions.
• Those Who Defer to Others—Those who put their
trust in an advisor, an asset management firm, a
prescribed portfolio model or investment strategy,
or perhaps some combination of all three.
The “Do-it-Yourselfers” have historically been much more
inclined to utilize tradable securities (ETFs, Leveraged ETFs,
options, futures, individual equities, etc.) to seek short-term
goals, and they have been much earlier adopters of alterna-
tive assets classes and strategies.
“Those Who Defer” have typically overwhelmingly favored
a “buy-and-hold,” long-only, traditional asset allocation ap-
proach with exposure to only stocks, bonds, and cash. How-
ever, recently that paradigm has begun to shift. More and
more, these investors, and the financial professionals who
advise them, have seen the need to incorporate alternatives
into their portfolios. Fortunately, this has become easier,
because, as mentioned above, many new alternative-strategy
mutual fund products have been introduced to the market
place, allowing these types of investors to maintain their buy-
and-hold approach while gaining exposure to the new funds
in which they are now interested.
Both types of investors should take good care to determine
if either strategy is suitable. Particularly, those who use
the tradable securities mentioned above must have a solid
understanding of the securities’ composition and expected
behavior and must plan to monitor them closely.
Retail Investors Are Embracing Sophisticated Alternative Strategies
Historically, alternative assets and strategies for risk
management were options for only those investors who
had access to the resources of the largest institutional
investment firms, such as Wilshire Associates, JPMorgan
Chase, or State Street Global Advisors. Recently,
however, access to these sophisticated—and highly
successful—strategies has expanded through a
convergence of traditional and alternative investment
products.
Why change is needed
If we’ve learned anything over the past decade, it’s this:
Investors face a new frontier in markets that are vastly
more sophisticated than could have been anticipated
by Markowitz in 1952. Today’s investors and financial
advisors need to make the most of every opportunity
in both “up” and “down” markets. Thankfully, today
there are more options than ever to amplify the benefits
of the (new) efficient frontier.
In fact, any advisor who is not offering solutions
for managing risk with un-correlated investment
strategies—ones that are transparent and liquid—may
be losing new assets to the competition. Within the past
few years, alternative asset classes and strategies gained
significant traction with Registered Investment Advisors
and high-net-worth investors through the introduction
of products that combine the use of sophisticated,
non-correlating strategies within buy and hold “40-Act”
(Investment Company Act of 1940) mutual funds offered
by institutional managers.
According to Strategic Insight, by the end of 2009,
investors held more than $110 billion in alternative
mutual funds in the U.S. and Europe, with the largest
flows going into long/short, market-neutral, commodity,
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
portfolios. The good news is that over the past several
years, many open-end mutual fund products have been
developed to help.
These so-called “Alternative Mutual Funds” have been
introduced into the marketplace to provide the broader
investing public with access to alternative asset classes
and institutional-style alternative strategies. These funds
are generally designed to accomplish three high-level
goals:
1. Provide diversification and additional sources of
returns with low correlation to traditional asset classes;
2. Offer access to short-term market opportunities; and
3. Provide tools to manage overall portfolio risk.
These funds come in many forms. Some are primarily
designed to simply provide access to alternative asset
classes, such as managed futures, real estate, or
currencies. Others are designed to implement alternative
strategies, while still others are design to do both—for
example, long/short management futures funds—such
as:
• Long/short or long/neutral strategies;
• Hedge fund replication;
• Absolute returns strategies; or
• Tactical asset allocation.
A growing number of investors have recently decided to
incorporate these funds into their portfolios in modest
proportions (perhaps 10% to 30%), because doing so
allows them a way to supplement their traditional asset
allocation strategies without having to change the way
they manage their portfolios from day to day, or month
to month. For this reason, alternative funds can be very
attractive to the group of investors described above as
“Those Who Defer to Others.” These investors prefer
to defer short-term investment decisions to a fund
manager or methodology of an alternative strategy fund,
and currency funds. These funds provide easy, cost-
effective access to sophisticated, institutional-style
investments, including trading expertise to help manage
risk and pursue growth.
Traditional institutional-only managers are applying their
expertise to these funds, providing the masses with
access to alternatives previously available only to the
largest and wealthiest investors. Whether investors and
advisors want to take an active “hands-on” approach,
trading futures, or leveraged tactical trading funds or
are interested in managed buy-and-hold funds that
offer exposure to alternative class assets and strategies,
they should at least consider the many new alternatives
for implementing the same strategies that today’s
institutions use to prosper in the new efficient frontier.
Alternative-Strategy Mutual Funds
At the end of 2009, many traditional buy-and-hold asset
allocation investors were very disappointed with their
portfolios’ returns over the decade. These investors
became frustrated with the markets, their portfolios,
and even their advisors—who had repeatedly told them
that buying and holding traditional asset classes in their
portfolios would, over the long run, eventually provide
their desired returns.
Now, with eyes wider open, many investors are looking
for other ways to build portfolios with which they can
feel more comfortable in various market conditions.
Many wise financial advisors are also looking for
additional options to both respond to their clients’
demands and to differentiate themselves from other
advisors who have not yet expanded beyond traditional
investment options. However, for both groups, old
habits die hard. These types of investors and advisors
have typically not been interested in drastically changing
their overall investment approach, nor the amount
of time and attention they devote to managing their
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
easier to adjust the portfolio for expected returns or
hedging risk. “In some of our asset classes, we have
a permanent long/short allocation,” he says. “We’re
looking for excess returns with the lowest risk possible.
We don’t usually exit our long or short positions, but we
do change our weightings, depending on the expected
returns. This provides more consistency.”
