The Stock Picker’s Quest for Alpha

Among academics, the active-versus-passive debate often centres on mutual funds. But among DIY investors—who readily concede that mutual funds with high fees are unlikely to outperform an index strategy—the discussion usually focuses on stock picking. Many people who shun mutual funds believe that building their own portfolios of individual stocks offers a high likelihood of market-beating returns.

At a recent symposium in Toronto hosted by Dimensional Fund Advisors, I listened to financial author Larry Swedroe discuss this idea and others in his book The Quest for Alpha. Swedroe also spoke the night before to a group in Ottawa that included several bloggers. Some were put off by Swedroe’s assertion that investors should not be picking individual stocks.

It’s impossible to make sweeping conclusions about the performance of retail investors who pick stocks, because the data are hard to get, at least compared with what’s available in mutual fund databases. Any researcher can look up the performance of funds, but how can we possibly know how successful individuals are?

Here’s what we know

In fact, there have been a number of studies by researchers who had access to account data from brokerage firms, and some of these are discussed in The Quest for Alpha. The most influential work has been done by Brad Barber and Terrance Odean in California, who have been at it since the 1990s. You can read Swedroe’s book for a summary of the research, or track down the individual papers, but the findings are about what you would expect. Investors routinely underperform risk-adjusted benchmarks, and the less they trade the better they do. Perhaps this quote from Odean sums up the research best: “The point seems to be that individual investors for the most part shouldn’t be trying to pick stocks. They did worse than if they had been throwing darts.”

Swedroe also raises another important issue: most individual investors, whatever strategy they happen to use, don’t know how to measure their performance. There is plenty of anecdotal evidence for this—just read my previous post about yield on cost, or go to any investment show and ask people if they’re beating the market: all of them will say yes. But anecdotes are not evidence, so Swedroe again goes to the research.

In a 2007 study, Markus Glaser and Martin Weber got access to online brokerage accounts and then asked the investors a series of questions about their own performance. Swedroe summarizes the findings both in the book and on his blog, and they are alarming. Echoing Barber and Odean’s work, the study found rampant overconfidence and consistent underperformance among investors who dramatically overestimated their returns. Four out of every five investors who had negative returns were unaware they had even lost money.

Tarring with the same brush

The research is clear that the overall performance of individual investors is worse than that of high-priced mutual funds. You might conclude from these studies that stock picking is an entirely futile exercise. But I would argue that’s too ham-fisted. What the studies show is that investors who trade too frequently get clobbered. There is no doubt that experienced, educated investors will perform much better than the average person in these studies—indeed, Glaser and Weber state this explicitly in their paper.

In my last post, I argued that disciplined, patient and courageous investors (to use Tom Bradley’s words) can do just fine if they stick to low-cost, well-run active mutual funds. Surely the same is true for stock pickers with those same traits. If they diversify properly, keep turnover extremely low, stay invested during the rough times, and control their emotions, they’re unlikely to go too far wrong—even if they don’t end up beating the market.

I’ve been surprised to hear how many investors use some combination of indexing and stock picking, and who seem to be making it work. If you find a purely passive strategy impossible because you can’t make peace with the idea of buying the whole market, then a side order of stock picking probably makes sense. If the comfort of holding individual stocks is what makes you adhere to your investment plan, then there is enormous value in that.

I’d still like stock pickers to read Swedroe’s book, so I’ll send a free copy to the reader who leaves the most interesting comment below. Rather than simply pulling a name from a hat, this is one contest I’m going to actively manage.

29 Responses to The Stock Picker’s Quest for Alpha

  1. Jon Evan June 30, 2011 at 10:15 am #

    I would expect Mr. Swedroe to be in a tad of a conflict of interest promoting mutual funds/etfs as the only way to invest! Surely it’s to his advantage that we all buy those products and Swedroe et al can profit from our fees?
    Speaking of fees, because the Canadian stock market is very small and it is dominated by a few big companies, one might reasonably approximate an index fund by holding only a few stocks and not have to buy the ETF itself. For example, I like dividend stocks and so I can buy XDV or I can buy only 10 of its top holdings and thereby replicate 50% of that ETF. Would my 10 year return be that different? But my cost would be quite different particularly the larger the portfolio. Norm Rothery has an interesting calculator trying to understand this at:
    http://www.ndir.com/cgi-bin/ETFsVsStocks.cgi
    Using it I find the cost differential for XDV versus holding its stocks individually rather stunning!

