AskDong

This is the long “awaited” last part of my five part series on Investing Basics. I last covered Mutual Funds I would not even categorize options or futures as basic. I personally do not invest directly in futures (at least not in my home portfolio). I dabble with options. Most people, I would think, can skip these and other derivative investments and be more than OK.

Both options and futures are considered derivatives. Warren Buffet has called derivivatives financial weapons of mass destruction. Of course, these are weapons that Mr. Buffet enjoys stockpiling. While it may seem on the surface inconsistent that Warren would slam derivatives one day, and praise their use the next, Berkshire Hathaway use of derivatives is completely consistent with it’s role as one of the largest insurers and re-insurers in the world. Selling insurance is not too different from selling options.

So what are derivatives? Derivatives encompass wide variety of financial products. Options, futures (forwards) and swaps constitute the vast majority of derivatives. Derivatives all have one thing in common. They are nothing in themselves. The value of any derivative contract is tied to the value of a real underlying product. In the case of stock options, the value of the option is directly tied to what a particular stock trades at. In this regard derivatives are the most akin to gambling. When you make a bet, the bet itself doesn’t have any intrinsic value. Rather the value is in the cards that are played, or who wins the basketball game. The bet is secondary to the actual event.

Options
So what is an option? An option is exactly what the name implies, it gives the owner of option the opportunity to buy or sell at a given price. A call option grants the right to buy, and a put option grants the right to sell. While a share of stock only really has one attribute – price, an call option on particular stock has number of attributes.

There are two types of option expiration conventions, European and American. American options can be exercised on any date before the expiration date, and European options only on the expiration date. In practice, there is nary a difference as there’s almost no reason to ever exercise an option before expiration. By excercising an option, you’ve basically given up the value of the “option” to exercise.

Below is chart of example value of call option with a strike price of 20 given the trading value of the underlying stock.

An option will never be worth less than 0, and at all points should have some value reflecting the option premium, and the intrinsic value. For example if the stock is trading at 20 and the strike price is 20, the option premium might be $2. $2 reflect the value of having the right to buy the stock for $20. The intrinsic value at that time is 0 because there’s no value in exercising the option to buy at $20 when the stock can actually be had for $20. However if the stock were to move to $30, then the intrinsic value would be $10. I could use my option buy the stock for $20, and turnaround and sell it for $30 – instant $10 profit.

Futures
Futures are standardized forward contracts. Forward contracts have two of the same components as an option. 1) Price 2) Date. Unlike an option a forward contract is an obligation to transact at a certain price. In many regards an option is modified forward contract. A future is a forward contract in standard form and can be traded on an exchange. For example oil futures that are traded on the New York Mercantile Exchange have given specifications for method of delivery, quantity, and the type of product.

So a if I were to buy an oil future for $200 a barrel with a delivery date of June 2009, in June 2009 I would be obligated to pay $200 a barrel even if oil prices at the time were $50. Forward and future contracts developed originally in the agricultural world to allow producers and users to get price certainty for goods that would be delivered later. Many companies such as Airlines still use futures to hedge future uncertainty, but there are just as many investors who buy and sell futures purely for financial reasons.

Most indexes such as the S&P 500, Nasdaq, MSCI World, and Russell 2000 are market cap weighted. The major exception is the Dow Jones industrial average. The granddaddy of the indexes is price weighted - essentially it’s a straight average of the share price (in truth it’s more complicated because of changes made to the index over the years, but that’s the basic principle). By virtue of being market cap weighted, larger companies impact the index more than smaller companies Market capitalization is simply the number of outstanding shares multiplied by the share price. So for example, let’s say I create index called AskDong 2 with two stocks, GOOG (Google) and IRBT (iRobot the maker of the Roomba) . GOOG has a market cap of 165 billion, and IRBT a market cap of $412 million. The resulting index would be heavily skewed towards GOOG with IRBT barely making a dent in the price of the index. The index would consist of 99.8% the price GOOG, and .2% IRBT.

While I think there’s very little disagreement that that market cap weighted indexes are a great measure of broad markets, some people believe that from an investment standpoint market cap index mutual funds are somewhat inherently flawed. Because market cap is affected by the share price, it’s inevitable that when someone buys into a index fund they are effectively buying more of the “hot” stocks, and less of the sagging ones. Mutual fund companies realizing this and that there’s money to be made marketing an alternative have introduced Equal Weight Index Funds.

Equal Weight Index funds eschew the market cap weight, and allocate dollars equally to each share that makes up the index. Example of such funds are the Rydex S&P Equal Weight Fund, RSP and Nasdaq 100 Equal Weighted, QQEW. Individuals who believe that equal weight index funds are superior generally tout the the increased exposure to the undervalued stocks since an equal weight index will own as much of the sagging companies as the winners.