Gillespie reduces the risk in his portfolios by managing
for equity-like returns in low-correlating asset classes.
The result from more diversification: portfolios with
more efficient risk reward ratios. He uses a trend
following commodity mutual fund to make that
possible. “Capturing trends in commodities can double
the effect of the asset class,” he says, “making them
more like equities than bonds, without affecting the
correlation. It’s a huge breakthrough to have access to
these alternative strategy products that have formerly
only been available to institutions. We use these types of
funds to get exposure because they are transparent and
liquid. Most of our clients have private businesses; they
don’t need additional complications.”
Registered Investment Advisor
Gary Clemmons is a principal with Texas Capital
Management, a registered investment advisor in
Baytown, Texas. He’s been an independent advisor since
1986, and the majority of his clients are petrochemical
retirees. “My focus has always been to find clients and
to keep them,” he says. “So, I never bought into the
buy-and-hold philosophy. I figured my clients would
be happier if we avoided major market downturns, so
I became a tactical asset allocator, before I even knew
what it was called. The market charts used to come
in a big folder; we’d thumb through them looking for
patterns.”
Consequently, Texas Capital Management focuses
on creating client portfolios with non-traditional
instead of attempting to implement their own alternative
strategy using more hands-on, short-term trading
vehicles. Alternative funds are also typically designed
to provide more downside protection in volatile or
downward-trending markets, which is very attractive to
those who have struggled to deal with the recent hyper-
volatile environment.
Alternative-strategy mutual funds in action
The following testimonials provide examples of advisors
who have successfully incorporated alternative strategies
and funds into their clients’ portfolios.
Portfolio Manager for an Accounting and Advisory Firm
As Chief Investment Officer at Elliot Davis Investment
Advisors in Greenville, South Carolina, Allen Gillespie,
CFA, conducts research and chooses products for his
firm’s $800 million in client portfolios. Much of that
comes from high-net-worth accounting clients who
own their own businesses, and their associated 401(k)
s. Gillespie is quick to point out that he’s not trying to
predict the direction of the markets, but he is trying
to make the most out of what the markets offer.
“We’re an asset allocation practice looking for positive
expected returns in a broad range of asset classes, while
mitigating the risk,” he says. “But, we believe that a
long-only approach is doomed to under-perform. You
need to be on both sides of a trend to have the most
efficient portfolio possible.”
To get adequate diversification, he uses 25 or so asset
classes in his portfolios, including some alternative asset
classes such as commodities and merger/arbitrage.
With that many asset classes, he’s virtually assured of
low correlations that allow him to hedge any position
and reduce his risk exposure. He also uses long and
short mutual funds in many asset classes, making it
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
asset allocations, using actively managed funds and
ETFs. “The last thing you want to be is disruptive to
a portfolio manager, so we don’t move in and out of
managed funds very much,” he says. “But when you
have tradable index funds [ETFs], it gives you a greater
degree of freedom.” His portfolios include holdings in
the S&P 500, NASDAQ, and Wilshire indices, as well as
currencies, commodities, investment-grade-quality bonds
and even junk bonds (“I love ‘em,” he says).
As for investment strategy, “It’s important to go with
your gut feeling,” Gary says. “When you’ve been doing
something for a long time, you develop instincts. If you
listen to it, the market will tell you where it’s going. We
watch for trading patterns: When something’s different,
it puts you on guard. When corn prices start to rise, or
the federal budget goes out of control, or the dollar
continues to fall, these are all clues. How did I avoid the
dot.com crash? If you are willing to listen to the market
it will tell you a lot.” His typical position has about a
.4 beta (less than half the volatility of the S&P 500). “I
used to have a .11 beta, I found that clients are willing
to except a little more risk if you can deliver an above
average return,” he says.
He’d prefer to go to cash when a position looks poised
to go south, but not always. He also uses a tactical asset
allocation fund to take advantage of those opportunities.
For instance, he took a 25% short position in August
2008. As a result, his average portfolios were only down
about 5% while the S&P 500 was down 38%. Over the
past 10 years, his portfolios have an average annual net
return of 6.2%, while the S&P 500 has posted -3%. “I’m
not a gambler,” he says. “I have clients that go back to
the 1980s.”
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Tactical Trading Tools
“Do-it-Yourselfers” seek the assistance of alternative
strategy tactical investments for similar reasons—that is,
to find short-term market opportunities, to diversify their
portfolios, and to reduce portfolio risk—but they tend to
take a very different approach. They prefer to do their
own research, build their own strategies, and find their
own investment vehicles that will provide liquid, instant,
and exacting exposure to the asset classes and sectors
that their strategies require.
These “Do-It-Yourself” investors come in many different
forms, from the most sophisticated and well-funded
institutional traders to educated, self-directed individual
investors, and various other investment professionals in
between. (See the investor profiles below.) The types of
tools that these investors are most attracted to include:
• Individual equities (traded actively);
• Passive index ETFs;
• Futures, options and other derivatives; and
• Index-based leveraged and inverse mutual funds
and ETFs.
These instruments tend to be easily accessible to
investors and are generally both liquid and nimble,
making them practical trading tools for the execution of
short-term trading strategies. However, these investment
vehicles are not actively managed by a Portfolio Manager
to seek an investment objective (beyond seeking to
track a benchmark in the case of the ETFs and leveraged
index-based mutual funds). So investors who are using
these tools carry their own convictions about the
markets (both short- and long-term) and have their own
directional perspective on the respective asset classes
and sectors in which they choose to invest. They build
their own overall portfolio strategies and make their own
decisions as to how these investments fit together to
help them reach their objectives.