  2. KevinC June 30, 2011 at 10:26 am #

    Hey Dan, great post, I find this topic very interesting and I’ll share my (limited) experiences:

    You led me on the path of a simple couch potato index strategy with TD e-series funds and I have stuck to it, setting my asset allocation and automatic monthly contributions – basically set it and forget it. After getting a good tax return this year I put most of it to savings for a down payment on my house, and left a good portion to invest. I was happy with the auto-contributions to the mutual funds, so I wanted to do something different with this money.

    Since I was happy with my down payment savings and a solid start on retirement with the index strategy, I considered the remainder of this cash as “play money”. I wanted to try out some other ways of investing just to get some experience and to see what worked best for me. I opened a Questrade TFSA and decided to pick stocks and chase a higher rate of return. I researched companies in industries that I am passionate about (tech, video games) and made my own speculations of their values and forecasts. For example Electronic Arts I bought and sold after it jumped 17% in 3 months. I’ve had some good success so far but I don’t want to be too confident because I know how quickly things can go in the opposite direction. I’m mostly glad to get more experience with different types of investing, and I find this mix of active and passive investing is fun and works for me!

    Hope everyone has a great Canada Day long weekend!

  3. Stephen L June 30, 2011 at 11:00 am #

    I couldn’t agree more with the second last paragraph. Everything points to indexing being the more consistent option, but when you hear stories about how people are making a killing with active investing; it’s hard to ignore. The greed comes out but that can quickly turn to fear when things go south if you decide to take an active approach.

    So what’s greed and fear? They’re emotions; and along with the two you’ll probably get the whole package of emotions which could lead to irrational decisions. But we’re human and greed is a powerful feeling (at least to me =p). This is why I started to adapt a hybrid approach where the majority of my portfolio is passive while a small fraction is active. This way I can satisfy my greed for higher returns while I still have the indexing to back me up if (…”when” is probably a better word here) I mess up. That’s why I agree that feeling comfortable is an important element to this investing game. When you’re comfortable – you play better.

  4. Canadian Capitalist June 30, 2011 at 11:19 am #

    I’m willing to wager $10 that 90% of investors who pick stocks haven’t a clue what their rate of return is. And exactly how many properly compare it to a benchmark? We only have their words that they are kicking the pants off the markets. I remain very skeptical of these claims.

  5. Echo June 30, 2011 at 11:49 am #

    I’ll admit that I’m clueless about risk-adjusted performance (I’m assuming you’re referring to the Sharpe ratio). Are you looking backwards or forwards? Do you use the Sharpe ratio for your entire portfolio, or for each individual security? If it’s individual, can you give me an example of the Sharpe Ratio for Fortis?

    I want to better understand the risk-adjusted performance statement because otherwise when you say that a stock portfolio can’t beat a passive portfolio when you adjust for risk, it sounds to me like it CAN beat a passive portfolio, but you are discounting the gains because of the risk involved to get there. Does that make sense?

  6. IndexInvestor June 30, 2011 at 12:28 pm #

    @Echo
    http://www.investopedia.com/terms/a/alpha.asp#axzz1QiRabQCz
    http://www.investopedia.com/terms/s/sharperatio.asp#axzz1QiRabQCz
    http://www.insidermonkey.com/blog/2011/06/08/as-warren-buffett%E2%80%99s-alpha-goes-down-the-value-of-a-lunch-with-him-goes-up/

    It’s definitely possible for individual investors to beat the market (have positive alpha), before fees, the sum of all investors’ alpha is equal to zero. Some will be above, some will be below.

    @CC
    I would also argue that passive investors don’t calculate their rate of return properly either. Some do but most probably don’t either.

    @Jon Evan
    Interesting calculator. If you own only the top 10 holdings of XDV, you would be very overweight in Canadian financials however, compared with the sector breakdown of XDV.

  7. Eric June 30, 2011 at 12:47 pm #

    Hi Dan,

    it was easy to beat the markets (TSX/S&P500) over the last decade using blue-chip dividend stocks. Most of my stocks did better (some of them are: TransCanada – Royal Bank – Abbott – Kimberly Clark – Johnson & Johnson ). All large & boring stocks. But that was a strange period, 2 crisis & the USD falling. I am now indexing a large part of my portfolio beacause I need more exposure to different markets & asset classes. It is a lot easier to concentrate on asset allocation than picking stocks. Once your targets are set, you stop timing the market. I don’t know if I’ll do better
    in the future but my portfolio looks more like a pension fund now.

  8. Holistic Investor June 30, 2011 at 2:21 pm #

    There is no universal solution in this investment world.

