How to Bet Against Techhttp://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
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.
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