“Investments” to Avoid

The following is for informational purposes only and not meant to be investment, legal, or tax advice. Please consult a CPA or an investment professional.

Social media, smart phones, and financial influencers are cajoling retail investor into financial instruments with ever shorter time horizons, high leverage, and little to no intrinsic value. Regulators have actively aided and abetted this process by approving every “financial innovation” almost all of which help the house win more often at the expense of the investor. A tremendous jump in AI company capital expenditures without any obvious return and a bubble in AI related stocks has further stoked speculative mania. The combination of these factors has created a world where the line between investing and gambling is blurred. 

It is this author’s contention that it is not difficult to tell the difference between investing and gambling. Investing has a reasonable positive expected return for the average investor over a long-time horizon whereas gambling does not. This article focuses on “investments” or “strategies” that for most of the investing public are gambling and should be strenuously avoided. I have termed these Keyser Soze investments because although they are in disguise and tell a great story, but if you know what to look for you can tell they are bad news.  

Key qualities of Keyser Soze Investments

Investments that are really gambling in disguise share a few commonalities:

• Extremely short time horizons
• Little to no intrinsic value or cash flows
• Use significant leverage or embedded leverage
• Inability to use fundamental analysis as a gauge for value
• High expenses
• More prone to insider trading

Zero-Day Options

Options are a tool to magnify or hedge a position. Options are not inherently a negative expected return instrument, but they have several characteristics that result in their misuse by unsophisticated retail traders. Options give traders significant leverage or the ability to control a larger position than they otherwise could with the cash at their disposal. The tradeoff is that the option will expire after a certain period (expiration date) and could expire worthless. The shorter the (long) option’s time horizon the higher the level of risk as the option trader is betting that the option will expire “in the money” by the expiration date.

How can you make options more like gambling and remove any element of fundamental analysis from the equation……you make the time horizon as short as possible. In some fever dream regulators approve the creation of 0DTE or Zero-Day to Expiration options which expire at the end of trading each day at 4pm EST. With a one-day period expiration you are effectively coin flipping to determine the final value of the option. There is no fundamental thesis that can play out over the course of the day nor does anyone have any real ability to consistently make money off these options. However, if someone were to have access to insider information or happen to have an inside track with the current administration which would allow them to trade before news is released…. Zero-Day options would be a perfect vehicle to maximize your profits!

Leveraged/Levered ETFs

A leveraged exchange traded fund (ETF) or exchange traded notes (ETNs) provide a trader with multiple times (2-4x) the daily return of an underlying index, asset, or security.

Leveraged ETFs fail to get anywhere near 2-4x the return of the underlying security because they have relatively high fees, are subject to volatility drag, and must pay for leverage through swaps, futures, or options.

The fees on leveraged ETFs tend to be significantly higher than the underlying indexes. Although I could not find an academic study that provides an industry wide average expense ratio, the ETF Data Base shows an average expense ratio of 1.08% (ETF.com shows a median of .96%) which according to the Investment Company Institute is about 2.5x actively managed equity ETF and nearly 8x average index ETF expense ratios.

Volatility drag is slightly more complicated mathematically but is actually a simple concept. Aptus Capital Advisors has a good basic explanation of volatility drag and the FPA Journal a longer, more detailed explanation. The more volatile the underlying security/asset the more a leveraged ETF will fail to approximate 2-4x the underlying’s return due to volatility drag. Days where the price of the underlying falls will result in a smaller base off of which the ETF can compound. To use an extreme example, on a $100 security if the underlying goes down 10% and then up 20% the unlevered price will be $108 ($100*(1-0.1) = $90, $90*(1+0.20)=$108). An ETF with 3x the return would be $112 ($100*(1-.30)=$70, $70*(1+0.6)=$112. In this case the total return for the security is 8% during this two day period, 3x the return should be 24%, whereas the 3x leveraged ETF only returned 12%.

In order to get 2-4x the return of a security/asset an ETF must use swaps, futures contracts, or in some cases options to boost the returns of the leveraged ETF. For some ETFs the swap cost is negligible, but in others it can be extremely expensive. The more esoteric the underlying security/asset the more difficult it is to get the leverage necessary to boost returns and the more the ETF will underperform the multiple of its underlying. Similarly, the higher the leverage multiple, the greater the total financing costs. To make matters worse, the swap cost is not reportable in the fund’s expense ratio, you just see it in the returns. ETF.com has a great article that expands on the cost of ETF leverage.