    Indexing, dividend blue-chips, are all important weapons, but none of them can fit in each every scenarios. They all come in with nice features but some kind of caveats as well.

    For average individual investors, its most important to diversify the investments spreading through a whole spectrum, from low risk fixed incomes, GICs to high volatile and spectacular stocks. Asset allocation with risk control is the key.

    “Beating the index” is a misleading topic. Why do we have to beat the index? If my return trails index by 15% but only hit by 50% of volatility, I will be much happy.

  9. Russ July 1, 2011 at 7:50 am #

    I actually work for a discount stock brokerage firm (no names, please). As a company we make money from all the commissions that our account holders generate but very often the gain/loss reports tip to the loss side. Most cannot be called investors. They are speculators, and it is amazing to see all these portfolios filled with over-the-counter bulletin board and pink sheet stocks worth next to nothing per share. For the most part, they have conviction in their abilities to select winning stocks but the results usually suggest otherwise. There are exceptions, of course, but they are few and far between.

  10. My Own Advisor July 1, 2011 at 8:27 am #

    I think what caused my eyebrows to rise is when Larry said “selecting stocks for your portfolio is a loser’s game.” To be fair to Larry, he didn’t context his point too much only to go on to state that getting in and out of the market; trying to beat the market; trying to play the active management game; achieve alpha – you have “the hope of outperformance.” Here, I agree with him 100% since trading and chasing and mining the market for outperformance is NOT investing. There is overwhelming evidence against that, etc., etc. I’ve got Larry’s book and hope to read it this summer. I’m sure it will be a learning opportunity for me.

    However, back to your post, I’m appreciative of your point above Dan: “disciplined, patient and courageous investors (to use Tom Bradley’s words) can do just fine if they stick to low-cost, well run active mutual funds. Surely the same is true for stock pickers with those same traits.”

    I know in my own unregistered stock portfolio, I’ve seen a few stocks run up and dive down in price over the last couple of years, some dove down more than 15%. Some are up more than 15%. However, I wasn’t worried or excited about either. In some cases, when things apparently “rough” I bought more of that company. As a portfolio, I intend to stay with these companies in good times and in bad. Over time, I plan to own more of them, diversifying the number of holdings. If I don’t trade, rather, I’m an investor who controls my emotions (I hope to your point), I’m “unlikely to go for wrong—even if they (I) don’t end up beating the market.” My comfort level, for now at least, is using a combination of indexing and stock holding that is helping me achieve my financial goals. Isn’t that what it’s all about?

    Thanks for the great post.

  11. Maxwell C. July 1, 2011 at 8:53 am #

    Dear Couch Potato,

    I would like to echo Echo up there. Is there any chance we could get a nice, shiny article teaching us about risk-adjustment, perhaps focusing on how it is used to sell funds (e.g. a fund could outperform an index and this could be used as a selling point, but after risk-adjustment one would see that this was just because the fund manager took on a lot more risk than was in the index, then got lucky).

    I don’t understand yet how risk adjustment is calculated, yet I get the basic idea and it is often mentioned in your blog. A full article explaining this term, and of course how it is calculated and applied when talking about investment instruments, would be AWESOME. Get on it! :-)

    ~From Russia with love (for index funds and ETFs!)

  12. The Dividend Ninja July 1, 2011 at 10:55 am #

    Dan, what a great post! A couple of days ago you were offering “active managers” an olive branch, and now you’re clobbering DIY investors with the same branch. Hmmm getting endorsement from the mutual fund companies? Kidding aside, one of your most interesting posts to date ;)

    I would also suspect also that most people don’t know what their Rate of Return (ROR,ROI) is. You should do a post on that! I think it would be fair to assume that applies to any type of investor regardless of their investing style – dividend investing, index investing, or mutual fund investors.

    @CC
    Only $10 ?

  13. Andrew Hallam July 1, 2011 at 11:29 am #

    Nice post Dan,

    I think that a person with the right emotional aptitude and some skill can pick baskets of individual stocks and probably match a broad market index over a long period of time (at least 2 decades) if they keep their annual turnover below 10% a year. But I’d guess that fewer than 1 in 1000 have the emotional fortitude to stick to the required “buy and hold” approach. The vast majority of people aren’t wired to do that…over an investment lifetime.

    As for one man ruffling the feathers of a group of stock pickers (by suggesting that they can’t beat the market) there’s probably a reason their feathers get ruffled: they are worried that the man (if it’s Swedroe in this case) might actually be right.

