The Difference Between Knowing and Pretending Not to Know

By Vedran Vuk, Senior Analyst

In the infamous case of the Goldman Sachs Abacus 2007 AC-1 fund, it doesn't take a whole lot to figure out the wrongdoing. Paulson & Co., a multibillion-dollar hedge fund, helped select the mortgage-backed securities held by Abacus while at the same time, Paulson was planning on shorting it. This was all unbeknownst to Abacus buyers, since Goldman Sachs conveniently left out the details of the Abacus' creators and their bet against the fund in the investment marketing materials. Ultimately, the case was settled for $550 million.

Goldman Sachs made a huge mistake here. By not telling its clients about the conflict of interest, the whole thing seemed like the coverup of a malicious act in order to defraud investors. What it really should have done is put the fund's flaws in difficult-to-understand language on page 82 of the hundred-page prospectus. After all, that's what everyone else in the industry does, and they're certainly not settling for half a billion dollars with anyone.

The exchange-traded fund (ETF) industry has made millions - if not billions - of dollars on products sold with a similar approach. If the problems are laid out somewhere, it's not the ETF company's fault when the fund fails. Better yet for them, ETFs never promise results... they are marketed only as an investment tool. In the majority of cases, this works just fine. It's wonderful that investors can purchase a whole index such as the S&P 500 with a single ETF.

Unfortunately, these incentives can create serious problem in the ETF industry, as popularity drives much of its profits, rather than results. When commodities became all the rage in the past decade, retail investors flooded billions into futures commodity ETFs promising to provide an easy way to invest in the asset class. It didn't matter that the underlying investments were doomed for failure. The funds lay out the risks in the prospectus and then wash their hands clean should the ETF head for the worst. Sometimes the failure of those funds is hardly an accident or the result of bad luck.

In regard to ETFs, Wall Street needs to answer the following question: Is there a moral difference between constructing a package of worthless securities while hiding the creation process, and packaging the same sort of garbage while informing the investors about the problems on page 82 of a hundred-page prospectus? In both cases, you're aggressively marketing a product which is known to be harmful, if not disastrous, to the investor.

Sure, one can pretend to not know what's in the product. After all, ETFs aren't promising returns... they are just an investment tool. It's always "buyer beware," but if the tool is broken, someone should be held responsible for the damage. In the securities industry, ETF companies are encouraged to play stupid. If one pretends not to know about the likely performance of the fund, then everything is fine, as long as the fund's faults are somewhere in the prospectus. But if one packages a garbage fund and doesn't write down the details, then one's likely to face a billion-dollar lawsuit.

In reality, the two are close to the same thing. Of course, one man's garbage could be another man's treasure, but there are cases where one could objectively call the product pure trash. When a company shorts a product it created or an ETF fails to follow its intended index, then these are truly garbage investment products. It's hard to say that anyone would want to invest in such financial instruments, if one properly understands them.

An ETF that resembles this description is the United States Oil Fund (USO). Let's take a look at the summary on the front page of :

The United States Oil Fund, LP ("USO") is a domestic exchange traded security designed to track the movements of light, sweet crude oil ("West Texas Intermediate"). USO issues units that may be purchased and sold on the NYSE Arca.

The investment objective of USO is for the changes in percentage terms of its units' net asset value ("NAV") to reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract for light, sweet crude oil traded on the New York Mercantile Exchange (the "NYMEX"), less USO's expenses.

If I were a retail investor sans the education of a master's in finance, I would immediately think that this sounds like a great way to invest in oil prices. Unfortunately, the devil is in the details. Essentially, because it's impossible to hold so much oil, ETFs must purchase oil futures contracts. And by investing in the futures market, the fund must worry about contango. When a futures contract comes close to maturity, the fund must sell the contract and buy one further out in the future, since the company can't take delivery of the oil.

If the futures curve is in contango, that means future oil prices are more expensive than the current maturing contract. So, when the fund sells the maturing contract, it must buy a more expensive future contract. The fund breaks the cardinal rule of investing - it buys high and then sells low! Over time, the fund continues to lose money until its path fails to follow WTI crude oil prices:

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(Click on image to enlarge)

In 2009, as oil prices began their drive from around the $30 range to over $100 today, USO stayed flat. Since mid-January 2009, oil prices have increased a stunning 142% while USO only rose by 33%. A lot of prescient investors who saw the rise coming made practically nothing with their prediction, thanks to this ETF.

This isn't an accident. Any financial professional with some basic knowledge of contango could have seen this coming. The fund simply doesn't track spot oil prices. USO is only useful in a situation of backwardation; it's the opposite of contango, where further-away maturities are cheaper than the nearest maturing contract.

All of these problems are spelled out by the company on its website - though the details are deep in the prospectus. One can't say that the fund is intentionally hiding anything. However, does the fund's existence depend on investors failing to read the prospectus or to comprehend the futures market? Those who understand the fund stay away from it.

With $1.51 billion under management, USO still finds plenty of unsuspecting buyers who think it's a good way to invest in oil. With all of this said, is the fund doing anything illegal? Absolutely not. Is the fund acting in an unethical manner, much like the Abacus scandal? I'll let the reader decide.

[Ten popular ETFs are anything but what their names suggest. One is the United States Oil Fund, which you've just learned about.

