The Right Way to Look at Risk and Reward

Last week, Felix Salmon commented on a story that appeared on WSJ about a GM bondholder. He makes a very keen observation on risk and reward in that post.

If you invest a large chunk of your 401(k) in the stock of just one company, your actions are fraught with peril. If that stock performs badly — which is always possible — then you could end up with a significantly diminished standard of living in retirement. But at least there’s a possible upside: if the stock does spectacularly well, you can end up in clover.

By contrast, there’s no reason whatsoever to invest a large chunk of your 401(k) in the bonds of just one company. You still have the same downside — the company can default on its debt — but there’s no upside at all: the best-case scenario is just that you muddle through getting your coupon payments until the bonds mature.

Interesting Reads: May 30th 2009

Here is a list of some interesting things that I read during the week.


Why GM Is Not Zero

A few days ago, I wrote about the GM bankruptcy and how the stock was worth nothing. Today the stock is still trading at 75 cents and I found out something very interesting about this.

From Barrons:

The mystery is that it isn’t trading at zero. That’s what the common is worth. Goosegg. Nadda. Zip. Zilch. Nothing.

So why’s it holding above 78 cents?

It’s still in indexes. It’s still in the S&P 500. And will be so until Standard & Poor’s reacts to the bankruptcy filing and replaces the stock with that of a viable company.

And until then, index funds have to own the stock.

Some of the biggest remaining shareholders are State Street, Vanguard and Barclays. Basically, the indexers.

So even if the Index funds don’t want to own it because the stock is worthless, they have no other option but to own it because it is part of the index they track. Very interesting.

What is Credit Card Insurance

Image by Wheat_In_Your_Hair

Yesterday, a friend noticed that he was getting charged $4 every month for credit card insurance. When he called them up to find out what it was, they said that it’s a type of insurance that protects him from a credit card default due to any emergency.

He got that canceled and though the concept itself is good, the umpteen riders render it useless. If you are considering credit card insurance then you need to think about a few things first.

1. When will the coverage trigger? You can’t simply stop paying your credit card bill and expect that the credit card insurance will cover it. Normally, the coverage kicks in, if you face death, disability, unemployment or other such emergencies. Find out what conditions will trigger the coverage.

2. What will not be covered? You need to ask questions about things that will not be covered. Things like, if you are unemployed at the time of getting this insurance, will you still be eligible for unemployment coverage. Many of these things will be specific to your situation and until you ask, you will not know whether it is covered or not.

3. How much will it cover? This is probably the most critical point. While in a lot of cases your full outstanding balance will be paid, sometimes this is not so. In some cases, your credit card insurance will only ensure that if you default, they pay the minimum balance for six months and after that – you are on your own. As you can well imagine, this is pretty useless. You need to specifically check, if this is the coverage you are getting.

4. When will the free coverage end? In a lot of cases, credit card insurance will be offered free for a few months and if you don’t decline coverage in those few months, you will be automatically enrolled for it. You need to find out how many months you get free, and how easily can you cancel the coverage.

I think these are some important point that you should consider before taking credit card insurance. Do you have anything to add to this list?

What Is An Inverse ETF?

Inverse ETFs are a class of ETFs that rises in value when their underlying asset falls. For example, the ProShares Short QQQ ETF (whose underlying asset is the NASDAQ) will rise, if the NASDAQ falls. So, if you expect companies in the NASDAQ to perform poorly, you could buy the ProShares Short QQQ. Recently, Inverse ETFs are gaining in popularity because the overall sentiment of the market is bearish, and everything seems to be going down (except the unemployment numbers).

Types of Inverse ETFs

Although Inverse ETFs are a relatively new phenomenon, there are already many Inverse ETFs that cover almost all major indices and sectors. This means you can pick a class that you are bearish on, and buy an appropriate Inverse ETF. For example, if I think that the financial sector is doomed, and I want to go short on the whole sector, I can buy the ProShares UltraShort Financials ETF, which bets against the Dow Jones U.S. Financial Index.

Similarly, there are other ETFs that short the Consumer Services Sector, Industrial Sector, Technology Sector, Oil and Gas Sector and also other classes like Emerging Markets, etc.  You name it, they have it.

Inverse ETFs Can Be Leveraged

Thanks to Lehman, leverage is no longer a financial jargon, but has entered the lexicon of the common man. Many Inverse ETFs are leveraged and aim to return twice or thrice the fall in the index value. For example, ProShares UltraShort Financials ETF gains 10%, if the underlying Dow Jones Financials index falls by 5%. The ETF will gain twice the amount that the index falls, and vice versa.

