Financial innovation has gotten a deservedly bad rap. At the height of the latest bubble, the Big Banks and other financial entities were pushing derivatives that would profit only themselves, trying to rake in deal fees by selling waste that would go toxic faster than a deep-fried Twinkie. Much financial innovation is shaped intentionally to be so complex and convoluted that only the creators know how a financial instrument actually operates. Such innovation often promises more profit and lower risk.
Like liquor after beer at 4 a.m., the alphabet soup (CDOs, CDSs, SIVs, etc) that blew up our economy seemed like a good idea at the time. So we should be rightly suspicious of further financial innovations that promise magnified gains with less risk. While the alphabet soup of products was generally restricted to qualified investors (i.e., those the government thinks can afford to lose money), the innovations mentioned below are available to everyone and their Aunt Jane. The democratic marketplace now means that retail investors don't have to be qualified to lose their shirt.
I've found some new securities -- I hesitate to use that word -- that smack of the seamier side of financial innovation and could be reasonable candidates for the worst investment ever.
So what counts?
When it comes to picking the worst investments ever for retail investors, what traits would a security need to have?
- No ultimate long-term business or purpose. Without an ultimate long-term business, a company (and thus its security) has no reason to exist. A security that has a great underlying business can power returns for years, whereas a financially engineered security exists to capture a trend in the market, which may or may not last.
- Complex or convoluted structure. Complex structures often exist in order to make money for someone, but usually not the buyer.
- Facilitation of short-term speculation rather than investing. A short-term orientation helps facilitates products and practices that are not auspicious for retail buyers, especially those that want to invest for retirement.
Structuring financial innovations with the above traits sets up retail investors in a losing position. The worst investment need not have abysmal performance (yet), but it doesn't hurt.
A family of ETFs recently introduced by Factor Advisors promises even more financial innovation. The New York-based asset manager has developed a suite of "spread ETFs," which provide both long and short exposure to a variety of asset classes. The newly minted shares include the following:
FactorShares 2X: S&P500 Bull/TBond Bear
FactorShares 2X: TBond Bull/S&P500 Bear
FactorShares 2X: S&P500 Bull/USD Bear
FactorShares 2X: Oil Bull/S&P500 Bear
FactorShares 2X: Gold Bull/S&P500 Bear
For example, if you think oil is likely to continue its rally and you want to amplify that position with the S&P 500 (since rising oil is detrimental to corporate profits), then you might opt for the fourth selection on that list, shares of FOL. If that's not enough for you thrill seekers, the funds are also leveraged 4 to 1, helping to magnify gains (and losses). But enough about potential losses, there's plenty more to be wary of.
The finance wizard behind the curtain
The company explains the working of its products in a helpful FAQ. While Factor Advisors does warn that its ETFs are for "sophisticated investors," their listing on the NYSE belies the fact that anyone can buy them, sophisticate or financial rube alike.
The FAQ lays out a helpful question-and-answer framework for prospective buyers. For example:
6) Will each Fund match 200% or -200%, as applicable, the return of its respective S&P Factor Index for a period longer than one trading day?
The return of a Fund for a period longer than a single trading day will be the result of each day's returns compounded over the period, which will very likely differ from approximately twice (either 200% or -200%) the return of such Fund's corresponding Index for that period. Due to a number of reasons as described throughout the Prospectus, including, but not limited to, mathematical compounding, daily rebalancing, the differences between the NAV Calculation Time and the Index Calculation Time, leverage and volatility, each Fund will not track its corresponding Index for a period longer than a single trading day and may experience tracking error intra-day.
Did you get that? Due to a bunch of technical reasons, "each Fund will not track its corresponding Index for a period longer than a single trading day." But even this performance is not guaranteed, since the ETFs "may experience tracking errors intra-day." So what exactly does this product do again? That's the definition of a complex financial product. To use this ETF effectively, you'll have to guess the right time to buy. That's not conducive to wealth-building.
It's clear that these ETFs meet our definition of what constitutes a terrible investment opportunity for retail investors -- no ulterior long-term business, a complex structure, and an orientation toward short-term performance. Some investors may make money on them, but that doesn't make these ETFs a good prospect.
Another investment alternative
So you're looking for another alternative? Look for businesses that provide a good or service that is absolutely essential to consumers and whose business success you can ride for decades. In my article "The Best Stocks to Hold for a Lifetime," I outline seven stocks that would make an absolutely core portfolio for any long-term investor. In particular, I highlight McDonald's
Add McDonald's and Brookfield Asset Management to your watchlist, or start a new watchlist and add any company you want. You'll get valuable updates as well as immediate access to a new special report, "Six Stocks to Watch from David and Tom Gardner."
Jim Royal, Ph.D., owns shares in Brookfield Asset and McDonald's. Brookfield Asset Management is a Motley Fool Global Gains recommendation. McDonald's is a Motley Fool Income Investor choice. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.