Leveraged funds
For actively trading retail investors, the most potentially
attractive of these strategies tends to be leveraged
funds: as actively traded individual stocks offer little
diversification; passive ETFs require more capital to get
the same level of exposure; and futures and options
require a margin account and are considerably more
complicated.
There are two kinds of funds that offer leveraged
investments: leveraged mutual funds and ETFs. Both
provide magnified exposure to a specific index in either
a positive fashion in the case of a bull fund, or in an
inverse fashion, in the case of a bear fund. Each dollar
invested provides 200%, -200%, 300% or -300%
of exposure to the performance of the benchmark,
which means 2 or 3 times the risk and volatility. Most
leveraged funds offer this magnified exposure on a daily
basis, meaning the funds’ net assets to market exposure
ratio is reset every day. It also means that the fund only
seeks to track its benchmark index at its stated leverage
point (2x, -2x, 3x, -3x) for a single day. It should not
be expected to track the benchmark index’s cumulative
return for periods greater than a day.
Some other mutual funds and Exchange-Traded Notes
(ETNs) do seek a monthly goal: They are designed to
track the benchmark index at a stated magnified rate
for a period of one calendar month. The net assets to
market exposure ratios are reset typically on the last
business day of each month.
Leveraged mutual funds
Today, the leveraged mutual fund business is largely
made up of active investors whose trading doesn’t
require intra-day access—such as a practice that focuses
on managing multiple client accounts and is trying to
apply an exact asset allocation across all client accounts.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
This is difficult to do using ETFs, because it is typically
not possible to trade partial shares. Also, some advisors
don’t want to expose their clients to the commission
costs of trading large volumes of ETFs. There’s also a
group that sees more value in a monthly fund rather
than one that resets daily.
Leveraged mutual fund advisor: Daniel Wiggins
Daniel Wiggins is a principal advisor with Black Label
Wealth Management in Durango, Colorado. He runs
depending on their goals and desire for taking risk:
• A conservative fixed income portfolio comprised of
85% long/cash High Yield and 15% long/short 10
Year U.S. Treasury funds;
• his Black Label Portfolio, made up of 20% long/
short S&P-500, 20% long/short Emerging Markets,
and 20% long/short 10 Year U.S. Treasury funds;
• Platinum Plus portfolio that invests in 100% long /
short Emerging Markets.
The holdings in all three funds are exclusively leveraged
mutual funds.
Wiggins uses what he calls a “multi-manager” system,
in which he purchases the signals (buy-sell-hold
recommendations) of 13 outside managers (some of
these “managers” are actually models, not real people)
who don’t know about the others. He then forms his
managers into two teams: the long-term team and
the short-term team, keeping some managers “on
the bench,” tracking them until their performance
demonstrates they should replace one of the first-team
managers. The consensus of the long-term sets his
predominant position every four to six weeks, while the
short-term team signals which of his long-term positions
to hedge temporarily.
“It’s not always good to be in the market,” he says.
“Leveraged index-based funds enable me to be nimble.”
Wiggins is only in the market about 65% of the time
and is “all in” only about 10% of the time. His goal:
portfolios that never give back more than 10% before
they recover. “Clients leave when you have a big draw-
down,” he says. “I only lost two clients in ’08.
“With leveraged funds, I can manage everybody’s
portfolio identically, commission free. And with no
redemption fees, I can be nimble to reduce or eliminate
losses,” he says. “I can also use 50% of my portfolio
to be 100% long. So the money I make on the money
market is automatic alpha.”
Leveraged ETFs
Institutional investors use many complex, sophisticated
tactics and investment products to implement the four
previously mentioned strategies: expanding to additional
asset classes, going short, hedging, and using leverage.
Many of those tactics are beyond the expertise and
resources of traditionally oriented retail advisors and
investors. To make these strategies available to the retail
and advisory markets in a manageable form and at a
reasonable cost, some companies have combined the
growing popularity of ETFs with a leverage component,
creating a new investment vehicle commonly known as
leveraged ETFs.
Historically, most of the investors who traded leveraged
mutual funds (before leveraged ETFs existed) were
active traders. Many of them flocked to leveraged ETFs
when they first launched, because they liked the added
flexibility of intra-day trading. ETFs are thought of more
as equities than they are funds, and their initial growth
really came from equity (and derivative) traders, not from
mutual fund users deciding they would rather use an
ETF. Many equity traders jumped on board soon after
the leveraged ETF came out, because they like the more
3 model portfolios for his retail and sub-advising clients,
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
broadly diversified equity that had built-in extra leverage,
with no need for a margin account. Today, the leveraged
ETF industry has grown dramatically, primarily within the
active trading world (and mainly with those who have
historically been equity trader types), while the leveraged
mutual fund world is much smaller—mostly for those
looking for exacting allocation percentages without
commissions.
Like traditional ETFs, leveraged ETFs use a currently
available index to provide asset class exposure (e.g., the
Russell Midcap® Index or the MSCI Emerging Markets
Index). Then, the leveraged ETF managers use futures,
swaps, options, or other derivative contracts to either
increase the exposure to that index (in the case of a bull
leveraged ETF) or increase inverse exposure to the index
(in the case of a bear leveraged ETF), by a factor of 2x or
3x the index. That’s the key to leveraged ETFs: because
investors are buying a fund (as opposed to individual
securities on margin) that uses derivatives to magnify its
exposure to an index’s gains or losses (by 2x or 3x), the
investor’s potential loss is never more than the amount
of their initial investment. In this way, investors get 2x
or 3x the investment exposure without putting up 2 or
3 times the investment capital, or borrowing funds that
would ultimately have to be paid back.