You still have a good-sized position in Berkshire so let's take a look at it.

Buffett and Munger have said a lot of smart things over the years. It was in 2007 - during the financial crisis - that their words started to conflict with their actions. A Google search using "Buffet [sic] hypocrisy" shows about 5,750,000 results [Ed. Note: Using the correct spelling of the name yields roughly 2,000,000 results.]. Of course I'm referring to the fact that they would have lost some or even all of their fortunes were it not for the bank bailouts implemented by the US government. I suppose the intention was to protect Berkshire Hathaway and country (in that order).

I have no ill will against these guys, other than the fact that they wrap themselves in the blanket of moral superiority. What concerns me most is that I have, over the course of my own investing career, put money with people who I felt would die richer than they are today; in short riding on their coattails. Their actions over the last couple of years have confirmed my hunch; expediency rules their actions. But it also highlights their vulnerability to systemic risk.

Nevertheless, Berkshire continues to prosper. And it will probably continue to do so insofar as the status quo is kept in place.

The status quo: the idea that the world will be the same tomorrow as it is today. This is something to ponder.

To my mind, there is every indication that the world is changing dramatically, and those who are the status quo are doing everything within their power to avoid this change. Buffett and Munger are the biggest cheerleaders!

Make no mistake. What Buffett and Munger are talking about here is government control - the use of force to keep things the way they are for their benefit (AND YOUR OWN GOOD)!

Buffett even wrote a thank-you praising this. Buffett suggests that without the bailouts, Berkshire would have failed. He stated this in his NYT op-ed piece "pretty good for government work." (Why did he thank the government? Wouldn't it have been more appropriate to thank the US taxpayers?)

To my mind, Munger also understands that maintaining the status quo for Berkshire is paramount. On September 14, 2010 at the University of Michigan, Munger said:

You should thank God [for the bank bailouts] ... Now, if you talk about bailouts for everybody else, there comes a place where if you just start bailing out all the individuals instead of telling them to adapt, the culture dies.... Hit the economy with enough misery and enough disruption, destroy the currency, and God knows what happens.... Germany was unable to stabilize its financial system in the 1920s and we ended up with Adolf Hitler.

It appears that the status quo is certainly on Munger's mind. Bailouts are great - for him anyway. Yet he neglects to mention a few things. A collapse could have purged the system of bad debts, simultaneously eradicating the system of corruption, which is the big banks, and hence set the stage for vastly improved economic conditions.

Further, he forgets to mention that the outstanding debts placed on Germany's shoulders by the treaty of Versailles afforded them no chance of economic recovery within even one generation. Or that there was a major currency war being played out even after bombs stopped dropping. A corollary to very same situations of all Western countries and Japan today.

Reporter Becky Quick recently tweeted about Munger in a conversation he had among shareholders:

If u think country u live in is going to kill u then gold is a good buy. Otherwise BRK shares are better.

Perhaps there is great wisdom in these words.

Given that gold was $285/oz. ten years ago and is $1,600/oz. today, using Munger's logic I can surmise that there are a lot more people in the world who think that their country is out to get them! The Defense Authorization bill recently signed by Obama which gives unlimited power to the president and US military personnel to arrest, imprison, and kill anyone they want - even on US soil - without trial is certainly a bullish argument for gold; again, at least as Munger sees it.

Where's Charlie's complaint about this Hitleresque legislation? Aren't we in the midst of another major currency war today? Isn't this the kind of stuff Hitler did to consolidate power in 1934? Is he arguing for or against buying gold?

Perhaps he doesn't know but is astoundingly clever to distill our current investment climate into one sage statement.

Let's look at it another way.

Also inherent in Munger's statement is that he judges the value of Berkshire Hathaway against gold!

Since Nixon closed the gold window in the early '70s, cutting the dollar's link to the metal, we have been using dollars as our ruler. I don't want to get into the details of monetary history, but suffice it to say that many of us alive today have known nothing else. For this very brief period of history we have not used gold as our measure. I suspect that the last 10 years have been a gradual realization of this and that we still have another decade to go before everyone will routinely use gold weight (or a currency convertible into gold) as the measure of value.

Is Charlie already calculating the value of Berkshire shares in term of gold rather than dollars? Where's he going with all this? Let's look at Berkshire shares in terms of gold.

Well, it looks like the holder of the metal has beat the pants off the sages in this decade. A decade! That's a long time. It must be galling to both these guys, to think that they could have sold their company and retired at the turn of the century and put all their retirement savings into gold and been even richer today!

Think of the significance of these data. One of the most important financial industrial conglomerates generating thousands of jobs and providing needed services to the world returned about half the return of the same original value of a dumb hunk of metal sitting in some vault somewhere, enriching no one but its owner.

There is something going on out there. This is just too weird.

Warren and Charlie have an ax to grind; the current system has been very, very good to them (and their shareholders). They will say or do anything that keep things as they are. And yet it will be these very actions, taken as a whole, that will feed the fire under gold and hence devalue their own position.

The tides will eventually go where they will in spite of the machinations of the powerful.

But for now, I vote to keep the Berkshire; but let's not kid ourselves. The wealth this company represents is dependent upon the status quo. It is the antithesis of gold.

Casey Dispatch