04/30/2008

Obama Should Have Used a Tighter Stop Loss

 Whenever I need help connecting political events with lessons for investors, I turn to my long-time friend and colleague, the incomparable Jim Woods. Here Jim shows investors how Sen. Barack Obama would have been best served by employing a tighter stop loss -- i.e., disavowing the Rev. Jeremiah Wright -- way before his association with the man did him any real damage. Read on -- I think you'll enjoy this cautionary tale.

By Jim Woods

By now, I suspect that most of you have either seen, or read about, Sen. Barack Obama's press conference Monday in Wilmington, N.C. In the press conference, the Democratic Party presidential frontrunner firmly denounced his former pastor, the Rev. Jeremiah Wright, saying Wright's "rants" of the past weekend were "appalling."

"They offend me," Obama said. "They rightly offend all Americans. And they should be denounced. And that's what I'm doing very clearly and unequivocally here today."

To Obama's denunciation, I say -- what took you so long?

The racism and paranoia spewed forth by Wright over the weekend was nothing new, although it did come in a very concentrated dose that illuminated just how distorted and truly imbecilic his views really are. I mean, this guy has the audacity -- to borrow a phrase -- to say that the government manufactured the AIDS virus to kill blacks, and that America's "terrorism" brought on the 9/11 attacks.

Surely, only the most naïve amongst us is capable of believing that Obama didn't know what kind of man he was dealing with in Wright.

In fact, the world got a glimpse of Wright's true colors in the post-9/11 Sunday sermon in which he damned the United States from his pulpit. Shouldn't that have been enough of a reason for Obama to cut his losses and denounce Wright? I certainly think so, but instead, Obama opted for another tactic.

In March, Obama delivered a speech in which he said he disapproved of Wright's comments, but he did say the pastor still played an important role in his spiritual life. Curiously, rather than take a more forceful attitude toward the ranting of Wright, Obama flipped the discussion into what I believe was a condescending attempt to educate us all on the state of race relations in this country.

Questions of poor judgment aside, why didn't Obama just come clean and cut his ties to Wright back in March? Or to put it in investment terminology, why didn't Obama put a much tighter stop loss on the Wright issue and cut his losses before they did any more damage to his campaign?

In retrospect, that is exactly what Obama should have done. But now ask yourself this question, have you ever behaved like Obama with an investment you've owned?

I suspect the answer is yes, even for the most vigilant investor. Why? Well, because we all have the natural tendency to try and justify our decisions, even if we know those decisions to be detrimental to our own interest.

The Obama/Wright situation reminds me of the investor who buys XYZ stock at $100, only to see XYZ plunge to $50. The investor knows that it was a bad decision to buy XYZ, but rather than admit the error of his ways and move on, the investor convinces himself that this is a great stock and that it will come back soon.

Of course, when XYZ falls to $25, the investor throws up his hands and finally admits that he was wrong. He sells XYZ and takes a really big loss.

The solution here, for both Obama and the investor, is to employ a much tighter stop loss on every position you have. If you are wrong about something -- be it a damaging association with a sick-minded spiritual advisor, or the profit potential of XYZ shares -- the best thing to do is cut your losses before you sustain any serious damage.

Life is full of mistakes, miscalculations and missteps, both in terms of the people we associate with, and with the financial decisions we make. But the first step in correcting a bad decision is to admit that you made one in the first place. The second step is to take action and cut your losses before your net worth is irreparably damaged.

If you've got a few Rev. Wrights in your portfolio, don't wait until they derail your campaign before you do something about them.

Jim Woods is freelance financial journalist specializing in the markets and the economy. He welcomes your comments on this piece, and he can be contacted by clicking here.

ETF Talk: Avoid the Tax Trap of Commodity ETFs

Exchange-traded funds (ETFs) are a great way to gain diversification and reduce money management costs that otherwise would cut the value of your holdings. But onerous tax problems have hit investors who have purchased certain commodity ETFs that use futures contracts. Investors that have purchased these ETFs are starting to express "shock and awe" on investment blogs about their unexpected tax liabilities. With sales of such commodity ETFs jumping so far this year, many investors may be piling into these investments completely unaware that they may be on the receiving end of a painful tax bite.

Keep in mind that this tax trap with commodity ETFs is a negative development in an ETF industry that is filled with many positives. Indeed, ETFs offer low expense ratios when compared to mutual funds and virtually any other investment. But we have uncovered a fairly serious tax problem for individual investors who are using taxable dollars for their commodity ETF purchases. If you are among those investors, read closely. If you are trading these commodity ETFs in tax-deferred accounts, you fortunately do not have this tax problem.

Those who most need to be concerned are investors in the PowerShares DB commodity ETFs and other ETFs that do not take delivery of the commodity itself. That is a different situation than what occurs with the purchase of streetTRACKS Gold Shares (GLD), an ETF that actually buys gold and stores it in a vault. But if you buy United States Oil (USO), for example, the fund uses futures contracts to get exposure to a commodity.