Mortgage REITS

 Mortgage Real Estate Investment Trusts or MREITS are investment vehicles that purchase pools of mortgages with leverage. For sophisticated investors that understand their underlying dynamics and actively hedge risk exposures, they can be interesting short-term trading tools. However, they should never be buy and hold investments because they hold pools of mortgage backed securities (MBS) that are subject to “negative convexity”, use extensive leverage, and have a history of failure.

MBS are not in themselves an uninvestable asset class despite their negative reputation for helping to precipitate the Great Financial Crisis. However, they have one key feature called negative convexity that presents significant challenges to all investors including MREITS. To simplify greatly, negative convexity means the price of MBS does not increase as significantly as a standard fixed rate bond when interest rates fall and it falls in value faster as interest rates rise.  Call it heads I lose more, tails I don’t make as much.

This phenomenon occurs because mortgages can be prepaid. The likelihood of prepayment is called a Conditional Prepayment Rate (CPR). As interest rates fall more people refinance making it more likely the MBS will not maintain its now more favorable interest rate. Conversely as rates rise, people retain their mortgages longer so prepayments decline. To deal with prepayment risk, MREITS use hedging instruments, but with a cost of lost return.

The rate on mortgages is relatively low with the average 30-year mortgage around 6.5% today. The return on equity that MREITs have to generate is higher than the rate provided by the MBS or investors would simply buy the MBS themselves. In order to generate a higher rate of return MREITs need to use leverage. In the past MREITS would often use sources of funding that would dry up in times of crisis, most notably repurchase agreements or Repos. When their funding dried up, they were forced to fire sell assets at fire sale prices and some ultimately declared bankruptcy. MREITS have gotten better about using longer term forms of liquidity, but they still have a risk of having their credit lines withdrawn or being forced to take haircuts on their assets which would necessitate fire sales.

Given these issues and a history of failures, MREITS are never an appropriate buy and hold investment. To trade them successfully is exceptionally difficult, requires very specific knowledge, and an understanding of the underlying MBS that almost all retail traders lack. As a result, they should generally be avoided by investors.

Crypto and NFTs

Crypto currencies and Non-fungible tokens both have no intrinsic value, are subject to extreme volatility, have massive regulatory risk, are expensive to trade, and are promoted by all manner of human scum. I have spilled a lot of ink in a previous article on this topic entitled, “Why I don’t Invest in Crypto and Never Will” so I will not rehash the same arguments here, but as probably the worst “investment” on this list I thought it warranted repeating.  

Diamonds and Precious Stones

It is undeniable that diamonds and precious stones have some intrinsic value. Humanity loves shiny things and diamonds are the hardest substance on earth. However, they do not cash flow and the rise of artificial precious stones should result in an erosion of their price over time. Diamonds prices were historically controlled by a monopoly and later duopoly, which resulted in artificially high prices and somewhat stable values. Improvements in artificial diamond technology and massive production in China and India have resulted in a price collapse as can be seen in the graph below. Goods for which economies of scale can be brought to bear and where incremental supply is very cheap should have significant price declines over time. Diamonds and precious stones should therefore be thought of more like a car, something that will depreciate over time and under the best case scenario could retain some of its value.

Cards and collectibles

There is currently a mania in trading cards. The advent of “breaking” videos where collectors buy an expensive box of cards and open it while live streaming has dramatically increased interest in the hobby. However, there is a big difference between a hobby and an investment. While it is true that some cards such as a Mickey Mantle rookie card or a Honus Wagner are so rare and valuable that they are almost like works of art (which are also by and large not investments), most cards do not fit this category.

PSA and Beckett have also allowed for greater standardization of cards by creating grades which are usually universally accepted thereby creating a more liquid market for cards. However, cards and collectibles will never be investments because they do not have any intrinsic value. Cards do not generate cash flow and are only worth what investors are willing to pay for them. There is no logical way to determine why a rookie Shohei Ohtani should be worth more than a rookie Victor Wembanyama other than one variant may be rarer than the other. There isn’t a universally applicable set of valuation principles that one can follow. The absence of cashflows make trading cards and collectibles like crypto, their value is entirely dependent on someone being willing to pay an ever-higher price for the same collectible. If interest in the collectible you are purchasing declines (which has happened many times in the past for trading cards, for example the late eighties early nineties) or there is a general decline of liquidity in the financial system, it is highly likely prices will decline. When you add in the cost of insurance and grading along with the potential for theft or fraud, purchasing cards/collectibles often has a negative long-term return.  

The list above is not exhaustive, but highlights some of the worst gambles in the guise of investments. Syndicated real estate deals, virtual real estate, penny stocks, and timeshares are also horrible gambles with their own idiosyncrasies. The best way to make money in any of the “investments” mentioned here is to avoid them.