Zen and the Art of Investing

Don't pick your nose with a power drill

2012-01-07T17:18:00.000-05:00

Derivativesoffer useful and cost-effective ways for investors to manage risks. In the ETFworld, derivatives have democratized investor access to asset classes likecommodities and currencies, and to strategies like covered-call writing, use ofleverage and short selling. Previously the sole domain of professional andsophisticated investors, this freedom has come with the expected consequencesof misuse and plain ignorant use of some or all of these products.

Threequestions arise from the increasing use of synthetic structures in retailproducts.

Are the benefits and costs associated with these products adequately understood by users?
Are there potential systemic risks arising from the growing popularity of these instruments?
Who is best equipped to determine if investors should have access to these products: regulators, investment professionals, or investors themselves? Each will be examined in more detail over the next three months. Here is a broad overview.

Overview: The right tool for thejob

Having aplan is as basic to portfolio construction as it is in the workshop. What willthe portfolio have to do? What characteristics must it have? Selecting theappropriate tools and materials and understanding the capabilities and inherentrisks with each is simply common sense. While possible to drive a nail with ascrewdriver, it isn’t always as effective as using a hammer. Selecting ETFs isno different.

Returnsare difficult to predict, but costs are different. The ETF Screener on the TMXMoney website offers two basic ETF classifications: those using passivestrategies and those using embedded strategies and costs are behind each.

Passive

Theseare straightforward ETFs that replicate an index and hold the actual componentsor a stratified sampling of the index holdings. Examples:

*PASSIVE*	TICKER	MER
BMO Aggregate Bond	ZAG	0.50%
Claymore S&P/TSX Canadian Dividend	CDZ	0.60%
Claymore Gold Bullion	CGL	0.50%
iShares S&P/TSX 60 Index	XIU	0.17%
iShares S&P/TSX Capped Energy	XEG	0.55%
iShares S&P 500	XPS	0.24%
PowerShares Canadian Dividend Index	PDC	0.50%
PowerShares QQQ (CDN Hedged)	QQC	0.32%
PowerShares Ultra DLux Long Term Government Bond	PGL	0.25%
RBC 2013 Target Corporate Bond	RQA	0.30%
RBC 2014 Target Corporate Bond	RQB	0.30%
RBC 2020 Target Corporate Bond	RQH	0.30%

Embedded strategies

Allother ETFs fall into this category, suggesting additional analysis may berequired. We have broken these into three subsets with additional costsassociated with each.

Strategic: Holding equal dollar amounts ofindex components is one example. Proponents claim reduced large capitalizationcompany bias in an index allows smaller faster-growing companies to contributeequally. Whether or not you believe this (there is research supporting bothsides), more frequent rebalancing incurs more trading costs. This holds truefor so-called fundamentally weighted indexes and active ETFs. Investors mustdecide if the costs are justified by the strategy. Examples:

*EMBEDDED STRATEGIES – STRATEGIC*	TICKER	MER
BMO S&P/TSX Equal Weight Oil & Gas	ZEO	0.55%
Claymore Canadian Fundamental	CRQ	0.65%
Horizons Dividend	HAL	0.70%

Exchange-traded derivatives: These ETFs can involve optionsand futures and introduce time as a more critical investment factor.Covered-call ETFs, for example, alter risk over time; modestlyfor ETFs overwriting a small portion of underlying holdings (i.e. FXF) to thosethat overwrite all of the holdings (i.e. ZWB). Commodity ETFs can holdthe underlying commodity, but many use futures. This subjects these ETFs toliquidity, basis, contango and backwardation risk. ETFs using exchange-tradedderivatives introduce some elements of additional cost from liquidity, basis,timing (backwardation/contango) in addition to possibly higher managementcosts. Leveraged-long and leveraged-short ETFs also fall into this category.

Examples:

*EMBEDDED STRATEGIES - EXCHANGE TRADED DERIVATIVES*	TICKER	MER
BMO Covered Call Canadian Banks	ZWB	0.65%
Horizons S&P/TSX 60 Bull	HXU	1.15%
XTF Can 60 Covered Call	LXF	0.65%
XTF Can Financial Covered Call	FXF	0.65%
XTF Tech Giants Covered Call	TXF	0.65%

Over-the-counter derivatives: OTC derivatives are based upontotal return swaps. A dealer commits to pay the return of an index over aparticular time period in exchange for collateral. This introduces a potentialcost as credit risk because the dealer or counterparty is promising to pay. Italso introduces potential liquidity risk related to the collateral. Examples:

*EMBEDDED STRATEGIES -OVER-THE-COUNTER DERIVATIVES*	TICKER	MER
Horizons S&P/TSX 60 Index (swap fee 0.0%)	HXT	0.07%
Horizons S&P 500 (swap fee 0.30%)	HXS	0.15%

Investorsand their advisors have a duty to understanding the risks inherent in theseproducts and their potential impact on broader markets. Do regulators knowbetter than advisors or their clients whether these products have a place inretail portfolios? We’ll address these issues in future columns.

Pension Breakthrough for the Rest of Us

2011-12-03T14:01:00.001-05:00

http://www.newswire.ca/en/story/888327/pension-breakthrough-for-the-rest-of-us

This is a press release that introduces an approach that could be disruptive to suppliers of the $525 billion invested in target date funds (TDFs) in the U.S.. TDFs are the fastest growing product in the defined contribution market in the U.S., Canada, Australia and elsewhere because they make investing simple. But they all benefit from a fundamental half-truth. They reduce equity exposure on a predetermined fixed glide path or become more conservative as a target date, like retirement, approaches. To the casual observer, it sounds like the fund reduces its exposure to risk over the life of the product. This would be exactly what plan members want and would do if they had the time and investing acumen to monitor and manage the assets themselves. Sadly these funds do not manage risk at all. The paper "What DC Plan Members Really Want" describes why this is the case and offers two ideas to fix and improve outcomes.

Target Practice

2011-11-04T12:19:00.005-04:00

Figure 1: Capital Accumulation Plan

Accumulating enough money to retire with a 60% replacement income is great, unless you were planning for 70%. Last month, we described Personal Alpha^TM as achieving a goal beyond a target, like saving money and earning extra years of retirement income. Accountants and financial planners, particularly fee-only planners who consider their client’s interests unbiased by product trailers and incentives, have been doing this successfully for some time. But new products like exchange traded funds (ETFs) and services like discount and online brokerages have ushered in a new reality. As consumers become more knowledgeable, financial advisors (FAs) will have to develop and expand their value proposition beyond trading and research.

ETFs allow investors access to instant diversification and relatively inexpensive exposure to a large and rapidly growing list of asset classes, regions, countries, styles, capitalizations, sectors, and industries. As retail investors discover the flexibility that ETFs offer, their expectations from other financial products will change. One consequence of an informed public is the growing acceptance of the principles of passive or index investing as the efficient way to access market or beta exposure. The debate over active or passive will rage on as investment professionals protect the turf that pays their bills. But most active managers concede a role for passive investing, particularly in a multi-fund, multi-manager environment when overlap yields market returns at full fees. At the very least, more investors understand that adding returns above the market is not easy and that few can do it consistently. FAs may find building a core business around this kind of activity to be frustrating at best.

Managing risk

An investment professional’s definition of risk - volatility - is different than most retail clients who fear absolute losses. An alternative definition, based on the reality of client’s lives, is the risk of not achieving a goal.

Let’s use retirement investing as an example. Defined benefit (DB) pension plans, given to Members of Parliament and civil servants, are tenaciously guarded by unions and some large corporations. They are professionally managed and, in retirement, pay a percentage of final year’s salary depending upon each plan. DB plans are administered by expert committees and employers are obliged to pay or, in the example above, the taxpayers are.

While both employer and employee contribute, investment decisions are left to the committee. Mandatory valuations every three years assess how the fund measured up to the theoretical liability to pay all those folks their pensions currently, if retired, or in the future, if still working. Any shortfall or funding deficit must be made up over time by the employer or taxpayers. In contrast, defined contribution (DC) plans are like registered retirement plans. The employee makes contributions, usually with employer matches, but the responsibility for investment decisions is the employee’s. Importantly, there is no target income in retirement and no triennial valuations assuring that the program is tracking towards success or failure. In fact, no targeted percentage of income like a DB plan is required. Over several decades, many DB plans have switched to DC or stopped admitting new members in an attempt to control corporate liabilities.

Financial advisors have a great opportunity here. By targeting a percentage of salary as retirement income, a DC or RSP portfolio can be managed like a DB plan. Investors benefit by focusing on a stream of income in retirement rather than short-term performance, and improve the chance that they receive what they want from a retirement plan - a reliable income. Here’s how to do it.

If someone wants to replace 70% of annual income in retirement, the FA calculates the capital required to fund an immediate annuity that would pay this amount in today’s dollars at retirement. Using the investor’s contribution rate and assumptions for inflation and something reasonable for returns, the FA establishes a capital accumulation path towards the target retirement capital. (See Figure 1, “Capital accumulation path.”)

Actual performance will be above or below this path as indicated by A, B and C in Figure 1. By matching the risk of a portfolio to the capital accumulation path, the FA makes decisions based upon progress towards the goal. The target may change modestly over time as interest rates change or dramatically as the investor’s circumstances change, such as a big promotion, more children than expected, family illness, inheritances or a lottery win.

This is an important function missing in DC and RSP management today. FAs can help investors work on a solution that is useful and valuable. For more details, go to advisor.ca/yamadaDCplan to find a link to our article, “What DC Plan Members Really Want” in the upcoming fall edition of the Rotman International Journal of Pension Management.

