The risk with betting with derivatives and leverage killing you...Akman and his Target fund

I am skeptical of investment methods using leverage and/or derivatives. When they work, the results are spectacular; when they don't work, it's usually a total wipeout. This is one of the reasons I don't hold William Ackman and Prem Watsa in high regard as many others seem to. You can see how the derivatives bet can blow up badly by looking at the following story from Bloomberg detailing William Ackman's investment fund that invests only in Target, the American discount retailer:

William Ackman’s hedge fund that invests solely in Target Corp. fell 40.1 percent in January, bringing the loss since inception to 89.5 percent, according to a letter sent to investors.

The decline in Pershing Square IV fund was about four times that of Target shares in January because Ackman made his bet using options rather than owning the underlying stock, which tumbled 9.6 percent. Ackman said he will personally add another $25 million to the fund, and employees and board members will put up more cash.

...

At the end of January, Ackman restructured the fund’s portfolio using longer-dated options that expire in January 2011. If the share price rises to at least $65 in the next two years from its current level of about $33, the fund’s value could jump by four times, Ackman said. If the stock is below $35 in two years, investors will likely be wiped out.

...

Ackman estimated in the letter that clients who want to exit could get back as little as 15 percent of their money.

The fund is down so much--down 40% in January alone--because it uses derivatives such as options which will expire worthless if the stock price doesn't recover within a few years. Ackman is at least an activist investor so he can influence the company. But if you were a small investor following a similar strategy, you would be looking at massive losses with zero influence over the company.

The problem with derivatives is that most people use them, not as a sophisticated security to complement stocks and bonds, but for their leverage. Leverage cuts both ways, of course.

There is also the additional risk that most derivatives involve placing a bet on the time frame (I'm not an expert on derivatives but my impression is that most options/futures/swaps/etc are not perpetual.) Not only do you need to get the direction right, but you also have to ensure that your bet is within the proper time frame. In this Target fund example, if the stock price of Target does not recover within a few years, you lose everything (you may also be able to sell out with a huge loss.)

Once upon a time, I invested in, or at least considered, derivatives. I remember tracking Owen's Corning (OC), a building material supplier somewhat like USG, and thinking seriously about investing in its warrants (PinkSheets: OCWAZ). In fact, my greatest profit ever was from warrants of Nevsun, a junior gold miner. I used to look favourably upon derivatives such as warrants and considered them part of my investment universe. Then I came around to the view--thankfully without huge losses--that derivatives are not for me and they definitely do not fit any sort of contrarian investing. It's one thing to get the analysis wrong and lose a fortune on a common stock (e.g. Ambac) but it's another to lose a fortune when the analysis is correct but your timing is off. I suspect that Ackman's analysis is correct and Target is worth more than it's current price, but I think he will lose due to getting the timing wrong.

It'll be interesting to see if Ackman tones down his derivatives bets or if he continues to utilize them aggressively. He has a tough decision. He lost a fortune on Target (assuming the stock price doesn't rally 100% within 2 years, which is what his options seem to require.) But he made a fortune by betting on CDS of monoline bond insurers.