A great deal of money evaporated last week when a few niche exchange-traded products (ETPs) blew up in spectacular fashion. After putting the stock market's returns to shame for years, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) destroyed about $1.5 billion of wealth last Monday, dropping more than 90% in a single day.
We don't need to get into the weeds with what went wrong (look here for that). Basically, this ETN is designed to generate really good (but volatile) returns unless the volatility index (VIX) rises to a number twice as high as where it started the day, at which point virtually all of the money invested in the ETN would simply disappear.
It's an obscure bet, but one that produced remarkable returns for a very long time. But then what wasn't supposed to happen actually did: The volatility index surged. Each share of the ETN, which had a fundamental value in excess of $100 no less than one week earlier, plunged to $5.18 by market close on Friday.
A lot of people lost a lot of money. But there's no sense in dwelling in the losses or rubbing it in. Rather, I think events like these are a good opportunity to revisit some basic and very important things you should know about funds and investing as a whole.
1. Funds aren't necessarily designed to be good investments
Some people assume that funds are designed to generate good returns. That's not always true. Many ETFs and ETNs (or just funds, generally) aren't designed to be good investments. Some aren't even intended to go up in value. But that doesn't preclude them from being good funds, and it certainly doesn't mean they shouldn't exist.
The Direxion Daily Small Cap Bear 3X Shares ETF is designed in a way that all but guarantees that it will incinerate billions of dollars of wealth every single year, year after year. Since it began trading in 2008, that's exactly what it has done. But, again, that's what it was meant to do -- its owners are made aware that it will do just that. It destroys money better and faster than just about anything. Yet many people shovel money into it.
This particular ETF is devised to rise 3% on days when small-cap stocks decline 1%, and to fall 3% on days when small-cap stocks climb 1%. For the purpose of generating the inverse returns of a leveraged portfolio of small caps on a daily basis -- the reason it exists! -- it actually works pretty well. Over a single trading day, it roughly multiplies the return of small-cap stocks by -3, which is what it is supposed to do.
It's imperative that you understand that fund managers don't create funds because they think they'll generate good returns for their investors over any time period. Instead, they're merely trying to create funds people will use. They get paid when clients decide to put money in their funds, not necessarily when their clients get a good return. That's an important distinction.
The point is that when a fund sponsor is launching a new fund that will invest in companies headquartered in Buffalo, New York, that generate more than 5% of their sales in Guatemala, for instance, they aren't necessarily endorsing the strategy as a good way to turn your money into more money. They're just trying to launch a product that they think people would like to invest in.
Cynically, what people want to invest in and what generates good returns over long periods of time are not always the same thing. If anything, the opposite is often true: The best returns come from stuff no one wants to own, and the worst returns come from those everyone wants to own. See tobacco stocks as one of history's best examples of how hated companies can generate mind-blowing returns.
2. Risk and returns are fundamentally linked
The best indicator that XIV had the potential to end in disaster was that it had returned 43% annualized for seven years running. Last year, an incredible year for stocks, the S&P 500 gained 22%. The XIV ETN was up 187.5%.
People write books about Warren Buffett, and some even travel halfway around the world to hear him speak, all because he compounded Berkshire Hathaway's book value at a relatively pedestrian (compared to XIV) rate of 19% per year. However, people who don't know where to find a company's annual reports (here) were reliably earning higher returns than the greatest investor to ever live. That's a good sign that XIV's excess returns were a function of risk rather than an investment opportunity everyone overlooked.
It's often said that one way most investors get caught up in silly mistakes is by extrapolating recent trends into the future. But in this case, perhaps the biggest problem was that investors extrapolated XIV's performance into the future, but they didn't take it far enough.
If you assumed XIV could duplicate its outperformance for the long haul, you'd essentially forecast a world where the entire output of the world economy is comprised of people shorting volatility and making money doing it. Imagine what a world that would be -- a world where people put $1,000 into a short VIX ETN and discover that 30 years later they're sitting on more than $50 million of nearly free money. It's pure fantasy land, but it's the implicit assumption you make when you think that any investment can compound at ridiculous rates for a long period of time.
3. The best investments are often simple
Life experience often reinforces the idea that more work or more complexity generally begets more money. Working 60 hours a week is a good way to earn more money than toiling for 30 hours. Surgeons earn more than cashiers because they have specialized knowledge and exposure to complex risks like malpractice lawsuits.
But the investment world doesn't differentiate between what's easy and what's difficult, and often what's simple works incredibly well. If you look at some of the best-performing stocks of all time, many are powered by a core business that does a pretty trivial thing better than anyone else.
People like to shop where they can find low prices, and Costco's business model of selling fewer items at low prices enables it to concentrate its buying power and sell merchandise at a cost others can't possibly match. That's simple.
A tech company like Alphabet appears complicated because it now does all kinds of things like making smart thermostats and launching weather balloons to bring the internet to remote locations around the world. But all that stuff has, in the aggregate, mostly just wasted money. Luckily, Alphabet has a cash faucet in the form of Google, which, for simplicity's sake, is really just a newer, better Yellow Pages. Simple.
eBay? An improvement on yesterday's classifieds. Visa? A toll road for money. WD-40? No one is so frugal that they'd prefer to listen to a squeaky door than spend $4.
Fund manager and former Fool columnist Morgan Housel said it best when he pointed out that finance is the only industry "in which someone with no education, no background and no experience can vastly outperform someone with the best background, the best education, the best experience."
The average person can understand what makes Costco's business model that much better than the average retailer. But only a mathematician or financier eager to find an edge in complexity would lose massive amounts of time and money trying to figure out if the VIX could double in a day before ultimately concluding, incorrectly, that it couldn't.