WallStreet Journal
Small Investors, Too, Get Nailed by Arcane Trades
Tuesday August 14, 2007 2:13 am ET
By Eleanor Laise, E.S. Browning, Jennifer Levitz and Craig Karmin

By day, Brian Abbott is a doctor at a cancer institute in Great Falls, Mont. In his off hours, he invests with borrowed money, shorts stocks and has taken a complex options position called a "short strangle" on wheat.

He has been trying to bulletproof his portfolio against sudden market declines, using investment tools usually associated with hedge funds and banks. But rather than protecting his $1 million or so in holdings, the 35-year-old physician says he left it vulnerable.

"Things that should have protected me weren't working," Dr. Abbott says of the market in recent weeks. "Everything was seeming to go down."

A growing number of nonprofessional investors have sought protection from market drops, such as the Dow Jones Industrial Average's 38% fall during the bear market of 2000 to 2002. Wall Street's financial engineers have devised a wealth of products to help Main Street investors diversify or hedge like the pros. As a result, many ordinary investors have shifted toward foreign stocks and currencies, or "market neutral" funds that are supposed to be steadier than ordinary mutual funds. They're dabbling in commodities futures and short selling, an investment bet that pays off if shares decline.

Now these small investors are facing the same problems as Wall Street pros: Many of the hedges aren't working as they expected.

In the past month, the market has been behaving in ways even seasoned players have been at a loss to explain. First the sagging housing market drove down the value of widely used investment vehicles tied to low-quality mortgages. Jitters bled into the broader credit markets, and, as troubled investment funds announced heavy losses, stock markets gyrated. Investments that were supposed to be diverse and uncorrelated -- including stocks, corporate bonds and commodities such as gold -- have fallen at once.

Many smaller investors in the U.S., particularly those whose portfolios favor blue-chip shares, have so far watched a whipsawing market without suffering big losses. But the cash inflows suggest that a good number of individual investors are exposed.

So far this year, U.S. investors on balance have put $81.28 billion into foreign funds, compared with $8.09 billion into plain-vanilla U.S. stock mutual funds, according to the Investment Company Institute, a mutual-fund trade association. (Traditionally, U.S. investors almost always have put much more money into U.S.-stock funds.)

The yen for foreign investment has also been stimulated by a host of new exchange-traded funds -- funds that contain baskets of investments and trade like stocks -- which let people directly play the markets of countries such as South Korea, Sweden and Brazil. ETFs also let investors bet on commodities and a wide variety of U.S. stock sectors. In this year's first seven months, 179 new ETFs were launched, bringing the total to 538, according to State Street Global Advisors.

Individual investors have expanded into other arenas as well. At optionsXpress Holdings Inc., an online retail brokerage specializing in options and futures, investors made 555,400 options trades in July, up 46% from a year earlier. Margin balances -- that is, loans to customers -- hit $178 million, up 20% from a year ago, it says. The brokerage doesn't require a minimum investment to open an account; the minimum for a margin account is $2,000.

Historically, individuals tended to limit themselves to stocks and bonds -- stocks to provide capital gains, and bonds for steady income. But the stock craze of the 1990s and the advent of online investing changed that for many people. Now amateur investors can easily trade not only U.S. stocks but also options, futures and ETFs.

Like most investors in the 1990s, Ed Chambless, a retired airline pilot and a former Marine officer, had much of his money in U.S. stocks. The powerful bull market made it seem unnecessary, even foolish, to invest heavily abroad.

But the long bear market took a big bite out of his family's savings and made him wary. After he sold his Atlanta home and some other property in Augusta, Ga., in 2002, Mr. Chambless invested the proceeds from those sales more internationally, and in a wider variety of more sophisticated investments, to protect against another sell-off.

Around that time, he attended an extravagant investment trade event in Las Vegas, the Money Show, aimed at individual investors. He was impressed with a presentation about growing global demand for commodities. "With China and India coming on line, they're going to need a lot of stuff," the 69-year-old, now in Denton, Texas, recalls thinking.

Mr. Chambless bought a natural-resources mutual fund, and another that tracked commodities. He added a precious-metals fund and scooped up some individual mining stocks, like Newmont Mining Corp. and Northgate Minerals Corp. and the Russian energy company Yukos.

Worried that U.S. government spending would be a long-term drag on the dollar, he bought certificates of deposit for the Australian and New Zealand dollars. He also invested in a Japanese real-estate investment trust. "I try, obviously, to be diversified," he says. His record has been one of slow but steady appreciation: His $850,000 savings from 2002 is around $1 million today.

Over the past four weeks, he's seen his portfolio reduced by $27,000. He believes he's positioned to ride out this current market slide, though he wishes he'd have kept a bit more of his money in cash. With so many investments to track now, he's not sure which ones tumbled the most during the recent turmoil.

"That's something I probably ought to know," Mr. Chambless says. "Right now it seems like everything is sort of going down."

Barron Segar, 44, who works in Atlanta for a nonprofit group, says he has been shocked at the losses in an investment that he thought would be a conservative way to hedge against risk. To help stabilize his portfolio, Mr. Segar says, he put about 5% of his portfolio into TFS Market Neutral fund. Market neutral funds buy stocks and also engage in short selling, in an effort to show gains in both up and down markets.