ETFs Reach Adolescence

2011-10-13T13:13:00.003-04:00

The Canadian exchange-traded fund (ETF) market has reached adolescence, and hair is starting to grow in funny places...like their chins.

What’s that smell?

The Canadian ETF market has matured with sufficient size ($45 billion) and momentum (30% annual growth) to get the attention of the major banks. According to BNY Mellon, the U.S. ETF market will double through 2015 - and Canada’s could match it. Banks and investment companies smell profit potential, and a chance to protect and grow their retail base despite massive books of profitable mutual funds.

They may also fear others will crowd them out of a lucrative market that is, apparently, here to stay. Heavy hitters RBC and Vanguard have declared their intention to enjoin iShares, Bank of Montreal, Horizon Beta/AlphaPro, Claymore, a newcomer to Canada, Invesco, and rookie XTF Capital Corp. in the battle of sponsoring ETFs here. A major Korean fund manager’s interest in BetaPro Management confirms the stakes are changing. Deep pockets and sophisticated distribution are changing the landscape.

Where did those come from?

Unlike early plain-vanilla indexes that got simple ETF wrappers, competing sponsors now race to represent different asset classes, occasionally using derivatives to replicate them. Regulators are concerned these structures may lead to another subprime crisis, or a “flash crash” like in May 2010. The Financial Services Authority (FSA) in the UK is considering banning swap-based ETFs from retail use altogether. The FSA is the UK’s version of Canada’s cluster of securities commissions. These products offer an exciting array of tools to enhance and enable new methods of portfolio construction, but registered representatives need to understand the underlying composition of all ETFs not only to use them effectively, but to manage the liability if a structure goes bad.

Why voices need to deepen

Blindsided by collateralized mortgage products, regulators are determined to prevent similar problems with ETFs. Although prospectus disclosure has been the regulatory focus for retail products, veteran fund executive Paul McKenna of One Financial reminded me that ETFs trade in the secondary market where prospectuses are available but issuance to buyers is not mandatory. Most registered reps know that prospectuses are a legal crutch few people read. Regulators need to rethink the principles and practicality of disclosure in a digital age and speak to consumers with a new voice. Perhaps making all advisors fiduciaries is part of the answer.

Will the ETF market grow up to look like the mutual fund market?

Duplication is costly and confusing, yet every mutual fund family feels it needs at least an equity, fixed income, and money market fund. ETFs compete for market share based upon a different and more useful set of metrics. Sponsors market ETFs based upon index construction, liquidity, diversification and other risk characteristics rather than how a manager happened to outperform his or her benchmark last year. While the conversation has been elevated to issues that really impact portfolios, it’s not as much fun as talking about whether RIM’s quarter will beat analyst expectations. However, getting money into investors’ pockets through lower costs is a powerfully persuasive pitch.

Each bank may want a complete stable of asset classes for their clients, but there may not be enough room for a seventh or eighth ETF based on the S&P/TSX 60. Watching RBC and Vanguard position their Canadian equity offerings will be interesting.

BMO’s ETF launch in 2009 signaled the return of banks to a space vacated by TD in 2006. Critically, taken with RBC’s filing of eight target maturity fixed-income ETFs this summer, the product category has been validated. Vanguard, the dominant index fund player in the U.S., will launch a series of funds in Canada by year-end. This is important and intriguing because Vanguard’s reputation for delivering straightforward passive products at low cost will challenge everyone. Will there be a refocusing on passive low-cost ETFs, or will active strategies finally gain traction?

Waiting for the swelling to go down

ETFs represent only 6% of Canadian mutual fund assets - a rounding error. Unquestionably, ETFs offer investors more effective, low-cost delivery of capital market exposure than mutual funds. Only two things stand between the consumer and a superior product: smarter investors and the entrenched investment advisor. Because information is ubiquitous, investors are getting smarter. Savvy RRs are already using ETFs and as clients get better informed, other advisors will follow. Peer pressure works in trading rooms as well as high school lunchrooms. Advisors sitting at the end of the bed waiting for the ETF swelling to go down are being left behind.

To women: Is your boss evolved?

2011-08-19T16:15:00.002-04:00

The CFA candidates gathered in the vaulted Great Hall of Hart House, once the exclusively men’s athletic facility at the University of Toronto. In two weeks these students would sit an exam with a Level 1 pass rate of 37%. Despite dismal odds, these particular students bristled with confidence because all were enrolled in Michael Hlinka’s (CBC Radio Business commentator) preparation course that boasts a 76% pass rate. They had a statistical edge and they knew it. Mr.Hlinka is known for frank observations of business and economics delivered daily on CBC Radio Toronto. Leveraging Michael’s energy, the students seemed completely self-assured.

They had come to hear Margaret Franklin, current Chair of the CFA Institute, the organization that oversees the exams and sets international standards of education, conduct and professionalism for the investment industry, a remarkable accomplishment for a Canadian. Ms. Franklin had presided over the annual CFA conference in Edinburgh earlier in the week and had flown back the night before to attend this reception.

Ms. Franklin, one of the 22% women of her graduating class fifteen years ago remarked that women constitute only 20% of the current roster of CFAs. Statistics confirm that women have made little progress in the investment business or in the boardroom. In my experience as a manager of investment professionals I applaud this lack of progress. It has made my job easier. As a young U.S. equity portfolio manager, the best coverage from Wall Street came from women. In retrospect, Canada was considered a third world market so many women would be relegated to cover institutional accounts north of the border because lucrative U.S. accounts were covered by men. What I quickly learned was that any woman in the investment business had to be better, more tenacious, more insightful, and more aggressive to survive. There weren’t many of them and the environment was never accommodating. My job was made easier by just hiring the women. They usually held an edge over the men.

Don’t get me wrong. I was never interested in equality or diversity, big themes with big companies these days, I just knew that for both good and bad reasons, women in the industry had to be better than their XY chromosome cohorts.

Speaking informally with a group of women CFA candidates afterwards, and in bewilderment over the apparent lack of progress over the years, I offered my observations about management in the investment business and how to identify “evolved” managers from those less gender neutral. Others encouraged me to list my albeit-unscientific observations as a guide to others.

If you are a manager, how evolved are you?

How to identify evolved managers

If your boss’s wife works, he is possibly evolved. If your boss’s mother worked and he was secure enough not to resent being left alone occasionally, he has a higher chance of being evolved. If your boss has daughters, he has the potential to be evolved.

Danger signs

If your boss’s wife is a stay-at-home “soccer” mom, danger; you are in trouble! Corollary rule; someone observed that 90% of investment bankers’ wives do not work; seek employment with bosses from the other 10%. If your boss’s mother did not work – he has a serious impediment to evolution. If your boss has a son in medical school and daughter in modelling, you are in for serious trouble!

Franklin made an interesting observation that women of an earlier generation were not always helpful to other women. So if your boss is a woman there are no guarantees. In fact some of the same dangers exist. If your boss has a house husband, beware, she is likely to be less empathetic.

Source: Catalyst 2011

Canadian public corporations have only 10.3% women board members according to a Global Survey released by Catalyst in May 2011. Canada is just behind Turkey’s 10.8%! Even the unenlightened U.S. has 15.7%. Why should investment professionals care? As Chief Investment Officer for several large institutional investment companies I have had the responsibility to vote proxies. In my experience, corporate governance in Canada is poor. Nortel is a good example of management failure and lack of board governance yet nobody has gone to jail. Is there any guarantee that adding women to boards would make a positive difference? No. But I know that women in my specialized slice of the world had to be better so why not give them a try? They could certainly not be any worse. In fact, true equality will only occur if women are given a chance to be as mediocre as the boys.

For those of you looking to hire graduates from that CFA class of 2011 and beyond, here is a tip that could give you the statistical confidence of Hlinka’s CFA candidates. Pick the woman. She is likely to be better than the average guy because, unfortunately, she has to be.

Final Score: ETFs 1: Leafs 0

2011-04-19T16:26:00.003-04:00

Too much success can be a bad thing.

The Toronto Maple Leafs don’t need to put a competitive team on the ice. Season ticket holders already compete for 90% of all seats, broadcasting revenues are maxed and virtually every game is sold out.

The Leafs represent a clear distortion in the marketplace. There is little incentive to win because fans act irrationally.

The popularity and institutional success of passive investing in general (replicating the performance of an index), and exchange-traded funds (ETFs) in particular, have led some to believe that distortions result because investors act rationally.

“ETFs are radically changing the markets to the point where they, and not the trading of underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” write Harold Bradley and Robert R. Litan in a 2010 paper for the Kauffman Foundation.

The authors are concerned about ETFs and other influences they feel discourage new issues and impede the efficiency of capital markets. They believe the popularity of ETFs has led to trading volumes that overwhelm the liquidity of underlying securities, thus distorting valuations.

Fundamental to the authors’ argument is the dominance of passive over active investing. Dominance that overrides the arbitrage of individual stocks gives their argument credibility.

The case for indexing

In an analysis for Vanguard research, “The Case for Indexing in Canada,” authors Philips, Walker and Kinniry restate in a Canadian context what others have observed elsewhere: that costs are difficult for active managers to overcome. The asset-weighted expense ratio for actively managed Canadian equities funds was 2.29% (May 31, 2010) versus 0.87% for Index funds, a difference of 1.42%. Cap-weighted Canadian equity ETFs have expense ratios between 0.07% (HXT) and 0.25% (XIC) for a difference of 2.04-2.22%.

Active management can occasionally overcome this disadvantage in the short term but has difficulty over the long term. The sidebar (see “Relative performance of Canadian actively managed funds”) from the Vanguard study shows the consistency with which actively managed funds underperform their benchmarks, and somewhat alarming median annual return shortfalls.