    If there’s something you know you can do, you won’t get ruffled when hearing others tell you that you can’t do it.

    Try telling me that I can’t run a mile. Send a thousand people to tell me that I can’t run a mile. Do you think I’d get upset and try to defend that I could?

    If I was that emotionally reactive, it would reveal plenty: it would reveal that I probably didn’t have the emotional aptitude to equal or beat the stock market with individual stocks because nothing tugs at our primitive sides like fear, greed, and the uncertainty of the markets.

  14. Canadian Couch Potato July 1, 2011 at 5:42 pm #

    Thanks, everyone, for the great comments.

    @Jon Evan: Advisors who recommend passive strategies are obviously not immune from bias. But overall, if you’re only interested in making money as an advisor, you are better off recommending active strategies, which tend to be much more lucrative.

    RE: unbundling ETFs, this can make a lot of sense with narrow sector ETFs that have few holdings, but be careful of using it as a substitute for larger funds. Buying only 10 stocks for a dividend portfolio is might save you the management fee, but it would give you little diversification.

    @Echo, Maxwell C and Ninja: I will try to put together a post about risk-adjusted returns in the future. In general, the idea is to calculate your own portfolio’s annual rate of return and its standard deviation. (If you have monthly data, that’s even better.) Then you compare this with the rate of return and standard deviation of an appropriate index benchmark. If you earned, say, 1% more than the index but with much higher volatility, then you did not really achieve alpha, you just took more risk.

    Preet did a post a while back about calculating the standard deviation of your portfolio. I’ve also written a post about calculating your personal rate of return, which includes a link to a useful online calculator from Weigh House Investor Services.

    And here is a link to a recent paper by Justin Bender of PWL Capital in Toronto on How to Calcualte Your Portfolio’s Rate of Return. You’ll see that it’s pretty complicated math.

    @My Own Advisor: Note that if Swedroe said “selecting stocks for your portfolio is a loser’s game” he likely meant it in the broad statistical sense. All market activity is a zero-sum game before costs (for every dollar that outperforms the market, another must trail by an equal amount) and a negative-sum game after costs (the aggregate return of all investors must be less than the market because of fees). This is simple math and not meant to be an insult, as in, “You are a loser if you pick stocks.”

    @Russ: A very interesting “insider’s view”! This actually helps support the argument I was trying to make about the academic research on stock pickers. It sounds like many (if not most) of the people in a random sample of brokerage accounts would be speculators, or at least really bad investors. That fact that almost all of these will fail doesn’t really say anything about prudent, knowledgeable, buy-and-hold stock pickers.

    @Andrew: Thanks for an interesting observation. I think you’re right: people who really were beating the market consistently would probably be quietly confident rather than defensive.

  15. Maxwell C. July 1, 2011 at 5:58 pm #

    @Canadian Couch Potato: “All market activity is a zero-sum game before costs (for every dollar that outperforms the market, another must trail by an equal amount) and a negative-sum game after costs (the aggregate return of all investors must be less than the market because of fees). This is simple math and not meant to be an insult, as in, “You are a loser if you pick stocks.” ”

    Has this been proven? I don’t see why this is a guarantee. If people are producing value of some sort through the constant addition of human labour (of one form or another), shouldn’t this then always be positive, at least over the long term? And if it is a zero-sum game, then why are average index returns over long periods well into the black?

  16. Canadian Couch Potato July 1, 2011 at 6:17 pm #

    @Maxwell: I didn’t mean to suggest that economic activity is a zero-sum game. Of course, real growth can be achieved in the economy without winners and losers. What I meant was that the average investor, by definition, cannot beat the market, because all investors taken together are the market.

    Index funds don’t beat the market: they typically trail it by an amount at least equal to their management fees. However, over the long term, most active investors will trail it by even more.

    William Sharpe explained it best in this classic paper:
    http://www.stanford.edu/~wfsharpe/art/active/active.htm

  17. Be'en July 1, 2011 at 7:13 pm #

    The company I was working for had employee-stock purchase plan through payroll deduction. We got 15% discount for the company stocks whenever they were purchased.

    I ended up buying nearly $25,000 worth of stocks in this company — my sole holding in an equity. No diversification and the recent trend in price is downwards. I have no idea how much I actually spent buying these and if I were to sell now, I would come out ahead. No idea what the ROR/ROI would be.

    Clearly one needs to learn the basics before getting into serious “investing”! I am not even sure if it is the right time now to sell these stocks to buy an ETF…

    Discovering these financial blogs has been a real eye-opener for me! I have yet to read a book on financial planning and investing..