Personally, I believe if someone who’s only investment is a S&P 500 or Total Market index fund then that person should consider an equal weight index fund just because they are not giving enough weighting to mid and small cap stocks. However if someone is properly invested in different market indexes already, they mostly likely have enough exposure to undervalued shares. More fundamentally, by assuming that those shares are “undervalued” implies that those shares will rise in value. The fact is poorly performing shares are often poorly performing because the companies are inherently flawed. Unlike traditional Index Funds which make no judgement about the market, Equal Weight Index Funds implicitly are contrarian to the market as they tend to chase the laggards.

A few months ago E*Trade eliminated their 12b-1 refund program. 12b-1 fees are marketing fees charged by Mutual Funds. These are basically monies paid to brokerages for selling their mutual fund. Sounds awfully like a kickback.  I’ve been investing in WFIVX, an Index Fund based on the Wilshire 5000 which in turn is an index of the entire U.S. stock market.  At E*Trade buying and selling WFIVX is a free, and the rebate made the fund somewhat more competitive with some of the more popular low cost total market index funds such as VTSMX (Vanguard), POMIX (T. Rowe Price), and FSTMX (Fidelilty).  None of those other funds are free to trade on E*Trade. Some like POMIX is not even offered. I had hoped to keep all my investments consolidated within E*Trade, but on further review I decided it would be imprudent of me to continue to do so. I’m being bled dry by WFIX, relatively speaking. Below is a table of the respective expense charges.  Expense charges ares expressed in percent terms, so an expense ratio of .5 is equal to .5% or .005.  Expense charges are charged annually as a percentage of the fund investment.  A 1,000 investment will be charged $5 every year (more as it grows) if a .5 expense ratio applies.

All numbers are courtesy of Morningstar.com. The Vanguard Admiral class shares are offered those investing more than 100k, and investors with a long client history with Vanguard.

When it comes to index funds, it’s all about lowering costs.  You’re not paying for sage investment advice or performance. You’re paying for someone to accomplish a predetermined task cheaply and efficiently.  While in the past I’ve derided ever so slightly some Vanguard adherents who don’t believe at all in individual stock picking, I’ve always been a admirer of Jim Bogle’s company and his consumer advocacy.  As a company Vanguard does a tremendous of job of keeping it’s fee’s low, though some feel that company has lost it’s way somewhat.  Despite the criticsm, and the slightly lower expense ratio of the Fidelity Spartan Total Market Index (FSTMX), I’ve decided to finally pony up and open a Vanguard account. Vanguard offers a wider selection of index funds at lower costs than Fidelity overall, and I am as interested in international funds and bond funds.  Also, someday I hope to be eligible for the Admiral class shares.  The fact is that Fidelity and Vanguard have been engaged in a price war, and it’s still unclear in the long run who will be cheaper.  All I know is price wars are great for consumers.

The benefit I’ll see by diverting my index fund investments towards Vanguard is quite substantial.

Over the course of 15 years, I will be around 3,000 better on 10,000 investment by investin at Vanguard instead of WFIVX. This free money on the table, that I need to take off. As of last week I’ve stopped adding to my monthly investment in WFIVX. The question now is how and when should I sell my shares of WFIVX and exchange them for Vanguard funds.

Reading BussinessWeek at the Gym during my visit last week was a treasure trove of information. In addition to learning about Chuck Feeney, I learned something new about the Mortgage Deduction that I didn’t know about. Of course this piece of information is less than beneficial.

Most people typically think of all the mortgage interest as deductible, assuming it falls under the 1 million dollar cap. However this is not true for the many individuals who have refinanced to take cash out of a highly appreciated home. Refinanced mortgage interest is only deductible to the amount of the original mortgage.  For instance let’s say I purchased a house 20 years ago for 100k with a 80k mortgage, and now it’s worth 500k.  I then do a cash our refinance for a total of 300k.  I can only deduct the interest on the original 80k, not the new balance of 300k. However, according to the article in BusinessWeek and my own reading of the IRS Publication 936, it’s possible to deduct the interest on another 100k if it’s in the form of a second mortgage, or home equity line.

I’m generally not a fan of the cash out mortgage, and this is yet another reason not to do it. As is, I don’t advocate taking a course of action purely because of tax issues, and too many people push taking out large mortgage because “it’s deductible.” Taxes are an important part of the financial decision of making process and tax consequences should shape decisions. Decisions should not however ever be made solely to avoid taxes.  In this case taking a cash out mortgage may not even be the tax deduction boon one would think.

Also, I’m under the Big Tent at My Two Dollars in the 106th Carnival of Debt Reduction, my article on Mary’s Ann’s Makeover is featured.  Please take some time to visit David’s blog, My Two Dollars.