The (weak) case for active management

1. The most popular argument for active management is a desire to beat the market. Advisors say the only way to guarantee you won’t beat the market is to index. It is possible to pick an outperforming stock but difficult to do so consistently, and really difficult to pick a portfolio of winners. If investors selected only a few stocks, watched them closely and kept trading costs low, they would have more success because high turnover costs kill returns. Picking active, outperforming mutual funds is a low-probability activity. Nevertheless, investors try to pick winners because they think it is possible.

2. Fun. Indexing isn’t. There is no question that passive investing is the intelligent choice. Lower costs boost returns, but talking about stock picks is more fun. People do it even if they aren’t quite sure what they are doing. There is higher entertainment value to active management.

3. Special knowledge. In most professional endeavours, specialized education is a barrier to entry. With no apology to my portfolio manager colleagues, picking stocks is not neurosurgery. Anybody can do it. Results may not be consistent and the methodology may at times resemble picking horses at the track, but anybody can open an online account and get some kind of return. In bull markets they are likely to be successful. Less so in bear markets. Investing is egalitarian.

Current SEC investigations aside, material non-public information is difficult to obtain and illegal to use, so potential access to inside information is no longer an advantage for Street veterans. Twenty-four-hour business news media has given the public access to the same information as the professionals, on as timely a basis. The poor record of investment professionals—reflected in the mutual fund numbers—suggests that educated and experienced pros find outperforming difficult. Despite what should be a discouraging record, mutual funds have 20 times the assets of ETFs in Canada. This is hardly the overwhelming dominance to which the Kauffman paper alludes.

4. The superstar. Western society has a fascination with the superior individual. The U.S. Naval Academy graduate with a Harvard MBA and PhD in Quantitative Finance from Wharton must be a superior human being and should be able to build portfolios that outperform on any basis. If such a person exists, she is working at a hedge fund and couldn’t care less about your money or mine!

5. Not-so-smart people do it. Hubris is a huge motivator. The annoying neighbour, the chatty dentist, and Uncle Fred the blowhard all talk about how they picked the stock of the decade. Maybe they did, but you will also notice that only lottery winners are interviewed, not the hundreds of thousands of losers. Ask Uncle Fred about his portfolio’s total return over five years for a reality check.

There’s not much of a case for active management. In Canada, however, a $12 billion-a-year gorilla of an investment industry stands between the retail investor and the door containing common sense. Greed will always create the motivation to arbitrage the valuation of underlying securities in an index. This may not happen as instantly as the Kauffman authors would like, but if there is an opportunity to squeeze a penny from the market, it will be done.

In the face of all this illogical behaviour, investors can still efficiently participate in the long-term growth of an economy, sector or industry using ETFs at low cost and with full transparency. Unlike the long-suffering, irrational Maple Leafs fan, an ETF investor may appear to perform in mediocre fashion throughout the season but in the long run will beat 90% of the competition.

Stanley Cup? Who cares, because someone other than the owners will be laughing their way to the bank: you.

Evolving Revolution in ETFs

2011-04-05T19:32:00.000-04:00

Free at last!

Once an opaque pastime for the rich, investing has been hidden behind obscure terminology, highly paid advisors, and arcane documents, like the mutual fund prospectus. The digital age is changing all that. ETFs are weapons in the movement to emancipate individual investors.

The explosive growth of exchange traded funds (ETFs) has been both exciting and bewildering. Retail investors, excited by broad access to timely, low-cost, tax efficient and diversified exposure to capital markets are also bewildered by the scope, breadth and number of products – 224 in Canada, 3,500 globally and 500 ETFs in registration with the Securities and Exchange Commission (March 2011). Sorting, selecting and constructing portfolios are new and growing challenges for investors. Nevertheless, ETFs have provided only the second significant advance for individual investors since the popularization of the mutual fund in the 1990s (the first being the introduction of the index mutual fund).

Mutual fund companies must also be excited and bewildered. Traditionally marketers and distributors of investment products, banks and fund companies are reassessing their business models. Scale has always been important but it is critical today with compliance expanding and margins contracting. Although the mutual fund continues to dominate retail investing, better-informed investors recognize that costs matter and that in an interconnected world, transparency and access to pricing more than once a day should be fundamental.

ETFs, because they are listed directly on stock exchanges without having to be “approved” by a sales entity, provide a distribution “end run” around the established axis of bank and fund company control, and give buying choice directly to individual investors. Furthermore, the hype around “star” managers and persistent marketing of past performance has worn thin. It is not exactly breaking news that past performance is no indication of future performance.

Sophisticated investors have been using ETFs for over a decade, but the broad public is catching on, albeit slowly. Early adopters of ETFs have been CEOs, senior executives, sophisticated high net worth investors, and investment professional themselves. However, innovation is still driven by professional money managers motivated by increasingly knowledgeable institutional clients. Individual investors can exploit these trends and ETFs enable them.

Democratizing diversification

The principle of diversification is not new. Natural selection and evolution itself may have been the first practical implementation of diversification as a means for the species to survive. Harry Markowitz put form around the substance of portfolio diversification in (Modern) Portfolio Theory (1952). Retail and institutional investors already knew not to put all their eggs in one basket but it wasn’t until the 1970’s that index or passive investing became pervasive among large institutional portfolios about ten years after the introduction of the Capital Asset Pricing Model (CAPM) suggested a distinction between systematic non-diversifiable or market risk, β, and unsystematic diversifiable idiosyncratic or asset specific risk, α. The idea of combining a low cost passive core portfolio using index strategies to capture broad market (β) returns and using satellite portfolios to generate excess (α) returns has been accepted institutional practice for 30 years. Importantly, passive investing, once the domain of the largest institutions and pension funds is becoming “mainstream”.

Investment professionals were the first to embrace exchange traded funds (ETFs) when the Toronto Stock Exchange introduced Toronto Index Participation Shares (TIPS) in 1990. Replicating the TSE 35 Index (predecessor of the S&P/TSX 60 Index), institutional managers found they could rapidly deploy cash in a diversified manner using TIPS. Individual investors gained their first access to instant transparent diversification through an exchange as a result.

Diversified Canadian Equity – ranked by diversification and cost	Symbol	MER
iShares S&P/TSX Capped Composite	XIC	0.25%
BMO Dow Jones Canada Titans	ZCN	0.16%
Horizon BetaPro S&P/TSX 60	HXT	0.07%
iShares S&P/TSX 60 Index	XIU	0.17%

International diversification

Thirty years ago, international equities were considered “alternative” asset classes. Access to markets and diversification within them were barriers. Not so today. ETFs offer access to a growing array of international markets. The emerging markets are an area of particular interest to professional investors. As a consequence, more granular choices are available to all.

International or Global Equity – ranked by diversification and cost	Symbol	MER
iShares MSCI World Index	XWD	0.45%
iShares MSCI EAFE	XIN	0.50%
BMO International Equity Hedged to CAD	ZDM	0.49%
Claymore International Fundamental Index (hedged and non-hedged)	CIE	0.68%
Emerging Markets Equity – ranked by diversification and cost
iShares MSCI Emerging Markets Equity Index	XEM	0.82%
BMO International Equity Hedged to CAD	ZEM	0.54%
Claymore Broad Emerging Markets	CWO	0.65%
Specific Emerging Markets Equity - ranked by diversification and cost
Claymore China	CHI	0.70%
Claymore BRIC	CBQ	0.64%
BMO China Equity Hedged to CAD	ZCH	0.71%
iShares MSCI Brazil Index	XBZ	0.75%
iShares China Index Index	XCH	0.85%
iShares CNX Nifty India Index	XID	0.98%
iShares MSCI Latin America 40 Index	XLA	0.65%
BMO India Equity Hedged to CAD	ZID	0.71%

The three factor model and the style box

Institutional managers have found CAPM a useful but imprecise tool. The Fama-French three factor model added style (value/growth) and size (small cap/large cap) to market risk finding that, for U.S. equity markets over time, value outperformed growth and small capitalization stocks outperformed large capitalization stocks. These simple ideas provided the basis for the Morningstar Style Box™ of money management categorization (1992) and contributed to the popularization of mutual funds over the past two decades. ETFs are available that address all three factor approaches.

Value Canadian Equity – ranked by diversification and cost	Symbol	MER
Claymore Canadian Fundamental Index	CRQ	0.69%
iShares Dow Jones Canada Select Value	XIC	0.25%
Horizon AlphaPro North American Value	HAV	0.70%
Growth Canadian Equity – ranked by diversification and cost	Symbol	MER
iShares Dow Jones Canada Select Growth	XCG	0.50%

Small Cap Canadian Equity – ranked by diversification and cost	Symbol	MER
iShares S&P/TSX SmallCap	XCS	0.55%
iShares S&P/TSX Completion Index	XMD	0.55%

Sectors and countries

If three factors are good, more must be better. Breaking market risk into more component factors can be a comprehensive way to control components of risk. The simplest example is the aready-pervasive practice of isolating sectors and industries domestically and globally. Canadian sector ETFs are available for energy, financials, information technology, materials and REITs from iShares with choice in most offered collectively by Bank of Montreal (BMO), Claymore and Horizon BetaPro. Global sectors include agriculture, real estate, and water offered by Claymore with choice in metals and infrastructure offered by BMO.

For U.S. markets, BMO offers banks, healthcare and NASDAQ ETFs. Investors with access to U.S. markets get an even broader palette of ETFs in every sector imaginable. On the fixed income side, there is a growing list of sector, quality, and term choices with international and inflation protection included. Commodities and income choices are also pervasive.