Although leveraged ETFs share some similarities with
non-leveraged ETFs, there are two key concepts that
impact the way they are managed and the way they
perform:
• Leverage: In the case of a 3x fund, each
dollar invested provides $3 of exposure to the
performance of the benchmark, which means
300% of the risk and volatility.
• Daily investment objectives: The funds seek to
magnify the returns of their benchmarks on a daily
basis. Returns for longer periods are a product of
the daily leveraged returns during the period.
The following are a few examples of advisors and
investors that use Leveraged and inverse Leveraged ETFs
as a part of a well-diversified investment strategy.
Leveraged ETFs in action: Todd Bessey
Financial advisor Todd Bessey is a 15 year advisor, who
for the past seven years, has been working with affluent
clients at Wintrust Wealth Management in Algonquin,
IL, about 50 miles northwest of Chicago. By the end
of 2008, many of his moderate to aggressive risk client
portfolios had started to decline after several good years,
and he needed to find a way to add some value in a very
volatile market.
His had been looking at using leveraged energy ETFs
as a way to create some short term profits. He started
moving a select group of his clients into 20-30% cash,
and then began taking positions with 300% long funds.
That way, he could put the cash to work, generating
some alpha, and still get as much exposure as each
client wanted. Before long, he slowly expanded his new
strategy into technology, real estate, treasuries, and
emerging markets.
His strategy works like this: When he sees a trend he’s
comfortable with, he’ll pick an entry point, and then
gradually buy long leveraged ETFs in that market until
the market turns around, and then he gradually sells out.
It’s his own updated version of dollar-cost averaging;
adding a little value to the buy-and-hold approach. His
current clients who like his new strategy have referred
others, and now Bessey has about 30 clients in it. “We
only offer this strategy to clients who understand it,” he
says, “and whose risk profile it fits.”
It’s an approach that seems to be working. SSo far, he’s
closed out about 500 trades on ERX (300% energy bull
leveraged ETF) from January of 2009 through December
of 2011, and has made money on 87% of them.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
“Everybody that’s been in our new strategy has been
very happy,” says Bessey. “Across our clients that have
participated, the average trade has generated a 13%
profit. In most cases, we are still holding another 10-
20% in cash reserve, so the clients had lower risk.”
Leveraged ETFs in action: Paul Ingersoll
Paul Ingersoll and his partners formed Good Harbor
Financial in Chicago in May 2003. Initially, they
conducted extensive research looking for an alternative
to the traditional buy-and-hold asset allocation strategy.
They concluded that asset prices aren’t driven by
projected cash flows, as many investors think: “We
believe that most changes in valuations come from
changes in the discount rate of those projected returns,”
Ingersoll says. “That risk premium changes over time.”
Consequently, the folks at Good Harbor spend their time
looking for leading indicators of where that discount rate
might go, and then adjusting their portfolios accordingly:
Their focus is primarily on economic data, changes in
interest rates, and the U.S. Treasury yield curve. They are
looking into the future a month, or two months at the
most.
Their research also revealed that a portfolio using
leverage would consistently outperform a static buy-
and-hold strategy with lower volatility (risk). In fact,
they found that the past 40 years of data shows the
optimal portfolio leverage to be 1.3 times. “If an investor
is comfortable with S&P risk,” he says, “then we can
generate more alpha.” To get that level of leverage,
they use separately managed client accounts that hold
a combination of leveraged and un-leveraged ETFs in
just the right proportions. “We couldn’t do what we do
without leveraged ETFs,” says Ingersoll. “We know what
we want, and ETFs work the way we expect.”
Their portfolios are tactical, based on their projections
of where the discount rates are going. They monitor
asset values on a day-to-day basis, but rebalance their
portfolios monthly. “We make big moves: 100% in
equities to 100% in fixed income,” he says. “The goal
of our strategy is to stay out of long, extended declines.
But how often do you react to data? Day-to-day has too
much noise, but if you wait too long, you miss good
information.”
Good Harbor Financial seems to have figured that out,
too. Their 5-year annualized returns are 13.9% vs.
0.25% for the S&P 500 Index. And since their inception
in May 2003, their portfolios are up 229.1% versus
the S&P’s 63.3%. “Recent markets have certainly
showcased our model,” says Ingersoll. “If we had tried
to market our story in 2006, we would have gotten
no attention. Our clients can opt out of our leveraged
portfolios, but investor’s rarely do.”
A Self-Directed Investor
A self-directed investor who works for a large financial
services company and prefers to remain anonymous has
been in the industry for nearly 15 years, spending some
of that time on a trading desk. Due to his experience and
market knowledge, he trades aggressively in his own
accounts. His strategy is primarily technical; watching
21-day, 63-day, and 120-day moving averages on the
sectors he follows. He uses leveraged ETFs and equities
to capture the opportunities he sees. “I like to keep
it simple and take the emotion out of investing,” he
explains. “I’m looking for convergences between the
moving averages, and tend to hold onto positions for
two or three months. During very volatile periods, such
as June through September of 2010, I’ll just hold the
position and have a stop limit.” His charts are always
running on his Thomson Reuters and Bloomberg feeds.
“I look at the charting every day,” he says. “And, when
they start to converge, I’ll get an alert in my email.”
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
He invests in some equities directly, but usually 65%
to 70% of his portfolio is in 3x leveraged ETFs: “I
want to capture the most profit,” he says. “I like the
diversification and the leverage. You never have to
worry about a margin call: Just sell, and you’re out.
