of events, as represented by a bell curve, tells usthat some investors and professional money managers will beat the market.But some also will fail in their attempt to beat the market. Since it’s impos-sible  to  predict,  in  advance,  just  who  the  winners  and  losers  will  be,  it’swise not to attempt to do so. It takes time, money, and energy to conductthe research necessary to try to beat the market yourself. It’s foolish to hireothers,  incurring  management  fees  on  top  of  research  and  trading  ex-penses, in an attempt to do so. Accepting an average return is a much moreefficient method of investing. By saving the costs of those management andtrade execution fees, investors are likely to be ahead of the game. Thus, in-dexing is not only expected to match the market, but, by saving all thoseextra costs, it is expected to do better than the professionals and beat them.Frank Armstrong, an SEC registered investment advisor, put it this way:“Notice that we are not saying that you can never win, only that it is unlikelyyou can consistently win enough to overcome the costs of trying.”17
CHOOSE INDEXING
MPT teaches that owning an assortment of index funds is the most efficientmethod for public investors to achieve a satisfactory return on an investment.Buying a mix of index funds may be rewarding, but it’s not an exciting strat-egy. If you are the type of investor who wants to own a volatile portfolio withlots of “action,” then indexing may not be suitable for your personality. Butmost people would be happy just to outperform the market year after year andwould consider such an achievement as anything but dull. The strategy taughtin this book enables you to actively participate in managing your portfolio bycombining  indexing  with  a  hands-on  options  strategy.  Investors  who  wantonly a small amount of hands-on decision-making can modify the strategy.
BEYOND INDEXING
The investment methodology outlined in this book goes way beyond tradi-tional indexing. You are going to learn to go two steps further when build-ing  a  suitable  investment  portfolio.  Part  II  presents  a  discussion  of  the
4339_PART1.qxd  11/17/04  1:01 PM  Page 19
Can You Beat the Market? Should You Try?
19
exchange traded fund (ETF), an improved version of the traditional mutualfund, and explains how to make them your major investment vehicle. SomeETFs are essentially index funds, and those are the ones to which we willpay the most attention. ETFs have many advantages over traditional mutualfunds that make them a wiser choice for most investors.
In Part III, you’ll learn about stock options and how to use them to en-hance investment returns and reduce the risk of owning a diversified stockmarket  portfolio.  Part  IV  merges  the  strategies  into  one  comprehensive,easy-to-adopt method of investing. You’ll learn how to combine the strategyof covered call writing with the ownership of ETFs.
After you follow the recommended investment strategy, your portfoliowill meet the requirements of MPT: reduced risk with the potential for bet-ter  returns.  Such  an  investment  portfolio  provides  you  with  many  of  thebenefits of investing in a hedge fund, but without having to pay the high fees.
But first, let’s take a brief look at hedge funds.
4339_PART1.qxd  11/17/04  1:01 PM  Page 20
C H A P T E R   3
Hedge Funds
Ahedge fund operates like a traditional mutual fund. The management
team pools money raised from investors and puts that money to workin a wide variety of investment vehicles. But hedge fund managersare allowed a great deal of flexibility in choosing their investments and canuse  investment  tools  and  techniques  not  available  to  managers  of  tradi-tional funds. Their goal is to hedge, or reduce the risk of owning, their in-vestments. For example, hedge funds are allowed to play both directions ofthe  market  by  being  long  certain  securities  and  short  others  simultane-ously. Hedge funds use derivative products, such as options and futures,and have the ability to borrow money in an attempt to generate additionalprofits by using leverage. (Leverage means using borrowed money [buyingon  margin]  to  enhance  returns  without  increasing  the  size  of  an  invest-ment.)  Hedge  funds  also  can  participate  in  arbitrage  opportunities.  Arbi-trage involves the simultaneous purchase of a security in one market andthe sale of the same security, or a derivative product (an instrument whosevalue is dependent on the value of the first security), in another market.Due to occasional short-lived market inefficiencies, the arbitrageur occa-sionally can profit from price differentials between the two markets.