What’s next and why

Investors who experienced the financial crisis and market meltdown in 2009 know that there were few places to hide from the twin forces of volatility and a liquidity vacuum. At one end of the spectrum, broad diversification did not save portfolios nor did stock picking at the other.

Expect more creative approaches towards diversification. Income generation is a popular one at the moment.

Income – ranked by diversification and cost	Symbol	MER
iShares Diversified Monthly Income	XMI	0.55%
BMO Monthly Income	ZMI	0.55%
Claymore Canadian Financial Monthly Income	FIE	0.65%
Claymore S&P/TSX CDN Preferred Share	CPD	0.45%
iShares S&P/TSX Preferred Stock Index Hedged to CAD	XPF	0.45%

Alternative approaches will also start to appear in Canada that replicate hedge fund strategies. BMO’s Covered Call Canadian Banks (ZWB 0.65%) and Horizons AlphaPro S&P/TSX 60 130/30 Index (HAH 0.95%) are examples. In the U.S. merger arbitrage and managed futures ETFs are several active global macro choices are also available.

Most intriguing are ETFs that reflect what professionals are trying to accomplish using risk and leverage. There is a clear relationship between volatility, as measured by the standard deviation of a market like the S&P 500, and market direction. Stable or falling volatility appears to accompany rising markets while increasing volatility accompanies falling markets. The reason is that volatility is persistent over the short term (autocorrelation = 0.75) and return is not (0.05). This has led to the tracking of VIX, a measure of volatility based upon option premiums. These strategies are not for the retail investor ...yet.

Volatility Indices	Symbol	MER
HBP S&P 500 VIX Short-Term Futures™	HUV	0.85%
HBP S&P 500 VIX Short-Term Futures™ Bull Plus	HVU	1.15%

As other professionals study the relationship between groups of securities we expect that their experience will be the same as PŮR’s. There are relationships that have always existed but have not yet been exploited. The application of various statistical techniques will lead to new ways to bend and shape risk and ETFs will be the testing ground for these new ideas. The retail investor will benefit in the end because the vehicles will be transparent and available on public exchanges.

The educated consumer is the ETF’s best customer today and the product stream of the future will affirm this. In a single digit return environment with pension plans shifting liability to individual and social welfare programmes under challenge, investors must take more responsibility for their financial futures. Advisors need to improve their skills and mutual funds will have to find a new value proposition.

Are we mismanaging RRSP and DC pension portfolios?

2011-03-24T10:40:00.001-04:00

Joe and Sally joined the same company right out of school and enrolled in the registered group savings plan. Sally was three months older than Joe and retired September 1, 2008 with a $600,000 portfolio. Joe’s portfolio was worth only $480,000 when he received his simulated gold watch a few months later. Had they been members of a defined benefit (DB) pension plan [DASH] DB plans determine a pension usually based on a percentage of salary, with the benefit being the employer’s obligation [DASH] Joe and Sally would be drawing identical pensions, all things being equal. They made identical contributions [DASH] with identical employer matches [DASH] to buy identical funds in the identical proportion for forty years. The difference in outcomes because of something as uncontrollable as a birth date seems incredibly unfair. Something is wrong here.
DC plans and RSPs are different than DB plans
DC and RSP benefits are completely a function of contributions and the actual investment result for each employee. Employees are responsible for the outcome, not employers, and the pension amount is unknown until retirement. High costs, poor investment decision-making and lack of scale are documented problems with DC plans, which have generally experienced returns 1% lower than DB plans over time, according to a recent Towers Watson study.
Investing time horizon
DB plans need to match long duration liabilities to pay pensions of existing and future workers, so they usually invest with a very long-term view. Mutual funds, following the objectives in their prospectuses, similarly invest with a long-term view and often a perpetual duration. As a result, establishing and rebalancing portfolios to a fixed asset allocation is popular with DB plans because short-term market variability is theoretically evened out over time. Perpetually long investing horizons always have time to make back losses. In reality, Sally, Joe and every RSP and capital accumulation plan investor has an investing time horizon that is shrinking and shortening every day, whether due to retirement or death. Constructing a portfolio that does not recognize this fact is at best irresponsible, and at worst negligent. Yet most advisors, registered reps and educational sessions for DC plans promote the same basic strategies that were designed for DB plans: diversify, buy, hold and rebalance. The exception is the “target date fund” that automatically reduces equity exposure over time on a fixed glide path. Early generations of this increasingly popular approach have not escaped controversy, a subject we will examine next month.
Conclusion 1: DB plans invest to match perpetually long-dated liabilities, while DC and RSP investors have investing horizons that are shrinking every day. By building portfolios that have fixed asset mixes without regard for the individual requirements of each investor, the industry is ignoring what investors need. Trimming risk from a portfolio as retirement approaches is one effective tactic. A simple way to do this is to introduce ETFs to build in an increasing proportion of stable, low risk. Here are some low-risk choices that can be introduced at least five years before retirement, ranked by cost.
SYMBOL ETF MER
CLF Claymore 1-5 Yr Laddered Government Bond ETF 0.15
ZFS BMO Short Federal Bond Index ETF 0.20
ZFM BMO Mid Federal Bond Index ETF 0.20
ZFL BMO Long Federal Bond Index ETF 0.20
ZPS BMO Short Provincial Bond Index ETF 0.25
CMR Claymore Premium Money Market ETF 0.25
CBO Claymore 1-5 Yr Laddered Corporate Bond ETF 0.25
ZRR BMO Real Return Bond Index ETF 0.25
XSB iShares DEX Short Term Bond Index Fund 0.28
ZAG BMO Aggregate Bond Index ETF 0.28
CAB Claymore Advantaged Canadian Bond ETF 0.28
ZCS BMO Short Corporate Bond Index ETF 0.30
ZCM BMO Mid Corporate Bond Index ETF 0.30
ZLC BMO Long Corporate Bond Index ETF 0.30
XBB iShares DEX Universe Bond Index Fund 0.33
XRB iShares DEX Real Return Bond Index Fund 0.39
XLB iShares DEX Long Term Bond Index Fund 0.39
XGB iShares DEX All Government Bond Index Fund 0.39

Conclusion 2: If returns are 1% below DB plans, using passive or indexed vehicles can help make up the difference. ETFs are appropriate to use if RSP contributions are made once a year. If deposits are made more frequently, as they often are with DC plans, the commission cost of buying ETFs may be prohibitive despite their low fees. Buying index mutual funds and making a transfer at the end of each year to one or two ETFs is the most cost-effective approach. Claymore offers a commission-free way to buy their ETFs through certain brokers, an option worth exploring for some investors.

SUMMARY
Joe and Sally have been abandoned by their employers and the investment industry. They make poor investment choices because they lack the time, inclination and expertise to make better ones. The pension industry [DASH] from portfolio managers, insurance companies and mutual fund companies to registered reps and employers [DASH] guides investors to build portfolios that mimic institutional DB mandates with time horizons ill-suited to the needs of individuals. The high cost of investing has robbed investors of at least 1% annually. ETFs can provide part of the answer, but they aren’t being used in Canadian DC plans at all. Cutting risk from portfolios at the appropriate time can help preserve capital, but investors still don’t get the reliable retirement income they want. We will explore alternative pension approaches that use ETFs in the future.

Target date fund guidelines miss the problem

2010-12-09T12:07:00.004-05:00

SEC guidelines for target date funds and disclosure miss the critical problem with these very popular products. They don't do what consumers THINK they do. Target date funds make investing easy for long term investors in 401k and other DC pension schemes by promising to make systematic asset allocation changes that reduce the equity exposure of the portfolio as retirement, or the target date approaches. As a result, 80% of all new and redirected assets into U.S.-based DC plans are flowing into these funds. 77% of assets in these products are controlled by three manufacturers, Fidelity, Vanguard, and T. Rowe Price who must bear much of the responsibility for the misdirection.

By suggesting that equity exposure is being reduced over the life of the investment, investors think RISK is being reduced. If this were true, there would be no problem. But equity exposure does not equal risk exposure and risk changes over time. Think in terms of two relatively recent example. The RISK of the S&P 500 pre-Tech Bubble with less that 10% technology exposure and in 2000 with technology representing over 30% the risk in the market, as represented by a 252 day moving average of S&P 500 SD, spiked to over 15% during the period. The recent financial crisis saw an even more dramatic shift in the risk of stocks and bonds as corporate spreads over treasuries ballooned in late 2008 early 2009 and the SD of the S&P 500 spiked to a mind blowing 60%! So for target date funds to imply that they are systematically reducing RISK exposure is misleading at best.

The remedy is Target Date Funds 3.0, an approach that maintains a consistent approach towards portfolio RISK. It is a systems solution as much as an investment solution but most importantly in the debate about full disclosure to clients, it provides an honest relationship between what investors understand they are getting and the marketing hype of the industry. For more information www.purinvesting.com

Risk is a Ten Letter Word

2010-10-19T17:24:00.002-04:00

Investors over the recent past not only know about volatility, they likely have the scars to prove it!

Exchange-traded funds (ETFs) are well known for their low cost, tax efficiency and diversified exposure to markets, asset classes, sectors, commodities and industries. Less well known is that ETFs provide neat packets of stable risk that can not only be used to construct tailored portfolios but also to control risk easily and more effectively than ever before.