Mr. Segar chose the TFS fund as an alternative to a bond mutual fund. In the late 1990s, he had about 25% of his portfolio in conservative investments such as bond funds and cash. But as bond yields fell in recent years, he looked for alternatives.

The TFS fund is down 7% for the three months through Aug. 10. The decline has made Mr. Segar rethink his decision, and he has withdrawn some money. "This fund has done worse than my aggressive growth fund," Mr. Segar says.

Richard Gates, a co-manager of the fund, says in the market's recent turmoil, both the fund's regular stock investments and short positions were hit simultaneously. He points to the fund's long-term track record, up an average 10.7% annualized since inception in September 2004, according to the TFS Web site.

Financial planner Reed Rinderknecht says that in the past 12 to 18 months, investors have asked questions about everything from ETFs to the short and long funds they read about in electronic newsletters or on brokerage Web sites. "We see people shooting themselves in the foot all the time," says Mr. Rinderknecht, a partner at Foster Group, a fee-only financial-planning firm in West Des Moines, Iowa, that specializes in broadly diversified, long-term investments. "A little information can be deadly -- because people know just enough to get themselves in trouble."

Pitfalls abound, even for experts. Short selling is considered riskier than standard stock investing because it involves borrowing stock and selling it. The broker that lends the stock can demand its return before the investor has made a profit. If a stock rises more than 100%, the short investor can lose more than 100% of his investment -- which isn't possible with a simple stock purchase. What's more, stocks generally rise when the economy is growing, so a short seller must act at just the right time, something even experts have trouble doing.

Commodities, options and futures are risky, meanwhile, because those markets can swing sharply, and because the trading accounts involved often use borrowed money. Foreign stock markets, particularly those of developing countries, can be more volatile than U.S. markets. Investors can also find it be challenging to obtain information about them.

James Hayden of Falls Church, Va., a 71-year-old retiree, started investing about two months ago in developing-country ETFs, in hopes of diversifying his risk and improving his returns. To choose ETFs, he says, he used research tools offered on the Web site of Chicago-based fund researcher Morningstar Inc.

Until then, in his 14 years of active investing, he had bought only regular mutual funds. He "lost a lot of money" in the collapse of the tech-stock bubble, he says, but gradually regained it. Lately, he has tried to invest in the parts of the world that have showed the highest total investment returns.

"Ouch! It's terrible," he says of his Brazil and Korea funds, which fell 5% last week. "I need this money to pay bills," says Mr. Hayden, a retired photographer for the Smithsonian Institution. He rents his home and lives on what he calls a modest pension, which is why he's trying to be aggressive in investing. All of his savings are in his investment portfolio, which he values at less than $100,000. He figures that 20% is in his two ETFs, with the rest in five mutual funds.

Not all of the investors are bleeding. For his part, Dr. Abbott of Great Falls figures that his portfolio is still up about 5% overall for the year, thanks mostly to bond holdings. Even so, he says he may have gotten in too deep. Until last year, he invested in ordinary stocks, as well as stock and bond mutual funds, and dabbled modestly in more arcane investments. He made a big push to diversify last year after the summer's market volatility. "It made me want to smooth things out a bit, performance-wise," Dr. Abbott says.

Now, investing online through six accounts, he has been trading in and out of funds with names such as the UltraShort QQQ ProShares ETF, which aims to move twice as much as, and in the opposite direction to, 100 large Nasdaq stocks. He owns the American Century Long-Short Equity Fund, which bets on both stock gains and declines in an effort to rise regardless of market conditions. About a year ago, he started investing directly in commodities futures contracts.

In the past six months, he bought the CurrencyShares Swiss Franc Trust, an exchange-traded product that tracks the Swiss currency. Recently he's even tried currency and interest-rate futures trading. "That's a pretty advanced thing," he concedes. "I'm not an expert."

A few months ago, he entered into the "short strangle" options position on wheat, using borrowed money. He stood to profit if prices remained stable. When wheat prices soared, he was about to face a margin call -- a demand from his broker for repayment. He got out of the position with a loss of about $5,000.

Now, Dr. Abbott's American Century Long-Short Equity Fund is down nearly 7% in the month ending Aug. 10, lagging the S&P 500 by more than 3 percentage points. His short positions in Amazon.com Inc. and Google Inc. haven't worked out as he anticipated, either. He is also concerned about correctly timing his exit from the UltraShort ProShares ETF. His $10,000 investment in the instrument could take a severe hit if the market starts to rally.

In the end, he says, holding so many exotic instruments has been overwhelming. He says he's shifting money back to a broad stock-index fund, and he's reduced his short position in Amazon.

"This points to the difficulty of being an individual investor. You have to time things," he says. "Few people can do the timing right, and I don't think I'm even one of them."

Write to Eleanor Laise at eleanor.laise@wsj.com, E.S. Browning at jim.browning@wsj.com, Jennifer Levitz at jennifer.levitz@wsj.com and Craig Karmin at craig.karmin@wsj.com



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