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How to Bet Against Tech

http://www.fool.com/investing/general/2003/11/07/how-to-bet-against-tech.aspx

Whitney Tilson
November 7, 2003

In last Friday's column, I argued that tech stocks are almost certainly overvalued -- an opinion that hasn't changed -- and disclosed that, to take advantage of the decline I foresee, I had purchased the Rydex Venture 100 Fund (RYVNX), a mutual fund that every day moves double the inverse of the Nasdaq 100. In other words, if the Nasdaq 100 falls 1% on a given day, this fund will rise 2% and vice versa.

I argued that owning this fund was a much better option than shorting the Nasdaq 100 tracking stock (AMEX:QQQ) "because gains are unlimited while losses are capped -- precisely the opposite of a short position. If tech stocks retrace their gains over the past year, for example, investors in the Rydex fund can more than double their money, yet if the Nasdaq 100 continues to soar, losses cannot exceed the amount invested."

While this statement is true, I have reconsidered my analysis of the Rydex fund and now believe that it is not a good investment vehicle for the long-term, fundamental bet I wish to make. As a result I just sold my entire position in the fund. The fundamental problem with the Rydex fund is that identical percentage losses hurt an investor more than gains -- for example, a 20% loss followed by a 20% gain yields a 4% loss.

This table shows how an investment in the Rydex fund might work over one week:

  Nasdaq  Rydex Venture            100        100     Monday     1.00%    -2.00%Tuesday    5.00%   -10.00%Wednesday  1.00%    -2.00%Thursday   1.00%    -2.00%Friday    -8.00%    16.00%WeeklyReturns   -0.47%    -1.74%

We can see that during this week, the Nasdaq 100 fell by 0.47%, resulting in an identical gain if one were short the QQQ. An investor in the Rydex fund, however, has lost money since the big gain on Friday can't make up for the earlier losses, as the gain was on a diminished base of capital.

This example is not hypothetical. This table shows what would have happened to someone who invested $10,000 at inception on 6/2/98 in the ProFunds UltraShort OTC Fund, which is nearly identical to the Rydex Venture 100 Fund:

  Date           Nasdaq     UltraShort                   100        ProFund06/02/1998     $10,000     $10,000             12/31/1998     $15,466      $3,252             12/31/1999     $31,233        $639             03/31/2000     $37,045        $385             03/31/2001     $13,252      $1,017             12/31/2001     $13,284        $616             09/30/2002      $7,013      $1,455               09/30/2003     $10,981        $445             Loss sinceinception        9.8%        95.6%

In other words, an investor who had simply shorted the QQQ (and had the guts to hang on as it more than tripled) would have lost less than 10%, whereas someone unfortunate enough to own one of the leveraged inverse funds would have been nearly wiped out. Even during shorter periods when the Nasdaq 100 didn't budge, such as 3/31/01 - 12/31/01, an investor in the ProFund lost nearly 40%.

To summarize, a leveraged inverse fund is not a good way to make a long-term fundamental bet that an index will decline, because even if one is eventually right, short-term volatility can ruin the bet. Such a fund is only appropriate, I believe, for short-term traders or those who can accurately identify peaks -- an ability I know I don't have and I'm skeptical of anyone who claims to have it.

Shorting
There are many ways to make bearish bets, however. Most obviously, one can short a stock or an index -- in most cases very easily. But I don't recommend this strategy for part-time investors, as even seasoned professionals are getting clobbered this year on the short side. (Full disclosure: I recently shorted the QQQ.) Shorting is psychologically tough and the economics are terrible, as potential losses are infinite, yet gains are limited to the amount of the investment. I've written about shorting and its perils at length in threepreviouscolumns, so I won't repeat myself here, but be careful!

Credit-default swaps
Another option -- again, only for professionals -- is buying credit-default swaps (CDS), a relatively new financial instrument that is essentially an insurance policy on a company's credit. If one owns a CDS on a company and it defaults on its debt, the CDS holder can buy the defaulted debt and receive full payment from the entity that wrote the CDS. (Note that most tech companies don't have debt, so CDSs do not exist for such companies.)

For example, let's say your believe Warren Buffett's warnings about the dangers of derivatives and are convinced that a blow-up will occur in this area in the next few years, so you want to make a bearish bet on a company such as J.P. Morgan Chase (NYSE: JPM  ) , which has massive exposure to derivatives. As of yesterday's open, one can buy a CDS on J.P. Morgan's senior debt for 30 basis points (40 for the subordinate debt). That's 0.3% or 0.4%, a preposterously low price given the risks, in my opinion.

Here's how it would work: To insure $100 million of J.P. Morgan debt (one doe