Case for more volatility

Capital market volatility threatens the adequacy of RRSPs, the solvency of defined benefit pension plans, the patience of clients and the sanity of advisors. Systemic risk from deregulation, interconnected global financial and banking structures exacerbated by an explosion in derivatives use, high frequency trading, and advances in information technology suggests that “returns are likely to remain highly heteroskedastic, showing periods of consistently high and low volatility,” says Ioulia Tretiakova, Manager of Quantitative Strategies, PŮR Investing Inc.. Nothing in currently proposed banking reform legislation suggests otherwise. The problem is that capital markets dislike uncertainty most of all.

Even if you believe that the credit crisis was a “once-in-a-lifetime” aberration, advisors have a duty to clients to protect them from it.

Managing volatility

Diversification theory suggests selecting assets that don’t move in the same direction at the same time (uncorrelated). This is smart because if one asset class is zigging (i.e. Canadian equities) while another is zagging (i.e. gold) the volatility of the combined portfolio will be dampened. But very much like a balance sheet, these relationships are more like a snapshot than the dynamic of an income or cash flow statement that show changes between periods. Two important things to remember:

• correlation between asset classes can and does change over time;
• market volatility can over-ride correlations.

I mention these caveats because they are too often ignored or forgotten by investment professionals and retail investors alike. The table below shows the correlations between several asset classes represented by ETFs. Because they are already individually diversified, ETFs provide reliable risk that can be assembled into effective portfolios. Low and negative correlations are the best combinations for diversification.

Diversification failed to protect portfolios during the market meltdown. There is little protection against crises of confidence and lack of liquidity.

This chart illustrates the development of the U.S. credit crisis as represented by the interest rate spread between U.S. Treasury bonds and corporate bonds. As confidence deteriorates, lenders demand higher yields to hold any debt instrument other than Treasuries, so the spread opens up. The shaded area shows the volatility of the S&P 500 – 126 day moving average. Volatility remained stable until mid-2007 before spiking in 2008-2009.

Market volatility is a big challenge for investors and their advisors. Let’s assume a 60% stock 40% bond portfolio is considered appropriate for an investor in 2005. As the stock market rose in 2006 and 2007, the portfolio sells stocks and buys bonds to rebalance to the 60:40 fixed asset mix. This seems reasonable because we’re supposed to “sell high” and “buy low”, right? But is the “risk” of the portfolio the same in 2008-2009 as it was in 2005? Clearly it is not.

A better solution would be to maintain the “risk” represented by the 60:40 asset mix consistently through periods of market volatility. The risk of a portfolio should represent the risk tolerance of the investor that doesn’t change in good or bad markets. If “12” represents the risk of a 60:40 mix in 2005, the “risk” of the portfolio would have spiked to over 30 in 2008-2009! To keep this portfolio at 12, equities would be 20% and bonds 80% in mid 2008. An alternative less disruptive to the mix would have been to buy the iPath S&P 500 VIX Short Term Futures ETN (VXX). Either approach would have saved serious money for investors.

Sophisticated

The idea of managing to a consistent risk is a sophisticated institutional approach on two levels. Firstly, the idea of budgeting risk is a concept used only by the largest pension funds and institutional pools of capital. No mutual fund in Canada uses this strategy as far as I know. Secondly, managing volatility is a cutting edge idea. The availability of volatility ETFs like VXX and VXZ (the mid-term version of VXX) makes these tactics available to individual investors. Hedging long positions with short or inverse ETFs is also a tactical option, but that is a subject for another time.

Summary

ETFs offer the potential to bend and shape risk in ways previously available only to institutional portfolio managers with hundreds of millions under management. This capability comes with the responsibility for advisors to “up” their game, but the payoff will benefit their clients and their practices.

ETFs and the Egg Management Fee

2010-10-19T17:19:00.003-04:00

I met a broker from Rochester at breakfast on the second day of an ETF conference in Albany New York. I was a speaker on the first day and a moderator on the second and was curious about the audience’s knowledge level and how the message was getting through. “Do you use ETFs in your practice?” I asked. He admitted that he had purchased some SPDRs (Standard & Poor’s Depositary Receipts, SPY) for his largest client. “I went to a meeting with her auditor and all he said was ‘I see that your broker bought an ETF for your portfolio, he must be doing a good job for you!’. I am here to find out what I bought and why they are so good!”
There is a halo effect over ETF use that transcends their undeniably beneficial use in portfolios. But we, in the industry, should not rest on our laurels. There is a directness that has accompanied the electronic revolution and social media that can bite, so making ETFs just another offering on the investment product buffet could be dangerous.
Take for example the Ally Bank ads that portray conventional bankers as insensitive to clients. Clients are portrayed as kids in the commercials. Fine print, exclusionary offers, undisclosed information, run-arounds, and the now ubiquitous “egg management fee” are offered as proof of big bank practices that “even kids know” aren’t fair. It could be argued that banks deserve this treatment. But mutual funds could be tarred with the same brush and with them, the entire investment profession. In Canada, the major banks, through branches and wholly-owned brokerage firms, account for two thirds of all mutual fund sales. And yes, mutual fund fees seem inexplicably large in relationship to what they deliver particularly when compared with ETF fees. But mutual funds still provide retail investors with professional management and diversification while sharing expenses. That their structure is out-dated is not entirely their fault: lack of transparency in an era of full disclosure, once-a-day pricing in a 24-hour-a-day global market, bundled fees when everything is being unbundled (except cell phone packages, strangely enough). The traditional mutual fund format struggles to keep up.
The same fate may await practitioners if they treat ETFs like just a bunch of mutual funds and stuff them into client portfolios like “last year’s hot performer”. ETFs should be used to provide the kinds of solutions, continuous client value and vehicles for managing risk for which they are so well suited with costs justified and construction communicated simply and effectively.

Managing an expanding ETF universe
There are lots of ETFs and more each week. While there are many ways to sort them, keeping things simple has great appeal because it is easier to explain to clients. Ioulia Tretiakova, Director of Quantitative Strategies at PŮR Investing, classifies the ETF universe into two basic categories: those that are passive and those with embedded strategies.
“Passive ETFs follow a simple index or an unleveraged commodity. They are characterized by low fees. Those with embedded strategies are everything else. ETFs with embedded strategies often have higher fees. Leveraged and inverse ETFs and those that follow a manipulated index like revenue or fundamentally weighted, are examples. Actively managed ETFs are the most obvious examples of an embedded strategy.”
Explaining to clients that a low cost core of passive ETFs is an effective way to capture beta, or exposure to market returns will help. You could build a core of actively managed mutual funds or ETFs with embedded strategies that try to outperform your benchmark, but it is difficult to identify successful ones in advance, extremely difficult to pick them consistently year after year, and you risk the inefficiency from fund overlap (see AER Sept 2010 “How Many?). You do, however, know their cost in advance. Go with what you know, it’s logical and clients understand it.
With your passive core established, consider the manageable characteristics of ETFs (or other assets) that make the most impact on portfolios, cost and diversification are the most important followed by liquidity, tax efficiency and tracking error. This column has examined each of these in the past.
What about returns? They can’t be predicted in advance, but by capturing the market return inexpensively with a core of passive products, you can select other “satellite” assets around the core that position the portfolio to perform. Diversified exposure to areas you feel will do well like small capitalization stocks, emerging markets, or commodities, can be added as individual securities, passive ETFs, mutual funds or ETFs with embedded strategies. If the satellite investments chronically underperform the core, you will know and so will your clients. But what to do about it will be clear. In coming issues we will examine the considerations for satellite assets more closely.
Keeping portfolio construction and classification of ETFs simple will help clients understand what you are doing, help dispel the mystery of the “egg management fee” and will distinguish ETFs as a signature part of the portfolio menu.
Mark Yamada is the President and CEO of PŮR Investing Inc. www.purinvesting.com

Target date funds 3.0

2010-07-12T18:23:00.004-04:00

By showing declining equity exposure as a retirement date approaches, target date fund managers imply that portfolio risk is automatically being reduced. This seems like a wonderful thing to investors who do not have the time or inclination to make asset mix changes themselves. Well, 2008-2009 showed us that risk for each asset class is far more important than the static relationship that professional money managers use to establish diversification between asset classes. In other words, they buy stocks, bonds, cash, and commodities in the belief that they all won't zig at the same time.

Target date 1.0 offered a date in the future. Target date 2.0 added conservative, moderate and aggressive options to each target date but the flaw remains. Fixed equity glide paths are like staring at a balance sheet; useful in helping to describe a "point in time" but useless in a dynamic capital market with risk that changes...often by a lot!

Target date 3.0 uses a dynamic glide path and constant volatility re-balancing. This means that the RISK of the portfolio is managed to a declining glide path and the asset mix is changed to reflect what is happening in the market right now. In TDF 1.0 and 2.0, the asset mix is managed to a fixed glide path while the risk is allowed to fluctuate. It doesn't make any sense to subject an investor to inappropriate risk. Furthermore, investors working towards a capital accumulation goal should know whether they are ahead or behind their projected growth path. TDF 3.0 automatically shifts risk based on progress towards this goal. Get behind, take a little more risk, get ahead, take a little less. Common sense. How does one do this for a defined contribution pension plan with thousands of members? Mass customization. www.purinvesting.com

The Death of Asset Allocation as You Know It Part 2

2010-05-20T18:18:00.000-04:00

“Experienced investors understand four wonderfully powerful truths about investing, and wise investors govern their investing by adhering to these four great truths:

1. The dominant reality is that the most important decision is your long term mix of assets; how much in stocks, real estate, bonds, or cash.

2. The mix should be determined by the real purpose and time of use of money.

3. Diversify within each asset class – and between asset classes. Bad things do happen – usually as surprises.

4. Be patient and persistent. Good things come in spurts – usually when least expected – and fidgety investors fare badly. “Plan your play and play your plan,” say the great coaches. “Stay the course” is also wise. So is setting the right course – which takes you back to great truth number 1.”