Traditional mutual funds have much stricter requirements and are notallowed to sell stocks short. Nor are they allowed to use leverage or deriv-atives.  A  few  mutual  funds  can  write  covered  call  options  (discussed  ingreat  detail  in  Part  III),  but  most  are  prohibited  from  using  any  optionsstrategy. By being forced to invest only on the long side of the market, tra-ditional  funds  do  well  in  rising  markets  and  fare  poorly  when  the  stockmarket declines. The best they can do in declining markets is to hold cash
20
4339_PART1.qxd  11/17/04  1:01 PM  Page 21
Hedge Funds
21
instead  of  being  fully  invested.  One  of  the  great  advantages  of  owningshares  in  a  hedge  fund  is  the  opportunity  to  profit  during  both  bull  andbear markets.
Although hedging techniques cannot guarantee profits, they do reduceportfolio volatility and make it significantly more likely that investors earna profit over the long term. That is why investors usually benefit when theyadd a hedge fund to a traditional investment portfolio. But most public in-vestors  don’t  understand  the  advantages  of  reducing  the  volatility  in  thevalue of their portfolios; instead they are concerned only with how muchmoney they can make right now.
A great many public investors (and professional money managers) suf-fered huge losses during the recent bear market, making many afraid to in-vest and encouraging them to find investments that make money in bothrising and falling markets. Hedge funds represent an investment choice tofill that niche.
FINDING A GOOD HEDGE FUND
Finding hedge fund managers who are skilled traders and who understandrisk management is not an easy matter. Using leverage provides an oppor-tunity to increase profits, but it also can result in increased losses if invest-ment  risks  are  not  managed  carefully.  As  with  traditional  funds,  not  allhedge fund managers are competent to manage an investor’s money. Butit’s  difficult  for  public  investors  to  obtain  the  information  necessary  tojudge the qualifications of hedge fund managers.
Unlike  traditional  mutual  funds,  hedge  funds  cannot  advertise  them-selves to public investors. Legitimate funds managed by qualified manage-ment teams can advertise only to “qualified” investors, typically those whohave $1 million or more to invest. Thus, public investors must learn aboutspecific hedge funds from sources of unknown reliability.
INVESTING IN HEDGE FUNDS: THE BAD NEWS
Hedge funds charge very high fees to manage your money. It is customaryto charge an annual management fee of 1 to 2 percent of the value of the in-vestment, but that’s not much more than traditional mutual funds charge.The  real  incentive  for  hedge  fund  managers  is  profit  sharing—managerskeep  20  percent  of  all  profits.  Because  hedge  funds  originally  were  mar-keted only to very wealthy clients, and because these clients are willing to
4339_PART1.qxd  11/17/04  1:01 PM  Page 22
22
CREATE YOUR OWN HEDGE FUND
pay big fees for excellent results, the tradition of paying 20 percent of theprofits continues. Investors get to keep 80 percent of the profits (before the1 or 2 percent management fee) and incur 100 percent of all losses. Thus,making money is difficult for investors. Despite those high fees, many pub-lic investors are eager to enter the world of hedge funds.
Consider  these  facts:  Operating  a  hedge  fund  can  be  very  lucrative;many public investors are searching for hedge funds; hedge funds are un-regulated and investment results do not have to be audited. These condi-tions  made  it  very  attractive  for  scam  artists  to  enter  the  business  ofoperating hedge funds. On top of this, the success of existing (legitimate)hedge funds during the bear market attracted investors who were losinglarge sums in traditional funds. Their ability to make money during bearmarkets  enabled  hedge  funds  to  greatly  outperform  traditional  mutualfunds. News of their profitability spread, grabbing the attention of investorseverywhere.
But hedge funds were not originally designed for the masses. Instead, aninvestor had to be “qualified” before being allowed to buy shares of hedgefunds. These requirements barred the vast majority of public investors.
The rationale behind those restrictions is that hedge funds are consid-ered too risky for most public investors. They are unregulated, given greatlatitude in the nature of their investments, and don’t have to report their re-sults—and  if  they  do  report  results,  often  they  are  unaudited.  Note  thatpublic investors were allowed to invest in the stock market and lose hugesums when the markets declined rapidly. Even the prudent man rule sug-gests that owning stocks is a conservative and intelligent thing to do. But in-vestors  were  prohibited  from  buying  shares  of  hedge  funds  because  thegovernment  agency  making  the  decisions  thought  these  funds  were  toorisky for the public. Imagine: Funds designed to reduce risk are consideredtoo risky for the average investor!