And you can’t beat the expense ratios.” He uses large-
cap bull and bear funds, bull and bear energy and
financial funds, and a daily 7 to 10 Treasury bear fund.
“Sometimes I’m not even focused on which fund it is,”
he admits, “but when the moving averages on a given
symbol start to converge, then I make my move.”
High-Frequency Traders
There are some investment companies that are involved
in so-called high-volume trading activities. These
organizations—sometimes categorized as “high-
frequency traders”—make markets by trading both the
buy and the sell side of ETFs. These firms seek to profit
on their ability to identify and collapse any dislocations
in the premiums or discounts between the fair value of a
fund (based on the value of the underlying constituents
of the fund’s index) and the price of the fund’s shares
trading on the exchange.
What’s less understood is that these market makers
are not interested in exposing themselves to significant
market risk. They almost always offset a trade in one
direction with a hedge in the other. As market makers
seek to hedge their risk, they often trade the underlying
securities that make up an ETF’s index or other highly
correlated securities, such as futures and other ETFs.
For example, if a trader tried to buy $5 million dollars of
a 10-Year Treasury ETF and the market maker filled that
order without the existence of a corresponding seller,
the market maker would be short the 10-Year ETF. To
offset this short position, market makers typically buy
equal amounts of the underlying securities (10-Year
notes in this example) to hedge their position. If they
can easily buy those Treasury notes in the open market,
without impacting their underlying price, they will
minimize their market risk (offsetting short position in
the ETF, and long position in the underlying Treasuries).
To recap, the easier it is for a market maker to access
these underlying securities, the easier it will be for them
to hedge their short position, and the easier it will be for
them to facilitate liquidity in the secondary market. The
above example should illustrate that even if the trading
volume of an ETF is relatively low, an ETF may still be
liquid, as long as the underlying securities in the ETF can
be easily accessed as a hedge.
Their speed, and ability to hedge their risk, will ultimately
determine how tight they can keep the bid/ask spread.
Tight bid/ask spreads reduce the implicit cost of trading
and therefore improve liquidity in the ETF, which is
a benefit to all who trade it. The peripheral benefit
is an increase in liquidity across several securities.
Consequently, these market makers serve the dual
purpose of maintaining fair bid/ask spreads, while
ensuring that the ETF shares trade at or near to fair
value—the fund’s NAV. Thus, they play a crucial role in
the health of the markets for all ETFs.
High-frequency trader profile
One high-frequency trader who preferred to remain
anonymous works on the ETF trading desk of a large
hedge fund and asset management company. Part of
his job is to manage the volatility of the products his
firm and its investors are trading relative to their bid/
ask spread. He uses leveraged products, including
leverage ETFs, to help him do that. “We try to make
money on the spreads,” he says. “Leverage increases
our opportunity to do that. Leverage also enables us to
hold down our costs, to do it more cheaply than a typical
one-beta product.”
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
He also uses leveraged ETFs to help the firm’s clients
manage their portfolios. For instance, he uses them as
hedges on options positions: “Leveraged ETFs can be
cheaper than taking out an offsetting option; we’re
getting built-in financing.” Clients who are sector
rotating often want to get some additional sector
exposure, but they don’t want to sell out of what they
are already holding. “They can sell a portion of what
they currently hold,” he says, “and they use a leveraged
ETF to get the additional exposure they want.”
His firm’s asset managers also tend (sometimes
exclusively) to use a high percentage of leveraged
products in order to get more exposure in their portfolios
for less capital or to overcome rules they encounter
against shorting in certain situations. “They can usually
buy leveraged ETFs in these instances,” he says.
The trader also says that leveraged ETFs have improved
the markets he works in overall. “Leveraged ETFs have
added a new investment avenue, which reduces spreads
on cash and even on the tighter futures. Cash is a dollar
wide, futures are 10 cents wide. Now that we have more
points to trade on, there is more liquidity, which means
the betas will be tighter as well.”
Suitability
These user profiles illustrate clearly that there are several and varying uses for leveraged and inverse ETFs, but they are
certainly not for all investors. Investors who are considering using the funds should assess whether there is a reasonable
fit. The funds may generally be seen as a good choice for sophisticated, hands-on investors with:
• the willingness to accept substantial losses in short periods of time;
• an understanding of the unique nature and performance characteristics of funds which seek leveraged daily
investment results; and
• the time and attention to manage positions frequently to respond to changing market conditions and fund
performance.
Conversely, these strategies are probably not for investors who:
• cannot tolerate substantial or even complete losses in short periods of time,
• are unfamiliar with the unique nature and performance characteristics of funds which seek leveraged daily
investment results, and
• are unable to manage their portfolio actively and make changes as market conditions and fund performance dictate.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
The Effects of Daily Rebalancing: The Key to Using Leveraged ETFs Effectively
In pursuit of their daily investment objectives (either 2x
or 3x a given index), leveraged ETFs must rebalance their
assets to the given exposure ratio on a daily basis. This
means that their returns, over time, are the product of a
series of daily returns, and not the fund’s beta multiplied
by the cumulative return of the index for periods greater
than a day. This variation in performance is commonly
referred to as compounding. The example below
illustrates that high volatility causes decay of long-term
returns for the funds, while sustained market trends can
result in positive effects on returns.
The Bottom Line: Monitor and Act When Necessary
Daily rebalancing funds are not meant to be held,
un-monitored, for long periods. If you intend to hold
leveraged ETFs for periods greater than a day, you must
always watch them closely, especially:
• during highly volatile periods for a fund’s
benchmark index, in which case you will need to
adjust your positions frequently if your goal is to
maintain constant exposure levels; and
• during periods of lower volatility for the benchmark
index, you should continue to monitor, but position
adjustments will likely be needed less frequently.