— Charles D. Ellis, 2007

Charles Ellis is a dean of institutional investing. The founder and managing partner for 30 years of respected consulting firm Greenwich Associates, he pioneered the systematic application of measurable investing activity. Supported by the 1986 research of Gary Brinson, L. Randolph Hood, and Gilbert Beebower, and follow on work by Jahnke, Ibbotson and others, the important role of asset allocation in the investment process developed.

In 2008-2009, extreme volatility, caused by the financial crisis, repealed the laws of asset allocation. Everything went down. Judicious choice of non-correlated assets was meant to invoke the protective properties of diversification. But correlations, based on historical relationship, have always wavered in the face of crisis. Yet advisors and professional investors alike embrace the tenets articulated by Ellis above.

It is not that these platitudes are wrong. There aren’t many absolutes in the investment world after all (except, perhaps, that costs detract from returns). Rather, there should be a fifth truth:

“The risk of assets selected for a portfolio should not only be consistent with the goals, time horizon, and risk tolerance of the investor or mandate, but should be kept consistent particularly when market risk rises and falls.”

Risk is like the temperature of bath water, some like it hotter than others, some cooler. If the temperature is too hot, add some cool. Conversely for a cooler bath, remove some cool and add some hot. Portfolios can be managed the same way.

If you would like to follow our ongoing research, please leave your email address and we’ll keep you apprised as we progress over the next several quarters.

Bird-brained stock picking

2010-04-15T18:52:00.002-04:00

Less guesswork with exchange-traded funds

Every week at home, as a keen young portfolio manager, I would pour over the charts of all the stocks traded on the New York and American Stock Exchanges that were included in a binder with 12 charts to the page, 24 in total when open.
My pet cockatiel, named Dow Jones, would fly around the room as I worked. One day, he landed on my shoulder and walked down my arm onto the chart book. He shuffled around and pecked showed his displeasure in a unique bird-like way on one of the charts. The next day that stock went down sharply! A humorous coincidence!
He did it the next week and the next. Each stock that received a “deposit” went down in price. Still a humorous coincidence, but I realized it represented a random key to how many people make investment decisions.
People are notoriously random when it comes to making investment decisions. They base them on conversations overheard in the office bathroom, or relatives who’ve seen big returns on their investments, or the sound bites of investment journalists. And then they pray. People do what they think worked for them in the past regardless of the method’s randomness. Sometimes their lottery ticket selection strategy is more systematic. No wonder so many investors end up with a portfolio of random securities with no plan or purpose.
But when it comes to exchange-traded funds, there is no guesswork. There is less guesswork with exchange-traded funds (ETFs). These securities track an broad indicies, a commodities, currencies, sectors and industries and allow investors to take leveraged long and short positions. a grouping of assets like an index fund, or a trade like a stock on an exchange. They offer diversification, and the ability to sell short, buy on margin, and purchase as little as one share and trade like a stock during regular exchange hours.
There are only three basic ways to build portfolios with them, all others are variations. Over the next three issues, I will examine each of these.
Here is a brief overview of how ETFs portfolio construction works:

Fundamental approaches
The fundamental approaches use some form of “top down” or “bottom up” analysis. Assessing views of global, regional and local economies and their impact on sectors, industries and companies, ETFs lend themselves nicely to these strategies because they make country, regional, sector and industry investing simple.
Institutional managers can use ETFs to establish broad exposure before making specific securities investments and they can hedge existing exposure by shorting the relevant ETF. Portfolios for individual investors can similarly benefit from diversified exposure to elements identified by the portfolio manager.
“Bottom up” managers, or stock pickers who screen for superior growth, value a combination of both or other factors, have style ETFs as well as large, mid-cap, and small capitalization alternatives in different regions and sectors to choose from.
Many large portfolios and pension schemes employ “core” plus “satellite” or “tactical” approaches. They create a passive core cheaply and select active alpha-seeking strategies around that core.
ETFs offer flexibility and choice at a low cost so these traditional approaches can be applied to private client portfolios effectively. The tax efficiency of separately managed accounts combines nicely with ETFs so many firms will be encouraged to transition pooled and mutual fund assets to this format. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.

Market timing
Today, there are 1,000 ETFs available worldwide, with another 500 or so in registration, a fact attractive to many. Include currency; commodity; leveraged or enhanced; long and short; so-called “fundamental” and even Chinese real estate ETFs; and the possibilities grow.
Traders feed on volatility. So it’s good news that the dampened relative volatility of groups of securities, which counters traders’ need for action, is offset by better liquidity from the ETF structure.

Leveraged ETFs that offer the holder two times the daily price movement of an index are available; inverse versions go up two times the daily fall in price of an index. This is the type of action that traders want. But leveraged ETFs are not just for traders.
Trading has done much to democratize capital markets for individual investors; specialized education in financial analysis is not required. Technical analysis, the trader’s discipline, doesn’t care about companies, products, margins or market share. All that matters is price movement.
Within the movement of prices (and sometimes trading volume) lies all the necessary information needed to make buy and sell decisions. Anybody can apply these methods to the price of anything. This is pure market timing.

SIDEBAR
Risk management
The low cost and tax efficiency of ETFs are what individual investors should exploit. However, there are many other perks to using ETF products:
1. A free lunch: Lowering risk by using levered ETFs : If achieved, investors benefit from the higher return potential from leverage without assuming additional risk.
2. Risk budgeting through sophisticated portfolio construction: Only the most sophisticated institutions use this approach that optimizes diversification by assigning weights by risk.
3. Constant volatility: Consistent risk exposure for individuals can help avoid sharp market declines.
ETFs are neat little packages of diversified risk that make effective building blocks for many kinds of portfolios. Next month: ETFs in greater detail.

ETF Tracking Error: Where's the beef?

2010-02-18T17:32:00.002-05:00

The 1 kg of stewing beef I bought ended up tasting like pork. When confronted, the butcher retorted “Well buddy, it’s meat isn’t it?” Most consumers would be incensed at this response, but for some reason, investors are far more tolerant. It may be that mutual funds have dulled our expectations by underperforming their benchmarks for decades.

But for exchange-traded funds (ETFs), the standards should be higher.

They should be higher because their benchmarks are transparent indices (for the most part) and the goal is replication.

Tracking error, what is it and why is it important

Mathematically, tracking error is the standard deviation of the difference between index and ETF returns. Example: 4% tracking error means that annual ETF returns will be within ±4% of index return, two times out of three.

Ioulia Tretiakova, Director of Quantitative Strategies, PŮR Investing Inc., affirms that while tracking error can be important if ETFs are used to hedge a portfolio, understanding tracking error helps individual investors employ these vehicles more effectively.

Causes of tracking error
There are three ways to replicate an index:
Stratified sampling: buy only some of the underlying securities: you order a chicken and get 1 wing, 1 breast, 1 leg, 1 thigh.

Optimization: use underlying securities and/or derivative instruments to mimic an index’s return: chicken fingers!

Full replication: buying all the components of an index is the most effective way to minimize tracking error. You order a chicken and get the whole bird.

Ordering a chicken and getting chicken fingers may not bother some investors, but understanding the possibility is important. To be fair, stratified sampling and optimization can be the only practical approaches given size and liquidity considerations. The DEX Universe Bond Index has 1,058 holdings while the popular iShares CDN Bond Index Fund (XBB) that mirrors it, holds only 301 issues.

Ms. Tretiakova observes, “Regulation has an impact. There is no maximum security weight for ETFs in Canada, but in the U.S. there is a 19.99% cap. Hence the return of Vanguard’s Information Technology ETF (VGT) lagged its benchmark MSCI U.S. Investable Market Information Technology Index, by 50% since inception (1/26/2004 to 1/3/2010) in part because the index weight of AT&T was 49% and only 19.99% for VGT.” This is like ordering three chickens and getting the two-bird maximum.

Should daily returns be used to calculate tracking error?
The index underlying the iShares MSCI EAFE Index Fund (EFA) and its “Loonie-hedged” cousin, XIN, does not have a contemporaneous closing time, so using daily closing NAVs and index values for tracking error calculations makes little sense; like roosters crowing dawn in each time zone.

On the other hand, the tracking error of leveraged ETFs (in Canada, the Horizon BetaPro series) should be calculated using periods no longer than daily. Over the longer term, daily rebalancing will cause divergence made all the greater by volatility; like ordering an egg and getting a two egg omelette.

Leveraged ETF tracking error
The multiple-of-daily-index-return objective of leveraged ETFs is not completely accurate, warns Ms. Tretiakova. What actually happens, in the case of a 2X ETF, is that “there is twice the total return minus one times the cost of capital. Currently, this is slightly better for investors than the stated objective of twice the price return because dividend yields are slightly higher than the cost of capital. However, when these two rates vary, the difference may be more significant.”
Leveraged Fund Performance Relative to Stated Objective
and its relationship to dividend yield-interest rate differential

ETFs with unusual tracking error
Some ETFs operate without a specifically stated benchmark, defining only broad asset class exposure. For example, the Claymore Broad Emerging Markets ETF (CWO, launched April 7, 2009) states that “The Manager will select an Emerging Markets Benchmark Index such as the MSCI Emerging Markets Index, the FTSE RAFI Emerging Index or another widely recognized emerging markets index in order to provide such exposure and may change the Emerging Markets Benchmark Index in its discretion without unit-holder approval.” This sounds like advertising chicken while delivering duck. The challenge is trying to determine the tracking error when the target index is changing. One comfort these unit-holders have is that the indicies for groups of emerging markets will likely have similar volatility (risk). This means that the advertised chicken is unlikely end up being pork chops!
Finding tracking error information

Most ETF sponsors offer tracking error information on their websites. Often shown in chart form, price movement of ETFs are easily compared with their underlying index. The actual tracking error of Canadian-traded ETFs and how they compare to others is available at http://purinvesting.com/demo/Screen.htm .