One way of doing this is by employing leverage.  However, this is quite dangerous because the risk of counter party default is very high in today’s economy. And there’s also a bigger risk with leverage when combined with another phenomenon known as Daily Returns.

Inverse ETFs Seek Daily Returns

Daily Returns mean that the fund value at the end of each day becomes the base value of the next day. Suppose, you invest in an UltraShort Inverse ETF, which aims to return twice the fall of the underlying index, a hypothetical situation can look something like this:

Day Index Inverse ETF
1 100 100
2 95 (down 5%) 110 (up 10%)
3 100 (up 5.26%) 98.42 (down 5.26 x 2 = 10.52%)

Basically, the index didn’t move at all after three days, but you lost money! I have taken an example in which the ETF loses money (just to drive home the point), but you can make money with zero change in the underlying index in a given period as well.

Inverse ETFs Are Not Meant for Hedging

Be wary of using leveraged Inverse ETFs to hedge your position, because leveraged ETFs are not good for hedging as explained above.

Inverse ETFs Are Ideal for Short Term Trading

Inverse ETFs are best for short-term trading, if you have a bearish view on a particular segment in the market.

Some other benefits of Inverse ETFs:

  1. You can short the index, but are exposed to only the amount you invested in the ETF.
  2. You don’t need a margin account, which is normally needed to short.
  3. You don’t need to buy fancy options in order to take a bearish view of the market.
  4. You can take advantage of the volatility of the market.
  5. You can buy a leveraged Inverse ETF, and increase your odds of a large profit with a small loss.

Bottom line

If you have a bearish view of the market, and want to trade short-term this product is good for you.  However, if you shun volatility or if you are more of a long-term investor, then you should not dabble in this product.

This post originally appeared on Moolanomy

Banks Want to Buy Their Own Assets With Taxpayer Money

From the WSJ:

Some banks are prodding the government to let them use public money to help buy troubled assets from the banks themselves.

Banking trade groups are lobbying the Federal Deposit Insurance Corp. for permission to bid on the same assets that the banks would put up for sale as part of the government’s Public Private Investment Program.

James Kwak has an excellent post on this topic. (Warning: While this post will make you wiser, it will also make you very grumpy)

I thought the headline had to be a mistake until I read the article.

To recap: The Public-Private Investment Program provides subsidies to private investors to encourage them to buy legacy loans from banks. The goal is to encourage buyers to bid more than they are currently willing to pay, and hopefully close the gap with the prices at which the banks are willing to sell.

Allowing banks to buy their own assets under the PPIP is a terrible idea. In short, it allows a bank to sell half of its toxic loans to Treasury – at a price set by the bank. I’ll take this in steps.

The Lopsided Credit Card Model

Image by Sumanth Garakarajula

Every time I travel by Delta I get some air miles, which is a reward for being loyal and profitable to them. If I buy stuff worth $50 from Kohl’s, they give me $10 in Kohl’s cash. Panda Express has given me some kind of a discount card, which I use to get 10% off on every meal. Discount Tires will rotate my car tires free for life because I bought them there.

So basically, the airline, retail, food, auto and I think most other industries give me a discount if I am loyal and profitable to them. The more money I make for them, the cheaper they make their services for me.

If you look at the credit card industry – it is the exact opposite of this.

The strongest criticism of the credit card regulation changes that were recently passed was that the credit card companies will have to cut back on their rewards program or charge an annual fee. This would hurt people who paid off their monthly balances and had good credit habits.

What is interesting is that no one defended the rule changes saying that they were fair, and that says a lot.

What they said was that if you don’t let us screw the people with bad credit habits, we won’t reward the people with the good ones.

The credit card model is such that it makes money off of people who spend a lot, don’t pay off their balances, take cash advances, forget making a payment etc. etc.

If you pay off balances in time, not run up too much credit and generally be good; your APR will go down. So, that means that if you don’t make much money for the credit card company, then they will reward you and allow you to make even lesser money for them.

On the other hand, if you run up a high balance that you don’t pay in full, take cash advances, hover close to your credit limit and other such things – your APR goes up.

So, if you make money for the credit card company, they will punish you by slapping higher interest and fee charges.

This is just the inherent nature of the credit card business and has generally worked well over the years. But, we must recognize that this is how it works and that you can’t use these arguments to say that you shouldn’t get rid of unfair rules that push troubled people deeper in the hole.