Leveraged ETF Myths
Despite the recent devastating market performance to
the contrary, more than a few investors—and financial
advisors—still believe that buy and hold is the only way
to manage investment portfolios. However, as we have
seen, many investment professionals, both institutional
and otherwise, have proven this untrue. Because markets
are not always efficient (hidden opportunities exist that
perform very differently than the broader markets),
smart investors take the time to find short- and medium-
term market trends and capitalize on them in ways
that those who only subscribe to long-term strategic
asset allocation methods repeatedly miss. Yet, because
leveraged ETFs were created to allow people to take
advantage of short-term opportunities, those who don’t
believe in these types of strategies would naturally not
understand their role, and therefore their advantages.
Consequently, due to the complexities of leveraged
ETFs—particularly the fact that they are rebalanced daily
(unlike traditional mutual funds or ETFs) and can either
benefit or suffer from the cumulative compounding
of an index’s gains or losses—there are many
misconceptions regarding these investment vehicles.
Here are some of the major misconceptions, along with
the facts.
Myth #1
The Funds Don’t Work: Shareholders are
disappointed because leveraged ETFs do not
provide returns through time, which are equal to
the fund’s target beta (200%, 300%, -200%, -300%)
times the cumulative return of the index.
While it is true that the funds do not necessarily provide
a return consistent with the cumulative return of the
index times the fund’s target multiple, this does not
mean that the funds don’t work. In fact, they have,
DayIndex Value
Index Daily Return
Index Cum. Return
Index Cum. Return 3x
3x Fund Daily Expected Return
Fund NAV
Actual Cum. Return
100 $20.00
1 95 -5.00% -5.00% -15.00% -15.00% $17.00 -15.00%
2 100 5.26% 0.00% 0.00% 15.78% $19.68 -1.60%
3 105 5.00% 5.00% 15.00% 15.00% $22.63 13.15%
4 100 -4.76% 0.00% 0.00% -14.28% $19.40 -3.00%
5 95 -5.00% -5.00% -15.00% -15.00% $16.49 -17.55%
6 100 5.26% 0.00% 0.00% 15.78% $19.09 -4.50%
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
at times, achieved their goals on a daily basis. Each
of the current leveraged index-based ETFs has a daily
investment objective, which means that the expected
returns for periods longer than a day is not the
product of: (a) the return of the benchmark for the
relevant period; or (b) the stated degree of the Fund’s
magnification.
In other words, if the Russell 1000® Index gains 5%
in a given month, an investor should not expect the
Direxion Large Cap Bull 3x Shares to gain 15% or the
Large Cap Bear 3x Shares to decline by 15% in that
same month. The returns of the funds for such longer
periods combine the product of the daily returns within
the period and the compounding that occurs over the
period because of the daily rebalancing, so it is therefore
dependent not only on the path of the underlying index
during the same period, but on the daily movements and
rebalances, which can therefore result in either more
or less than the cumulative return of the index for the
period.
The tremendous volumes of the leveraged ETFs, relative
to their shares outstanding, indicate that holding periods
are very short, meaning that the vast majority of users
are not confused about how the funds function or
should be used.
Daily leveraged funds have limited goals and functions,
but they can function as intended. These funds have
become extremely popular and are an invaluable
resource for any number of investors who manage their
portfolios actively and reject the long-only, buy-and-
hold investment strategies still touted by much of the
investment community.
Myth #2
Inverse (bear) ETFs cause downward pressure on
the markets.
People who make this argument sometimes sound as
though they would like to see an outright prohibition on
shorting. Perhaps this is not the case. As a fundamental
matter, it’s hard to understand the notion that shorting
harms the markets.
Healthy markets are designed to discover the proper
price levels for whatever is being traded. Most people
recognize that permitting short selling simply adds
robustness to price discovery. Those in favor of banning
shorts entirely are trying to manage the market higher
by silencing one side of the argument. This is generally
self-defeating and harmful in anything but the very short
term.
The recent housing bubble was caused at least in part
because it is so difficult to short housing. This illustrates
the danger of one-way markets.
While it would seem logical to believe that markets are
most efficient if they are two-way, and that shorting
should be permitted, it is also important to support the
belief of those who feel that market manipulation—
“Bear Raids”—should be stopped and that the
practitioners should be uncovered. At this time it is
unknown how extensively “Bear Raids” by hedge funds
have occurred, but the sponsors of leveraged ETFs are
usually market-agnostic and would generally try to point
out that the use of an index product to conduct a “Bear
Raid” on an individual name would be very inefficient.
Myth #3
Leveraged ETFs allow people to get around margin
rules.
This criticism seems to imply that margin rules were
designed to protect investors by limiting the risk profile
of their holdings. This is not the case at all. There are
two separate margin rules: 1) limits on borrowing in
taxable accounts; and 2) prohibitions on borrowing and
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
shorting in tax-exempt accounts. The rules that apply
to taxable accounts were put in place to protect banks
and brokers from the loss of their clients. They were not
designed as investor protection rules.
Leveraged ETFs are risky, as is noted in all the literature.
However, they do not pose risks to the brokerage
firms because an investor cannot lose more than their
initial investment. The margin rules that apply to tax-
exempt accounts were put in place primarily to prevent
fiduciaries from engaging in transactions with implicit
conflicts of interest with accounts over which they have
fiduciary authority. The rules essentially prohibit certain
behavior between the fiduciary and the account holder.