A cost to investors, tracking error is well worth monitoring. It’s one way of keeping ETF sponsors honest and assuring you don’t get salt pork when you expected steak.

Mark Yamada is President of PŮR Investing Inc. a registered portfolio manager specializing in risk management using exchange-traded funds.

Lower costs, better portfolios (sometimes)

2010-01-26T10:44:00.001-05:00

Exchange-traded funds (ETFs) are less expensive than mutual funds by a wide margin. Embedded mutual fund distribution costs, paid to financial advisors for selling them, are most of the difference. Claymore is the only ETF sponsor in Canada paying advisors from a separate ETF series that is 0.50-0.75% more expensive. While brokerage costs must also be considered when acquiring ETFs, improving transparency is helping investors make more informed choices.
Canadian Median Mutual Fund MER vs. ETF MER

Canadian Equities Mutual Fund Median 2.45%
0.16% BMO Dow Jones Canadian Titans 60 (ZCN)
0.17% iShares Large Cap 60 (XIU)
0.25% iShares CDN Composite (XIC)
0.65% Claymore Canadian Fundamental (CRQ)
1.15% HBP S&P TSX 60 Bull Plus (HXU)

Canadian Bonds Mutual Fund Median 1.96%
0.15% Claymore 1-5 yr Laddered Gov’t Bond (CLF)
0.325% BMO Canadian Gov’t Bond Index (ZGB)
0.35% iShares CDN Government Bond (XGB)

Int’l Equities Mutual Fund Median 2.69%
0.455% BMO International Equity Hedged (ZDM)
0.49% iShares MSCI EAFE Hedged (XIN)
0.65% Claymore International Fundamental (CIE)

Emerging Markets Mutual Fund Median 2.93%
0.535% BMO Emerging Mkts Equity Index (ZEM)
0.65% Claymore BRIC (CBQ)
0.82% iShares CDN MSCI Emerging Markets (XEM)
1.15% HBP MSCI Emerging Mkt Bull Plus (HJU)

Commodities Mutual Fund Median 2.60%
0.40% iShares COMEX Gold Trust (IGT)
0.75% HBP COMEX Gold (HUG)
1.15% HBP COMEX Gold Bullion Bull Plus (HBU)

ETF COST DIFFERENCES
Among the Canadian Equity ETFs shown, newcomer Bank of Montreal (BMO) undercut comparable and more established iShares LargeCap 60 by 0.01%. and similarly positioned themselves in bonds, U.S. and international equities, and emerging markets.

Sometimes costs reflect structural differences. Higher-priced iShares CDN Composite at 0.25%, includes a broader holdings base (S&P/TSX Composite’s 204 issues). Claymore’s Canadian Fundamental (0.65%) would appear to be out of step with the group, but includes an “embedded strategy” namely a value bias in the construction of its index. Claymore is actually offering an actively-managed ETF in passive clothing.

PASSIVE OR EMBEDDED STRATEGIES
Distinguishing passive ETFs from those with embedded strategies is a good starting point for portfolio building. One is not better than the other, but those with embedded strategies are usually more expensive. Director of Quantitative Strategies at PŮR Investing, Ioulia Tretiakova, maintains: “You never know what the future return of an ETF is going to be, but you do know its cost.”
Embedded strategies try to offer something in return for their higher cost. In Claymore’s RAFI Fundamental series, it is a tilt towards value stocks. If this is what you want, ETFs can give you effective access. The Horizon BetaPro (HBP) Plus ETF series offers two times the DAILY return for the “Bull” version and two times the inverse DAILY return for the “Bear” series. This powerful leveraging capability comes at a cost of 1.15% but considering the “double exposure” makes the effective MER 0.575%. This appears expensive in the Canadian equity category with offerings at 0.16-0.17%, but in emerging markets, where iShares cost 0.82%, HBP appears more competitive.

TRADING COSTS
While lower cost is a key ETF benefit, management expense ratios tell only part of the story. Studies of U.S. mutual funds showed that annual trading costs were 1.44% per year (Edelin/Evans/Kadlec, 2007). Canadian mutual fund trading costs are not available, but exchange traded fund trading costs are certainly lower than mutual fund costs for two reasons:

1. the index nature of ETFs means little trading is required for rebalancing;

2. market-makers for Canadian ETFs assume the cost and risk of rebalancing including index composition changes. Elsewhere in the world, the cost of an index change is borne by the ETF unit-holder. If the annual trading cost for an active Canadian mutual fund is 1.0%, and the comparable ETF cost is 0.0%, it is little wonder that active funds have so much difficulty beating index and ETF performance.

LOONIE EH?
Canadian investors, like counterparts around the world, focus most investments in their domestic currency. This makes sense because liabilities and expenses are Loonie-centric. Some international ETFs are offered “hedged”. This comes at a cost. Is it better to buy the hedged or unhedged ETF? The answer is related to your expected holding period. Here’s a guideline:

1. The longer the holding period (over 4 years) you may be better off unhedged. The cost of hedging is fixed and compounds over time.
2. If you have a view about the direction of currencies, hedging for protection or unhedging for exposure can become part of your strategy.

ETFs offer an increasing palette of risk shapes and colours giving investors broad scope to construct portfolios that reflect their views and address their needs. Cost is a rare certainty in a financial world filled with unknowns. Consequently, it is one of the most important considerations in building any portfolio.

PŮR Investing Inc. is a registered portfolio manager specializing in risk management using exchange traded funds. PŮR’s free ETF screener is available at: http://purinvesting.com/demo/Screen.htm .

Taxes, like hemorrhoids, are annoying ETFs can provide relief

2010-01-26T10:35:00.001-05:00

People don’t like to talk about them and they are decidedly a pain . . . but taxes are the bane of an investor’s existence.

Investment professionals know that three key characteristics make exchange–traded funds (ETFs) tax efficient:

Index-based ETFs have extremely low turnover. Transactions trigger gains taxable in the hands of unit holders.

The redemption of ETFs allows for in-kind transfers, allowing sponsors to transfer out the lowest cost shares without incurring tax. This maintains the adjusted-cost base closer to the market value. Unit holders pay most taxes when they sell the ETF, effectively deferring taxes until realized.

The creation method and exchange-traded nature of ETFs means that supply and demand are balanced in the marketplace and units do not have to be sold (incurring a possible tax liability) to meet redemption requirements as mutual funds do. As a consequence, ETFs hold less cash to earn taxable income. (albeit not much lately given low interest rates).

These tax minimizing characteristics are a big relief for taxable investors. Had they owned mutual funds, they could be subjected to big taxes unrelated to their actual investment results. Paying for the capital gains or income received by others is just silly.

Tax losses

ETFs are ideally suited for capturing tax losses. The conventional way is to replace a losing stock position with an ETF. Example: sell Research in Motion (RIM) at a loss to buy iShares Canadian Tech Sector ETF (XIT). The loss in the stock position is captured, to be used to offset capital gains in the current year, back three years or carried forward indefinitely. The portfolio exposure, to the technology sector in this case, is maintained.

Another effective tactic is to swap between ETFs with similar underlying risk. An example is iShares S&P 500(IVV) and SPDR 500(SPY). Both have the S&P 500 as their underlying index but because the ETFs have different sponsors, BlackRock and State Street Global Advisors respectively, they are considered different securities for tax purposes. Therefore, they may be traded simultaneously to capture a loss. The 30 day waiting period to avoid a superficial loss is not required.

Holding a core portfolio of ETFs and owning a satellite portfolio of individual stocks is a good way to protect capital gains generated by the stock portfolio by applying tax losses generated from the core. Some firms may offer a tax-loss-capture module, like PŮR Investing’s, that does this automatically.

Caution

Ms. Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, says that while ETFs have tax efficient characteristics, some have shocked investors at tax time.

The 2008 experience with some leveraged Rydex Inverse sector series ETFs is shown here.

ETF	Gain
Rydex Inverse 2x Sector Energy	86.61%
Rydex Inverse 2x Sector Technology	59.46%
Rydex Inverse 2x Sector Financial	42.35%

Ms Tretiakova explains that inverse, leveraged long and leveraged inverse ETFs use swaps and derivative instruments rather than securities that can be transferred in-kind. This creates potential tax liability when the contracts are closed out. Capital gains, influenced by volatility and the expiration of futures contracts related to the underlying sectors on January 1, 2009, were huge for several Rydex ETFs. In Canada, a similar situation is not expected although in 2012 the Horizons Beta Pro’s leveraged ETF products listed below have OTC derivative contracts maturing. A different Canadian structure, unavailable in the U.S., allows sponsors to better minimize taxes. At any rate, leveraged ETFs should always be watched carefully.

ETF

Date

Symbol

HBP S&P/TSX Financials Bull Plus ETF

HBP S&P/TSX Financials Bear Plus ETF

June 11, 2012

HFU

HFD

HBP S&P/TSX Energy Bull Plus ETF

HBP S&P/TSX Energy Bear Plus ETF

June 18, 2012

HEU

HED

HBP S&P/TSX Global Gold Bull Plus ETF

HBP S&P/TSX Global Gold Bear Plus ETF

June 25, 2012

HGU

HGD

Screening ETFs for tax efficiency

While it should be clear by now that taxable investors should always use ETFs rather than mutual funds, differences in the tax efficiency of ETFs bears some attention. Like other forms of investing, “tax” should never be the prime reason to make an investment, however, it is common sense to be mindful of an instrument’s tax impact.