Hedge Funds for the Masses
As stated, running a successful hedge fund is a very profitable proposition.Many new hedge funds were organized with the purpose of encouraging thepublic investor to enter the game. During the past three years, assets undermanagement by hedge funds increased from $500 billion to $800 billion.1 Tomake it easy to attract investors, initial investment requirements were as lit-tle as $5,000.
Deciding  which  hedge  fund  to  invest  in  is  even  more  difficult  thanchoosing a traditional mutual fund. It’s still impossible to know, in advance,who the skillful fund managers are and which funds are going to be suc-cessful. But beyond that, there often are no verifiable track records for theinvestor to consider. That makes choosing a hedge fund difficult. As if that’s
4339_PART1.qxd  11/17/04  1:01 PM  Page 23
Hedge Funds
23
not enough, public investors have no idea of the background of the fund’smanagers.
In a recent article that is extremely critical of hedge funds, Neil Wein-berg and Bernard Condon describe how many unqualified individuals wereable to pass themselves off as qualified fund managers, open hedge funds,and raise capital from eager investors.2 Although not able to advertise di-rectly  to  investors,  some  were  able  to  circumvent  that  rule  by  claiminghuge profits. In turn, the tales of big profits sometimes were enough to gaina  television  interview  for  the  hedge  fund  managers,  during  which  theyboasted of a great track record and told viewers how to obtain informationon  the  fund.  Notice  that  the  managers  were  not  advertising;  they  weremerely describing their results to an interviewer.
Look at it from the perspective of hedge fund manager wannabes. Ifthey can raise $50 million from the public, and if they earn a return of only5  percent  on  the  money,  that’s  a  profit  of  $2.5  million.  Their  20  percentshare  of  the  profits  comes  to  $500,000.  That’s  enough  money  to  attractmany scam artists.
Unethical fund managers who are able to raise a great deal of moneyare in position to gamble with that money. If they take big risks in an at-tempt to earn large profits, they have nothing to lose. (They lacked integrityto begin.) If they go broke, it’s not their money; if they hit it big and doublethe money, their share of the profits from a $50 million account is $10 mil-lion. These windfall possibilities, coupled with the fact that hedge funds areunregulated, was bound to attract some unscrupulous scam artists. Wein-berg and Condon claim “it’s amateur hour in the hedge fund business” be-cause hedge funds are being operated not only by those well qualified torun such funds, but also by “shills, shysters, charlatans, and neophytes toocrooked or too stupid to make any money.” Sadly for public investors, theinvested capital often disappeared quickly—either through trading lossesor outright theft.
There  are  many  excellent  hedge  funds  available  to  the  investor,  butdue diligence is required to find a legitimate fund with qualified managers.Good information often is difficult to obtain because legitimate funds arenot allowed to advertise to those seeking information. Few take the time toattempt to verify the claims before investing after hearing (untruthful or ex-aggerated) claims of the fantastic results achieved by some hedge funds.
Fund of Funds
A breed of mutual fund is called a fund of funds. The managers of thesefunds invest money by buying shares of other funds—both traditional andhedge  funds.  Although  this  sounds  like  a  good  way  to  own  a  very  well-diversified portfolio, consider the management fees. The investor who buys
4339_PART1.qxd  11/17/04  1:01 PM  Page 24
24
CREATE YOUR OWN HEDGE FUND
shares of a fund of funds must pay a management fee to those people whooperate the fund of funds. Then the money is invested in other funds whosemanagers also charge a management fee. Finally, the hedge fund managerscollect 20 percent of all profits. Too many fees!
If you ever consider buying shares of a hedge fund, be certain to readthe prospectus carefully to determine the type of investments used by themanagement team and the level of risk involved. Remember, the greater thereward  promised  by  the  fund  managers,  the  greater  the  risk  required  toearn that high reward. If possible, invest only in funds that produce an auditof their investment results.