  18. Jon Evan July 2, 2011 at 9:26 pm #

    @CouchPotato says ” unbundling ETFs, this can make a lot of sense…..”
    Precisely why many investors do it so you need not be “surprised” :).
    In fact, those with larger portfolios do buy their own stocks because it does make sense to do so in a diversified portfolio particularly those of us favouring dividend stocks for the income produced. Using the example of XDV which has 30 stocks but is overly concentrated by financials one can easily buy a good representation of the ETF or even buy all XDVs stocks. Using Norm Rothery’s calculator for a 200,000 dollar investment for ten years with the etf annual growth rate of 5% and with no dividends reinvested the cost of the ETF is ~13,000.00 whereas if one owns all the ETFs stocks the cost is only 600 dollars over the same 10 year period! This represents a stunning difference and this why one MUST be careful particularly the larger your portfolio. Now, I can see why Mr. Swedroe has a bias! He’s not kidding it is indeed “a loser’s game” for the investor who needlessly pays such fees for certain ETFs.

  19. Mark Swanson July 3, 2011 at 7:48 pm #

    I agree in theory that one cannot beat the market, but my problem is that I have (and still do). My Schwab IRA account is up 550% in the last 8 years with regular (not frequent) trading but no additional investments (I’ve been funding my newer Vanguard Roth IRA instead). To be honest, I’ve probably just been lucky, but I’ve been mostly buying and selling at the right time (mostly = about 2/3 of the time). Yes, I got creamed 2 years ago, but have more than bounced back since. And I’m playing two online stock-picking games with non-matching portfolios and doing well above average in those also.

    I still think that either I’ve just been very lucky or somehow my temperament and experience have given me very good intuition, and, if the latter, past intutional success is absolutely no guarantee of more of the same in the future.

    My challenge now is trying to figure out how far I can ride my intuitive “skills” and to what degree I need to hedge against a possible reversion to the intuitive mean.

    Random test: I expect July to be a pretty good month for stocks with a probable correction sometime after the first week of August.

  20. Andrew Hallam July 3, 2011 at 10:50 pm #

    Mark,

    Congratulations on your stellar investment performance. I also take my hat off to you for your balanced perspective.

    I had similar results picking stocks with my personal account, and with an investment club account as well.

    I was able to do it for 10 years. But instead of giving me confidence over time, it ironically eroded my confidence. Smarter men than me have taken long runs, beating the markets for long periods of time, but most of them eventually get spanked by the market.

    Half of my account was indexed, but my non indexed portion was far ahead of the indexed half. I figured, however, that 10 years is a stock market blip…not nearly long enough to be statistically relevant.

    That said, I’m not qualified to suggest that my streak (or yours) was a component of luck alone.

    I’ll never know. But after fully indexing my entire portfolio, I have to admit that it’s a lot easier to manage, and no matter what happens, my low cost account will ensure that I’m in the 90th percentile, in terms of future performance. I’ll beat 90% of the pros without having to do any research. And those are odds that I can truly embrace.

  21. Mark Swanson July 3, 2011 at 11:53 pm #

    Thank you Andrew. As my net worth increases and I get older, I trust a larger portion of my portfolio to indexes (though I am still active in determining my own asset allocation decisions) and the portion I allow myself to manage actively gets progressively smaller.

    It’s too much fun when I do something like I did last Monday morning when I took a big position in UMDD after the market had 6 or 7 negative weeks and got stellar results, but I really do expect the “lucky streak” to end, and probably end spectacularly, at some point, and I don’t want to risk all my gains when that happens (but I’ll risk some of them).

  22. Andrew Hallam July 4, 2011 at 12:26 am #

    It sounds like you have a great head on your shoulders Mark. And I often wonder whether most people should have a portion of their portfolio that they actively manage.

    Perhaps it’s like dieting, for some people. If you’re too “hard core” perhaps you could freak out at some point and eat a couple of chocolate cakes in a single sitting. Some indexers might find a similar urge to trade stocks.

    For that reason, perhaps a healthy eater should schedule a weekly piece of cake or pie, and the indexing investor should set aside 5% or 10% of their portfolio to do one of the things that humans like doing best: competing, and using their heads to outwit others, if possible.

  23. Canadian Couch Potato July 4, 2011 at 6:39 pm #

    @Mark: Like Andrew, I’m sure you’re a smart guy and I respect that you recognize that at least part of your recent success is due to luck. As I mentioned in the post, if people want to actively manage a small part of their portfolio to indulge their urges, that’s probably a good thing if it keeps them from tinkering with their serious money.