If you tell me that I won’t get 1% cash back because you can’t charge a penalty rate on someone else who defaulted on some other credit line, I won’t mind at all. In fact, I may just thank you for being nice all these years and say that it’s time to be nice to someone else.

Facebook Valued at 10 Billion Dollars

From Bloomberg:

Facebook Inc. received an investment from Russia’s Digital Sky Technologies that values the company at $10 billion, a third less than the valuation assigned to the social-networking company when Microsoft Corp. invested in 2007.

Digital Sky will buy $200 million in preferred stock, gaining a 1.96 percent stake in the company, Palo Alto, California-based Facebook said today in a statement.

I really find it difficult to digest the fact that Facebook is worth 10 billion dollars and I think the guys who are valuing this at 10 billion make a mistake. That’s not based on any mathematical model but just that I don’t remember the last ad I saw on Facebook and I am pretty positive that I never clicked on one.

A Tale of Two Words

The current debate about bank nationalization reminds of the – Disinvestment process that started in India about ten years ago.

Indian economy was slowly opening up and the government was selling its equity stake in large public sector companies to private investors and corporate houses.

This process was fraught with political perils and was called – Privatization, in the beginning. However, the government soon found out that the word – Privatization was one that had a lot of negative connotation and didn’t go down well with the largely socialist mindset that used to prevail then (and now) in India.

Privatization raised many difficult questions such as:

1.     How will the government value its stake in the companies that it owned?

2.     Would the government sell off its crown – jewels to private players for bargain prices?

3.     What will the government do with the money it raises by selling its stake?

4.     Would it make the existing private players stronger, if they bought large public sector companies with which they were competing?

5.     Should foreigners be allowed to own a stake in India’s crown jewels?

These were some thorny issues that the government had to navigate and there were quite a few uproars at the way some of the deals were handled.

One thing that happened along the way was the Privatization process was renamed to – Disinvestment.

I think this was done to get away from the word – Privatization and the negative connotation it held in the minds of a lot of people. Although there is no formal research to prove whether changing the name worked or not — I think it certainly helped reduce the sharpness of certain arguments against Privatization. As a university debater – I was taught to use words that were loaded and painted a picture in people’s mind, instead of dull bland words. This is something we do subconsciously every day.

Consider these two statements:

  • Do you want war?
  • Do you want the bloodshed that comes with war?

The word – bloodshed is charged enough to change the complexion of the question and is quite likely to sway the thoughts of most who read it.

What does it have to do with Bank Nationalization?

The US government has got large stakes in a lot of too big to fail US banks, it decides how much capital they need to survive, it guarantees their capital, even toys with the idea of replacing board members and CEOs.

After all this – the debate must be all, but over. But, it just doesn’t die down. They just need to change the name of the process, so that people don’t get all worked up about it and the inevitable takes place on its own pace.

iShares S&P North American Natural Resources Sector Index Fund: IGE

iShares S&P North American Natural Resources Sector Index (IGE) is an equity ETF that tracks an index based on US traded natural resources related stocks.

iShares IGE ETF is a passive fund and seeks to replicate the performance of the underlying index. At any given point, it invests about 90% of its assets in the underlying index related stocks.

The iShares IGE ETF has a total operating expense of 0.48%. The iShares IGE ETF may declare and pay out a dividend semi-annually and if there are any capital gains from sales of its assets, it may pay that at the end of the year.

The ETF has about 1.24 billion dollars worth of assets under management and its P/E Ratio was 13.31 as on 5/15/2009.

Top Stock Holdings

Chevron: 6.93%

Exxon Mobil: 6.75%

ConocoPhilips: 6.06%

Schlumberger Ltd: 5.25%

Occidental Petroleum: 4.87%

Encana Corp: 3.29%

Barrick Gold Corp: 3.06%

Goldcorp Inc: 2.63%

Newmont Mining Corp: 2.37%

Apache Corp: 2.32%

Top Sectoral Holdings

Oil Gas & Consumable Fuels: 64.87%

Metals and Mining: 15.58%

Energy Equipment & Services: 14.36%

Containers and Packaging: 2.74%

Paper and Forest Products: 1.23%

Construction Materials: 1.07%

S-T Securities: 0.09%

Source: iShares Fact Sheet


The iShares IGE ETF is a good passive investment vehicle for people who are looking for investing in natural resources related stocks. While it is concentrated in the Oil and Energy sector, it has very little exposure to any single stock and that helps hedge risks against the declines in stock prices of a single company.