DO IT YOURSELF
You can avoid the risk of hiring fund managers who are unqualified. Youcan  eliminate  the  uncomfortable  feeling  of  having  money  invested  whenyou don’t fully understand the investment methods used by those managingyour money. If you follow the strategies outlined in this book, you won’thave to worry about the integrity of the fund manager, because you will bemanaging your investments by yourself. There will be no worry about themanagers taking more risk than you are willing to take, for you will be man-aging that risk yourself. In fact, if you adopt the methods described, yourportfolio will be significantly less risky than the portfolio of a typical Amer-ican investor—someone who buys a collection of stocks and seldom sellsany of them (a buy-and-hold investor). Hedging is a way to reduce the riskof owning other investments, and the investment strategy described in thisbook reduces the risk of owning stock market investments.
If you learn to operate your own hedge fund, you are assured the fundmanager is ethical. In addition, there are no fees to pay, and you keep allprofits for yourself (except for taxes, of course). This book doesn’t explainall of the many possible methods of hedging investments. Instead, we con-centrate on two hedging methods that are easy for average investors to un-derstand and implement. When you become satisfied with the results andfeel comfortable, you can always expand your hedging education.
OR DO IT WITH HELP
If you like the ideas taught in this book and want to run your own hedgefund, but would like the reassurance of working with others, form an in-vestment club. If you show this book to friends, family, and business asso-ciates, and if you suggest joining forces and adopting the strategies outlined
4339_PART1.qxd  11/17/04  1:01 PM  Page 25
Hedge Funds
25
here, you will be in position to discuss specific investment ideas with eachother and rely on the pooled judgment of several people. That should helpget you started, if you don’t want to tackle this do-it-yourself strategy alone.By pooling ideas and money, each club member contributes to the suc-cess of the club. These investment clubs represent a great educational op-portunity. The NAIC (National Association of Investment Clubs) can helpyou get started with forming a club,3 but be warned: The association is stillusing  yesterday’s  investment  methodology—namely  buy  and  hold.  Thehedging strategy outlined in this book works well and is a sound basis fororganizing a modern investment club.
A better choice for learning about investment clubs is bivio.4 They offeran application enabling groups of investors to create and manage a club.Bivio is the only accounting service for investment clubs that supports op-tions, and their software handles the club’s bookkeeping chores.
In  Part  II  we’ll  continue  our  journey  with  a  discussion  of  exchange
traded funds.
4339_PART1.qxd  11/17/04  1:01 PM  Page 26
4339_PART2.qxd  11/17/04  1:02 PM  Page 27
PA R T   I I
ExchangeTraded Funds
4339_PART2.qxd  11/17/04  1:02 PM  Page 28
4339_PART2.qxd  11/17/04  1:02 PM  Page 29
C H A P T E R   4
A Brief History of Mutual Fundsand ExchangeTraded Funds
Exchange traded funds (ETFs) are a recent innovation and the twenty-
first-century  version  of  the  traditional  mutual  fund.  They  first  ap-peared  on  the  scene  in  1993.  Before  learning  more  about  thisinvestment vehicle, let’s take a brief look at the mutual fund industry andhow it all began.
HISTORY
As  noted  earlier,  public  investors  did  not  always  invest  their  money  instocks.  As  recently  as  100  years  ago,  no  professional  financial  advisorwould ever suggest that average investors place any savings in the stockmarket.  But  the  world  changed  when  the  first  official  mutual  fund,  TheMassachusetts Investors Trust (MIT), opened for business in March 1924.This fund is still in existence today. By establishing the minimum invest-ment  at  $250,  and  a  sales  charge  (load)  of  5  percent,  the  fund  managersmade it easy for public investors to buy shares. MIT is an open-ended fund,meaning that new shares are issued to anyone who wants to buy them. Thefund management team takes the newly invested cash and issues shares tothe investor. The managers keep the cash in reserve or use it to make addi-tional investments for the fund’s portfolio. Investors can redeem shares bynotifying the fund management of their desire to sell. New shares are is-sued, and existing shares are redeemed, at the true value of the fund, calledthe net asset value (NAV).
29
4339_PART2.qxd  11/17/04  1:02 PM  Page 30
30
CREATE YOUR OWN HEDGE FUND
The existence of mutual funds such as MIT gave public investors aneasy way to own a diversified portfolio of stocks and opened the gates ofWall Street to the masses. And eventually the masses became very inter-ested. As of June 2004, the mutual fund industry managed more than $7.59trillion of the public investor’s assets, according to The Investment Com-pany Institute (www.ici.org).