    However, I think it’s worth pointing out that triple-leveraged funds such as UMDD are pure gambling. It’s one thing to hand-pick some blue chip stocks and quite another to use highly speculative short-term instruments. Hope this part of your portfolio is just play money.

  24. Mark Swanson July 4, 2011 at 7:18 pm #

    I agree with both of you. I suppose I could have just bought an index on margin, but I never buy on margin, even tho using UMDD isn’t a whole lot different. It’s not quite gambling, but close obviously I thought, (right or wrong) that I had a slight statistical edge or I wouldn’t have done this, and obviously I can survive the loss of what I risked here, but I wouldn’t say “play money” or “gambling” but highly speculative, high-risk, high-reward.

    My two single biggest holdings, btw, are AAPL and a TIPS fund. Approx half of my assets are in Vanguard funds, and that doesn’t even include the TIPS fund which is in a DC account. My most recent stock purchase (talk about boring) was POR. I once had a big stake in Worldcom and I lost almost half my value in ’08-09 so I’m aware that risk is not just a theory. Nevertheless, I could argue that if one were to allocate 5% of their portfolio to a leveraged etf like UMDD and just leave it there for 10 or 20 years it would be a highly rational application of risk/reward.

  25. Canadian Couch Potato July 4, 2011 at 7:27 pm #

    @Mark: Regarding your comment, “I could argue that if one were to allocate 5% of their portfolio to a leveraged etf like UMDD and just leave it there for 10 or 20 years it would be a highly rational application of risk/reward.”

    This is absolutely not true. Unlike a margin account, the leverage on ETFs like UMDD is reset every day. This means that these ETFs are wholly inappropriate as long-term holdings. If markets are volatile (and they always are), they are virtually guaranteed to lose money over the long-term. I urge you to read up on these products before you put more money into them.

    I did a post about them a long time ago:
    http://canadiancouchpotato.com/2010/01/26/the-trouble-with-leveraged-etf/

    There are many other online resources that go into more detail.

  26. Mark Swanson July 4, 2011 at 8:05 pm #

    I’ve seen that argument made and in fact, I don’t hold UMDD long term but I have tested it and if you look at the charts of 3X etf’s, I don’t see how you lose (vs an index fund) unless you sell the etf when the underlying index is lower than it was when you got in. Since that pretty much never happens if you hold for 10 years or more, I’m not seeing the risk.

    Here’s the UPRO chart, compared to the DOW. Granted it’s during a raging bull mkt but if you look at the last six months, as long as the DOW is in positive territory, UPRO does at least as well. And all long-term markets are bull markets (until the end of the world as we know it). Am I missing something mathematically? Can you lose money on these if you buy them and hold them until the underlying index is higher than when you first bought? And therefore, aren’t they safe as a ten-year or more investment? I LIKE volatile investments (volatility is another name for risk and all the highest return investments are volatile), but I try to minimize portfolio volatility via asset allocation. For the equity portion of my portfolio I want (ideally) highly volatile non-correlated investments.

    http://finance.yahoo.com/q/bc?s=UPRO&t=2y&l=on&z=l&q=l&c=^GSPC

  27. Canadian Couch Potato July 4, 2011 at 8:40 pm #

    @Mark: The key mathematical thing to understand here is the daily reset. This is necessary to protect the investor from losing more than 100% of his money—compared with a short position, where the loss could, in theory, be infinite. Because the leverage is reset every day, the path of the returns is hugely important. If the market charges relentlessly up or down, then your leveraged ETF will behave more or less as you expect. During the period you’re looking at, that’s basically what happened.

    In a very volatile market, however, the leverage erodes your returns a little bit every time the market reverses. So if the market goes up and down, up and down, over and over, but still ends up with a positive return, your ETF will not behave you like expect. In fact, you can easily lose money even over a period where the market return was positive. I encourage you to read the post I linked to and check out the report about the leveraged gold ETFs that is linked in that post.

    This piece might also help clarify the risks:
    http://www.hbpetfs.com/pdf/20090908_dh.pdf

  28. Mark Swanson July 4, 2011 at 8:50 pm #

    Got it. thanks.

Trackbacks/Pingbacks

  1. Weekly Reading Links 7.9.11 - July 9, 2011

    [...] The Stock Pickers Quest for Alpha @ Canadian Couch Potato [...]

Leave a Reply