The reality is that commodity ETFs that use futures contracts have been set up as partnerships. When you own a position in a partnership, you are subject to taxes and will receive a K-1 tax form from the partnership. Investment blogs are warning that these commodity ETFs are creating tax nightmares.

One blogger on the DBA investment Web site advised never to trade a commodity ETF: "BEWARE OF THE HORRIBLE TAX NIGHTMARE."

The blogger, who used the moniker Grizz, shared the following:
-An investment in USO resulted in a trading loss of $741, with no interest received, but he received a K-1 form that reported a taxable profit of $9,136 and interest of $210.

-A trading profit in UNG of $1,900, with no interest received, generated a K-1 form that reported a taxable profit of $4,319 and $120 in interest.

-An enviable trading profit of $4,335 in DBA, without receiving any interest, triggered a K-1 that reported profits of $6,963 and $207 in interest.

-Modest trading profits in DBC of $337, with no interest received, led to a K-1 that reported profits of $3,406 and interest of $195.

It appears that commodity ETFs that use futures contracts are generating thousands of dollars of "phantom income" by incurring a tax liability without producing income. So far, I have identified a number of ETFs that fall into this tax trap situation. They include PowerShares DB Agriculture (DBA) and PowerShares DB Commodity Index Tracking Fund (DBC).

"Years ago, commodities generally were for hedgers and speculators," said Kevin Rich, a managing director at Deutsche Bank who directs its PowerShares DB commodity ETFs.

Unlike investing in equities, in which you own the stock until you decide to sell it, for individual investors, it is impractical to own the commodity if you invest in futures contracts, Rich explained. To stay invested in futures contracts, an investor would need to buy new ones to replace expiring contracts, he added.

The Internal Revenue Service (IRS) taxes futures investments differently than equity investments. In contrast to equities that remain unsold, holdings in futures contracts and T-bills are marked-to-market at the end of each year. As a result, there is a tax consequence on commodity ETF investments even if they have not been sold yet. This leads to the cost basis of these investments being adjusted at the end of each year, Rich explained.

One way to avoid these tax issues is to use an IRA or other tax-deferred accounts for commodity ETFs, rather than putting them into taxable accounts, Rich said.

Deutsche Bank had more than 380,000 different investors who owned its commodity ETFs in 2007, and each of them received a K-1 to complete their tax returns, Rich said. To assist those investors, Deutsche Bank provides a toll-free phone number, 1-800-578-8755, for them to call with any questions. The investment firm also tries to send out all of the K-1 forms it needs to distribute no later than the second half of February to help its investors ready their tax returns in time.

High returns for commodity ETFs since last year are helping to draw a significant amount of additional investment dollars into commodity ETFs. Institutional money also has moved into commodities in recent times because generally speaking, commodity investments do not exhibit a high correlation with overall market returns.

For commodity investors who do not want to receive K-1 forms that could surprise them with unexpectedly high tax liabilities, DB recently has begun to offer exchange-traded notes (ETNs) that invest in commodities. The returns of ETNs are reported on 1099 forms. The ETNs have the transparency of ETFs but the notes guarantee the investors a return that matches the index that they follow, Rich said.

Three gold notes were introduced by Deutsche Bank during February. Four agricultural notes were launched during the first half of April, while four diversified commodity notes were unveiled on April 29.

For investors who are concerned that commodities will not go up forever, Deutsche Bank recently began offering funds that allow investors to go short on these investments. These so-called inverse funds include leveraged products that give twice the exposure to losses or gains than the amount that is invested.

For investors who want to diversify into commodities, beware of the tax trap with funds that use futures contracts. If you want to steer clear of the year-end tax uncertainty, those who seek commodity exposure may want to consider using tax-deferred accounts for such ETFs or just buying ETNs.

Investor Education Hub

Looking for a little education?

I know that we all can use a little information edge with the markets gyrating as wildly as they are, so that's why today I am going to give you a few links to some of my favorite Fabian educational sites.

Each of these sites addresses a specific investment area that you need to know about right now. Here are my "fab four" investor education links.

1. The Fabian Lemon List
   
   Does your mutual fund taste sour these days? Do you even know how your funds are performing versus their peers? If the answer to either of these questions is yes, you need the Fabian Lemon List.

2. The Fabian Wealth Strategies Risk Management Primer
   
   Do you know the six threats to your retirement nest egg? In my experience, most investors are woefully unaware of what could happen to the most important money they manage -- the money that will fund their retirement years. This special report by Fabian Wealth Strategies, a fee-only investment advisory firm that specializes in ETFs, will tell you how to manage the biggest threats to your nest egg.

3. The Retirement Income Coaching Call
   
   Retirement income investing isn't as easy as it used to be, especially in this tough market. Find out how to get yourself on the right path toward reaching your retirement goals by listening to my monthly, retirement investment conference call.

4. Big Money's "Secret Weapon"
   
   Want to know how the pros on Wall Street make huge money even when the markets are tanking? Want to learn how to employ those same tools and strategies in your portfolio? We show you how in this special report.