The first closed-end mutual fund arrived on the scene in 1927. Initiallycalled investment trusts, closed-end funds do not issue additional shares.Instead, existing shares trade on an exchange where they can be bought orsold in a manner identical with stocks. The price of such shares is deter-mined by supply and demand, not by the true value of the underlying fund(NAV). Most of the time these funds trade at a discount to their true NAV,but they have been known to trade at a premium.1
In April 1928, the no-load fund was born when the Norfolk InvestmentCorporation was established without a purchase fee (load). A month laterthe  fund  changed  its  name  to  the  First  Investment  Counsel  Corporation.Today it is part of the Scudder family of funds.
The  market  crash  in  1929  and  the  depression  that  followed  broughtmany  changes  to  the  investment  industry.  The  Securities  Act  of  1933  re-quired all funds to sell shares through a prospectus that points out the risksassociated  with  such  investments.  Previously,  salesmen  were  allowed  tosell mutual funds without any government regulations. Three years later theSecurities and Exchange Commission (SEC) was created, naming Joseph P.Kennedy (father of future president John F. Kennedy) as its first chairman.In 1946 funds allowed investors to reinvest dividends without paymentof the sales load for the first time. In 1951 the total number of mutual fundssurpassed 100.
Money market funds appeared in 1971, giving investors an easy methodof holding the equivalent of cash for those periods of time when they did notwant to be invested in any of the mutual fund company’s other offerings.
In 1976 Vanguard issued the first index fund, whose goal is to capturealmost 100 percent of the market’s annual return and is based on the beliefof Vanguard’s founder, John Bogle, that “beating the market is so difficultthat people are better off trying to match the market.” 2 They accomplishthis goal by buying all the stocks in the Standard & Poor’s 500 index andholding  them  forever.  Today  index  funds  are  extremely  popular,  but  theidea did not immediately catch the fancy of public investors, and the sec-ond index fund did not appear until 1984.
In 1993 the modern version of the mutual fund, the exchange tradedfund, was brought to the market by State Street Global Advisors and theAmerican Stock Exchange. Standard & Poor’s Depository Receipts, nick-named spiders, attempts to provide investors with the same return as theS&P 500 index.
4339_PART2.qxd  11/17/04  1:02 PM  Page 31
A Brief History of Mutual Funds and Exchange Traded Funds
31
As the technology bubble was expanding in the final years of the 1990s,the number of funds exploded. According to the Insurance Information In-stitute,  there  were  more  than  8,300  funds  in  existence  at  year-end  2001.Today some of those funds have disappeared, but the mutual fund industryremains  huge  and  influential.  How  well  it  survives  the  competition  pro-vided by exchange traded funds and the scandals of the early 2000s is anopen question.
For those interested in additional history of the mutual fund industry,Jason Zweig wrote an article commemorating the seventy-fifth anniversaryof the mutual fund industry in 1999.3
HISTORY OF EXCHANGE TRADED FUNDS
It  started  in  1993  with  spiders.  Diamonds,  qubes,  webs,  and  vipers  wereadded later. These newcomers to the investment world, with strange nick-names, have exploded in popularity, and a little more than one decade aftertheir birth, this new class of securities has grown so rapidly that as of June2004, investors had poured over $178 billion into them. At that time, therewere at least 143 different ETFs, and the number is growing steadily. ETFsare not only American products; they exist overseas as well.
What makes these newcomers so popular? We’ll take a look at how thismodern version of the traditional mutual fund can be used by a great many(but  not  all)  investors  to  obtain  benefits  not  available  from  traditionalfunds. As you will see, ETFs provide an easy way to get around the high ex-penses and poor performance associated with the mutual fund industry.
ETFs can be considered as hybrid securities, part mutual fund and partstock. They’re not exactly mutual funds, although they invest in a diversi-fied basket of stocks, just as mutual funds do. They’re not exactly stocks,but  they  trade  on  an  exchange,  just  as  stocks  do.  If  these  two  attributesmake you think they resemble closed-end mutual funds, that resemblanceis superficial.
ETFs have advantages over traditional mutual funds that make themmore attractive to both public and institutional investors. We’ll discuss theadvantages of ETFs in Chapter 6 after taking a look at traditional mutualfunds and how well they serve the needs of today’s public investor in Chap-ter 5. One major advantage of ETFs is that, unlike traditional mutual funds,many are optionable. This means investors can buy and sell put and call op-tions on these ETFs. Optionability is important because you will learn howto incorporate a conservative strategy, called covered call writing, into yourinvestment program to enhance the performance of your investment in thestock market. Part IV presents a detailed discussion of this topic.