The use of leveraged ETFs essentially prohibits certain
behavior between the fiduciary and the account holder.
The argument against the funds based on evasion of
margin rules imbues the margin rules with an intent that
is simply not there.
Myth #4
Leveraged ETFs exacerbate market volatility at the
end of the trading day.
At the end of the day, leveraged ETFs are market
participants that serve to: (a) respond to creations/
redemptions; and (b) to rebalance in light of market
movements. The first activity has no material impact
on the market at or near the close, while the second
activity might essentially prohibit certain behavior
between a fiduciary and the account holder. The use
of unaffiliated leveraged ETFs does not implicate those
concerns either.
Creations and Redemptions: When there is natural
demand for an ETF, the market maker sells more shares
of the ETF than he has in inventory and builds a short
position in the ETF. Concurrently, the market maker
creates a hedge by, for example, buying a basket of the
index’s underlying securities with the equal notional
value to assure that the short position will have limited
economic impact on the market maker. At the end of
the day, the market maker goes to the ETF sponsor and
buys ETF shares through the creation process to cover
his short position in the ETF. At the close, the sponsor
spends that money to create the required number of
ETFs and the market maker unwinds his hedge since he
will receive the ETFs at that night’s closing price. These
two transactions are offsetting, and have no net impact
on the markets. (In the one beta [non-leveraged], in-
kind ETF world, the market maker delivers the hedge—
the basket of underlying equities—to the sponsor,
which makes the lack of market impact perfectly clear.)
Daily Rebalancing: The trading activities related to
rebalancing leveraged funds can theoretically have an
impact on the markets because bull and bear funds
rebalance in the same direction and in a direction
consistent with the daily movement of their benchmark.
For example, when the benchmark rises, the bull fund
assets rise and the bull fund buys to increase exposure,
while bear fund assets decline and the bear fund buys
to decrease short exposure. Conversely, when the
benchmark declines, the bull fund assets decline and
bull fund sells to decrease long exposure, while the
bear fund assets rise and bear fund sells to increase
short exposure. Theoretically, it is possible that this
rebalancing activity impacts the markets in the last
hour or half-hour of the day. Practically, at this point,
the trading volume attributed to leveraged ETFs in the
last half-hour of the trading day is small relative to the
overall markets and so it seems unlikely. (Credit Suisse’s
Victor Lin cited this in his recent paper “Leveraged ETF
Rebalancing in Perspective” from August 2011.)
More importantly, however, rebalancing activity is very
transparent. The net asset value and number of shares
outstanding of each ETF is public information. Market
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
participants know exactly what an ETF needs to do each
day given market movements and such participants can,
and do, try to arbitrage these trades, just like they do for
other events about which they have forewarning, like
index rebalances, Market on Close (MOC) imbalances,
forced asset allocation rebalances, etc. The fact that
arbitrage is occurring seems to be borne out by the facts.
If you believe that the leveraged ETFs have an impact
on the market, you would expect the market direction
after 3:00 p.m. Eastern Time to confirm the direction
until 3:00 p.m. (You would expect a declining market to
get worse as the leveraged index funds sell into it and
a rising market to get even more carried away as the
leveraged index funds buy in response to market gains.)
However, there is no empirical evidence that the market
is following through any more than 50% to 60% of the
time, depending on the particular index. If the funds
are big enough to have an impact, that impact seems to
have been understood and internalized by the markets.
Conclusion
Today, more than ever, it’s essential for retail investors
and financial advisors to fully understand the investment
vehicles in their portfolios. While more and more
financial professionals and industry analysts these days
are touting the virtues of alternative investments, not
all types are created equal. Risk parameters can differ,
time horizons can vary, and in the case of leveraged
ETFs, daily rebalancing can change the effects of
compounding. Some alternative investment vehicles
require active monitoring and management, while others
employ a managed strategy that provides buy-and-hold
investors access to the category. Misunderstandings
about these investments, particularly leveraged ETFs,
have led to many myths in the media and popular
culture. To set the record straight:
• Leveraged ETFs are designed to meet daily
investment objectives (based on a multiple of the
underlying index), not to provide compounding of
returns beyond one day (as is commonly the case in
buy-and-hold investing);
• Most alternative investment vehicles, particularly
those involving leverage, actually help to identify
market inefficiencies more quickly and therefore
increase market efficiency;
• Leveraged ETFs actually provide a valuable benefit
by allowing investors the ability to take short
positions without having to be subjected to losses
greater than their principal investments, as is the
case with margin accounts; and
• There is no evidence that leveraged ETFs change
the market directions when they rebalance their
positions after 3:00 p.m. on trading days.
The bottom line is that, like Mary Shelly’s Frankenstein
monster, because alternative investments and leveraged
ETFs are different from traditional investment vehicles,
they are widely misunderstood and criticized, while the
truth is that they are beneficial, both to their investors
and to the markets as a whole. For investors and
advisors who use today’s alternative investment products
as they are intended, the effects on their portfolios can
be quite dramatic. The additional asset classes they
offer (including commodities, currencies, and debt),
along with short positions, hedging, and leverage, are
all tools that sophisticated investors have used very
effectively for many years. The difference is that now, for
retail investors and most financial advisors, there are a
number of vehicles that offer access to these strategies,
including alternative mutual funds, passive ETFs, futures
and options, and index leveraged and inverse-leveraged
mutual funds and ETFs—and a growing number of retail
investors and investment advisors are using them.
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A new perspective on investing
Financial advisors have been preaching the
commandments of diversification and asset allocation to
their clients for decades. Today, in hindsight, reality may
cause many to consider a more active solution. The fact
is that investment markets have changed—experiencing
higher volatility, especially during certain periods, and
increased correlation levels across asset classes. This was
especially evident over the past 10 years, the so-called
Lost Decade, which ended with the Market Meltdown.
