THE BLOG
09/07/2010 09:04 pm ET Updated May 25, 2011

The Wall Street Way

Here's an insight about Wall Street you probably won't get anywhere else:

The creation of new investment products has nothing to do with investing. It's done primarily to separate you from your money.

Sub-prime mortgages are the best example. Others include hedge funds of all stripes, structured products, money market funds that promise "extra" yield, leveraged municipal bond arbitrage, and structured securities.

The allure is the same: The promise of outsized return without increased risk. It's a false promise.

130/30 mutual funds are an excellent example. These are leveraged mutual funds. For every $100 invested in stocks the fund manager believes will increase in value, the fund borrows $30 against these purchases, and shorts stocks it believes will decline in value. The fund manager then sells the borrowed shares and uses the proceeds to buy more shares of stocks he believes will increase in value.

The strategy is fundamentally flawed and risky. It's flawed because it assumes fund managers have the ability to select stocks that will either rise or fall in value. It's risky because of the leverage.

As William Bernstein, author of The Intelligent Asset Allocator, stated: "It turns out for all practical purposes there is no such thing as stock picking skill. It's human nature to find patterns where there are none and to find skill where luck is a more likely explanation (particularly if you're the lucky [mutual fund] manager)."

Naive investors ignored this admonition and flocked to these funds, no doubt intrigued by their unique investing strategy. By some estimates, over $1 billion is invested in 130/30 funds.

Their performance was predictable. According to The Wall Street Journal, a study by Morningstar found 130/30 funds underperformed their "long only equivalents" in both the 2008 bear market and the subsequent rally.

Of course, the managers of the 130/30 funds that outperformed their peers attribute their success to their superior skill. However, when you look at the qualifications of the managers of the poorer performing funds, it's clear they are also well qualified. The Rydex/SGI Global 130/30 Strategy Fund (RYASX) ranks in the bottom 20% of its Morningstar category for the past one and three year period. The manager of the fund, Yon F. Perullo, has stellar credentials. He has a CFA designation and extensive experience in "quantitative modeling, portfolio simulation and risk analysis software."

The five year average return of this fund is a loss of 5.17%. Let's put that loss in perspective. If you had invested in an all stocks, globally diversified portfolio of boring, low cost index funds, starting in January 1, 2005 and kept them to date, you would have a annualized gain of 2.29%.

130/30 funds, like other complex investment vehicles, are designed to mesmerize you with their novel strategy. Don't be fooled. They are premised on an investment skill that neither exists nor persists. The 130/30 funds generated huge fees. Some of them have expense ratios over 2%. They win. You lose.

It's the Wall Street way.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

Here is the trailer for my new book, Timeless Investment Advice.