4339_PART2.qxd  11/17/04  1:02 PM  Page 32
C H A P T E R   5
TraditionalMutual Funds
The mighty mutual fund industry has been in existence for more than
80 years and has pretty much had things its own way. But becausesome management companies have behaved questionably, the indus-
try has been scrutinized intensely in recent times.
IS THE MUTUAL FUND INDUSTRY IN TROUBLE WITH THE PUBLIC?
Recent allegations that fund managers allowed some preferred customersto buy shares after trading hours rocked the public’s confidence in the in-dustry.1 Additional charges of favoritism (allowing preferred customers totime the marker by frequently buying and redeeming shares) provided fur-ther trouble.2
Mutual fund mangers make a fortune.3 As difficult as it may be to be-lieve that they would jeopardize that income stream for the chance to earna few extra dollars in fees, some clearly have done so.
The shareholders are the true owners of their mutual funds, and themanagement teams are charged with the responsibility of managing thosefunds with the best interests of the shareholders in mind. In fact, they arepaid huge fees to do just that. However, it has become obvious that somemanagers operate the funds with their own bottom lines taking precedenceover their responsibilities to their own shareholders. For example,
32
4339_PART2.qxd  11/17/04  1:02 PM  Page 33
Traditional Mutual Funds
33
• Managers earn a yearly fee based on the amount of money under man-agement,  so  it’s  to  their  advantage  to  attract  new  capital.  But  largerfunds often have a difficult time trading huge quantities of stock, mak-ing managing the portfolio inefficient. That’s unfair to the shareholder.• Management teams do not offer the funds the same discounts offered
to their institutional clients.
• Instead of absorbing marketing expenses, managers force shareholders
to pay those expenses.
• Reports  to  the  shareholders  are  supposed  to  provide  accurate  com-mentary on management team performance. A serious conflict of in-terest arises when managers gloss over their own shortcomings.4
Investors might overlook the shortcomings of their mutual funds if theyproduced superior profits. Thus, the question: Do mutual fund managersoutperform the market?
THE FACTS ARE CLEAR: MUTUAL FUNDS UNDERPERFORM
The professionals on Wall Street are in the business of trying to convincepublic investors they can easily beat the market and that everyone eithershould open an account with their brokerage firm or give their mutual fundcompany  money  to  manage.  Do  you  remember  those  TV  ads  during  thetechnology bubble of the late 1990s in which one brokerage firm tried tosell the idea that you could a) retire to your own Caribbean island or b) ownyour own helicopter and airplane if you would only invest with them? Theymay  have  been  using  tongue  in  cheek  humor,  but  they  were  selling  theidea—mainly  to  day  traders—that  the  stock  market  was  an  easy  path  toriches.  Indeed,  many  people  quit  their  day  jobs  to  become  active  daytraders. In truth, it was a road to riches for the brokers, but not individualinvestors.
It’s the same for the mutual fund industry. They try to convince publicinvestors that they constantly produce excellent investment results, but thetruth is professional money managers do not live up to expectations, andjust like individual investors, they are unable to consistently beat the mar-ket. Details demonstrating how these professionals fail to perform betterthan  the  averages  have  been  adequately  covered  elsewhere5 and  a  sum-mary of the findings is sufficient for our purposes. Using data from Morn-ingstar  and  commenting  on  actively  managed  funds,  Baer  and  Genslerconclude, “it is likely that fewer than 20 percent of all funds actually beat
4339_PART2.qxd  11/17/04  1:02 PM  Page 34
34
CREATE YOUR OWN HEDGE FUND
the market over a five-year period, and fewer than 10 percent over a ten-year period.”6
A similar conclusion was reached by John Bogle, the father of the indexmutual fund: “Over the past 25 years, only 32 percent of actively managedequity funds have outpaced this unmanaged index (S&P 500), and no onehas ever suggested a methodology by which those few winners could havebeen selected in advance.”7
It may not be surprising to find that public investors underperform themarket. One might expect that as a group individuals can