Those who benefited over the decade were those who
used investment vehicles that sought returns from short-
term market trends. Institutional investors and hedge
funds have been utilizing these strategies with a high
degree of success for several decades.
Thanks to several innovative product developments in
recent years in the “40 Act” mutual fund and ETF space,
today’s investors—and financial advisors—have increased
access to similar strategies. Although we are in the
early stages of this product democratization, broader
access to these sophisticated strategies has proven to be
very beneficial to the broader investment community,
particularly for those investors who realize the limitations
of the “buy-and-hold” approach in today’s challenging
investment environment.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Glossary of Terms:
Beta
A measure of the systematic variability of a security or a portfolio in relation to a target index. A beta of more than 1.00
indicates that the security or portfolio would have higher volatility than the index; a beta of less than 1.00 indicates lower
volatility.
Alternative Investment
An investment that is not one of the three traditional asset types (stocks, bonds and cash). Most alternative investment assets
are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regula-
tions and relative lack of liquidity. Alternative investments include hedge funds, managed futures, real estate, commodities
and derivatives contracts.
Asset AllocationAn investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s
goals, risk tolerance and investment horizon.
Derivative
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a
contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common
underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are
characterized by high leverage.
Leverage
The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
Hedge
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an
offsetting position in a related security, such as a futures contract.
Absolute Return
The return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation (ex-
pressed as a percentage) that an asset - usually a stock or a mutual fund - achieves over a given period of time.
Long/Short Strategy
A hedge fund strategy that involves buying certain stocks long and selling others short. There usually isn’t a restriction on the
country that the stocks trade in either.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Currencies
A generally accepted form of money, including coins and paper notes, which is issued by a government and circulated within
an economy. Used as a medium of exchange for goods and services, currency is the basis of trade.
Commodities
Seeks to achieve capital appreciation through investment in various commodities, such as energy, livestock, metals, and other
commodities.
REITs
A security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mort-
gages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of
investing in real estate.
Correlation
In the world of finance, a statistical measure of how two securities move in relation to each other. Correlations are used in
advanced portfolio management.
Sub-prime Meltdown
A financial crisis that arose in the mortgage market after a sharp increase in mortgage foreclosures, mainly subprime, col-
lapsed numerous mortgage lenders and hedge funds.
Volatility
A statistical measure of the dispersion of returns for a given security or market index.
Managed Futures
Seeks to capitalize on market trends through investment in a variety of futures and options contracts.
Compounding
The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other
words, compounding refers to generating earnings from previous earnings.
Risk Management
The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Es-
sentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for
losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance.
Inadequate risk management can result in severe consequences for companies as well as individuals.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
S&P 500
An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to
be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
The S&P GSCI
A composite index of commodity sector returns which represents a broadly diversified, unleveraged, long-only position in
commodity futures. The S&P indexes are trademarks of Standard and Poor’s, a division of the McGraw Hill Companies, Inc.
The Russell 2000
An index measuring the performance of the 2,000 smallest companies in the Russell 3000 Index, which is made up of 3,000 of
the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small cap stocks in the United States. The Russell Indexes
noted herein are trademarks of Russell Investments. These funds are not sponsored, endorsed, sold or promoted by Russell
Investments and Russell Investments makes no representation regarding the advisability of investing in the funds.
MSCI EAFE
An index created by Morgan Stanley Capital International (MSCI) that serves as a benchmark of the performance in major
international equity markets as represented by 21 major MSCI indexes from Europe, Australia and Southeast Asia. This
international index has been in existence for more than 30 years.
MSCI EM
An index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in
global emerging markets. MSCI indexes are the exclusive property of MSCI and its affiliates. All rights reserved. Indexes are
unmanaged and cannot be invested in directly.
The DJIA
A price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The DJ-UBS
Commodity is composed of futures contracts on physical commodities.
The CTI and FXTI
Long/Short Indices of commodities and financial futures.
The BarCap US Aggregate Bond Index
An index used by bond funds as a benchmark to measure their relative performance.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Standard Deviation
In Finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility.
Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatil-
ity.
Alpha
A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its
risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index
is a fund’s alpha.
FTSE 100
The FTSE is similar to Standard & Poor’s in the United States. They are best known for the FTSE 100, an index of blue-chip
stocks on the London Stock Exchange.
NASDAQ 100 Index
An index composed of the 100 largest, most actively traded U.S companies listed on the Nasdaq stock exchange. This index
includes companies from a broad range of industries with the exception of those that operate in the financial industry, such
as banks and investment companies.
Volatility
A statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by
using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the
volatility, the riskier the security.
Arbitrage
The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by
exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage
exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value
for long periods of time.
Futures
Financial contracts obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a
financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underly-
ing asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical deliv-
ery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage
relative to stock markets.
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The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.
Options
Financial derivatives that represents a contract sold by one party (option writer) to another party (option holder). The contract
offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon
price (the strike price) during a certain period of time or on a specific date (exercise date).
Derivative
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a con-
tract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underly-
ing assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized
by high leverage.
Drawdown
The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually
quoted as the percentage between the peak and the trough.
Swap
Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or
because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps.
Dollar Cost Averaging
The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price.
More shares are purchased when prices are low, and fewer shares are bought when prices are high.
Merger
The combining of two or more companies, generally by offering the stockholders of one company securities in the acquiring
company in exchange for the surrender of their stock.