Screening ETFs by the proportional size of their historical distributions is a fair way to assess their tax efficiency. It is these distributions that incur the tax that investors seek to avoid. To be fair, indexes that change their components or are in start-up mode, may incur more transactions and more taxable activity. This should diminish over time.

When choosing between similar ETFs, picking the one with better tax efficiency may improve your after tax return. To see the tax efficiency of ETFs trading in Canada, check the free screener at: http://purinvesting.com/demo/Screen.htm

Picking the right ETF: Liquidity

2009-10-30T18:10:00.003-04:00

Lack of liquidity is treacherous for everyone.

Catastrophe in capital markets is always characterized by a lack of liquidity. Significant imbalances between buyers and sellers (widened bid-ask spreads) can create market “gaps”. Occasionally this happens to the upside but predominately it occurs on the downside. Examples: October 1987, September 2001, Q4 2008. Liquidity is important for investors, but a lack of liquidity is treacherous for everyone.

Liquidity of underlying securities

Since the 1990 launch of the first exchange-traded fund (ETF), the Toronto Index Participation Securities (TIPS), liquidity has been important. Originally developed for retail investors, TIPS became popular among institutional investors seeking broad market access in part because of the liquidity of the 35 stocks underlying TIPS. It follows that ETFs with illiquid holdings should be watched carefully. Fixed income ETFs can fall into this category.

Theoretically, trading volume and liquidity for today’s ETFs is not a problem with the creation/redemption mechanism. This structure authorizes designated brokers to create additional units if demand exceeds supply, and conversely, remove units when supply exceeds demand. But there are differences in bid-ask spreads impacting every investor’s bottom line that require explanation.

Timing and volume

“An ETF manager may be doing a terrific job of tracking an index,” says Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, “but the retail investor may still be impacted by liquidity costs, paying a hefty price in the form of wide bid-ask spreads or volatile premiums/discounts to net asset value (NAV), all resulting in less than stellar market liquidity.

“Transacting before a holiday or at other times when volume is expected to be low, can be expensive and should be avoided. For example the closing bid-ask spread for actively traded iShares CDN S&P/TSX 60 (XIU), as of Friday, October 9, 2009 (Thanksgiving weekend) was $17.08-17.10 or 11.7 bps (normally about 5.8 bps) and for less actively traded Claymore Canadian Fundamental Index ETF (CRQ), was $10.85-10.99 or 129 bps (normally about 28 bps). Bid-ask spreads are generally correlated with trading volume and tend to be tighter for ETFs with more assets under management as the examples above demonstrate. 3 month average trading volume: XIU 17.6 million shares vs. CRQ 35,632 shares. The chart below demonstrates that trading volume and bid-ask spreads are correlated. This is not a surprise. More activity reflects popularity which suggests better arbitrage opportunities to keep spreads narrow and ETF values close to NAV.

“Poor liquidity can cost investors money. Most ETF prices oscillate around their NAV. The absolute level of premium/discount and its standard deviation, a measure of how far, on average, the market price of an ETF tends to deviate from the NAV, warrants scrutiny. Some ETFs, primarily fixed income, trade mostly at a premium. For these ETFs, the magnitude of the average premium depends on the liquidity of the underlying assets, a good example being iShares Canadian Real Return Bond ETF, (XRB). Due to the limited depth of the Canadian real return bond market, this ETF tends to trade at a premium to NAV, closing at $20 on October 9, 2009 with a NAV of only $19.75, or a 1.27% premium.”

The daily historical premium/discount to NAV for the XRB is shown below.

Conclusion

The overall measure of ETF liquidity is a combination of factors; bid-ask spreads, fund assets, trading volume, premium-discount and last, but not least, the liquidity of the underlying assets. Imbalances can lead to tracking error that can distort strategies (to be covered in a future article).

If investors intend to hold positions for longer than 6 months, liquidity may be less of an issue, but larger spreads can be costly over time to frequent traders. A rule of thumb for liquidity is that if the securities underlying the ETF are popular, the ETF’s construction is transparent, and trading is active, liquidity should be pretty good.

PŮR Investing Inc. offers a free ETF screener on their website that includes liquidity: www.purinvesting.com.

Picking the right ETF: Diversification

2009-10-30T18:07:00.001-04:00

PICKING THE RIGHT ETF: Diversification

First of a series of articles exploring how to sort and evaluate exchange traded funds.

The need

Exchange-trade funds (ETFs) have had the most profound impact on personal investing since the introduction of the modern mutual fund in 1924. To the advantages that drove mutual fund growth; diversification, professional management, and shared expenses, ETFs have added low costs, transparency, market access throughout the trading day and tax efficiency.

Institutions lead the use of ETFs for effective acquisition and hedging of portfolio positions. In 2008, the ability to short financial ETFs while shorting individual financial company shares was banned is only one example of the value of these instruments.

With over 100 ETFs trading in Canada, over 800 in the U.S., and over 500 more in registration, this rapidly expanding universe demands better selection tools.

These articles will explore key factors for evaluating ETFs beyond simple categorization and screening. Diversification, liquidity, cost, tax efficiency and tracking error will be examined for their impact on portfolio construction.

DIVERSIFICATION

Definition

Diversification is a method to control risk by limiting exposure to any one holding. Institutions typically diversify by:

 asset class (stocks, bonds, cash, real estate, commodities, currency)
 region (domestic, foreign, emerging markets)
 style (value, growth, core)
 size (large cap, mid-cap, small cap)
 sector (financials, materials, technology, energy)

All of these are available via ETFs. Individual investors no longer need millions of dollars to get broad exposure.

How to measure it

The quantitative way to measure diversification is by measuring the specific (idiosyncratic) risk in a portfolio. The less specific risk there is, the better the diversification. Specific risk is the risk "specific" to a security, not explained by systematic market factors (such as energy prices, interest rates, etc).

Specific risk is a metric routinely calculated by risk models. Investors without access to risk models can use PŮR’s “rule of thumb” approach:

 total number of securities (PŮR recommends at least 50),
 weight represented by the top 10 holdings (PŮR recommends under 30%)
 weight of maximum individual holdings (PŮR recommends 10%).

Why it is important

According to capital market theory, specific risk is not rewarded. That's why minimizing exposure to this risk by increasing diversification makes sense. Better diversification can mean less variability in a portfolio’s value. Professionals call this “risk management”, investors call it “sleeping at night”.

How it works

The principle is based on the idea that prices of selected assets can move independently from one another (uncorrelated). Good diversification means lots of different risks not lots of different assets, as many investors often forget. ETFs’ risk is more reliable than that of individual securities because it is dampened by the variety and number of their holdings. The result offers a more effective approach to portfolio construction.

What are you trying to do?

Are you an investor or a trader? This will impact how you choose ETFs.

Investor: Your investing horizon is 5 years plus and you’re looking to overweight areas of the economy that will outperform. You need to manage risk, so diversification is important. Selecting the more diversified ETFs from different asset classes, regions, styles, sizes and sectors is a good way to succeed.

Trader: Your investing horizon is lunchtime tomorrow (maybe up to one year). All you need to predict price movements is in price, volume and trading statistics. You gain by exploiting volatility and you trade frequently. Ironically, ETFs dampen volatility! Nevertheless, it may be easier to make a call on a sector (like financials) rather than a single security (like TD Bank ). Diversification is a two-edged sword for you, but is useful in assessing broad or specific exposure to underlying indices.

Examples

An ETF’s diversification is a function of the number, concentration and nature of its holdings.

iShares CDN Large Cap 60 Index Fund (Symbol: XIU) with 60 holdings vs. iShares CDN Composite Index Fund (Symbol: XIC), with 220 holdings, illustrates similar ETFs with different diversification. While similar, the XIC is somewhat better. This doesn’t necessarily mean that XIC is the better choice however. As we will see in a future article, cost is a very important factor.

The iShares CDN Tech Sector Index Fund (Symbol: XIT) with only 5 holdings is a very concentrated ETF that would score low on diversification but may be interest traders.

Single commodity-based ETFs represent pure systematic risk. They are asset classes by themselves. Some U.S. ETFs track commodity indices that have different sector concentrations. Look before leaping.

Summary

Diversification is one the most important factors in ETF evaluation. It is central to portfolio construction and an important reason for ETF popularity today. In the next issue, we will discuss liquidity, important for when the $%^t hits the fan as it did in 2008.

PŮR Investing Inc. is a registered portfolio manager specializing in risk managment using exchange traded funds. PŮR’s free ETF screener is available at: http://purinvesting.com/demo/Screen.htm

Goals-based asset allocation: Part B

2009-07-08T16:55:00.004-04:00

Using the right tool for the job is fundamental in many disciplines. To drive a nail one needs a hammer, to insert a screw, a screwdriver, to screw unsuspecting investors , Goldman Sachs (http://www.rollingstone.com/politics/story/28816321/the_great_american_bubble_machine/print) But I digress! Actually, from the viewpoint of many investors, all advisors, not just the ones at GS were guilty last year.

"If your only tool is a hammer, every problem looks like a nail." I love that phrase and it applies well to the investment business. Investment advisors too often believe that making as much money as possible is everyone's goal all of the time. Is that equally the case for a 26 year old investment banker and a 68 year old retired school teacher? Maybe, but not likely. So why do advisors push similar solutions for each client?

Whoa! You may argue that giving the retiree a conservative balanced or all fixed income portfolio and the banker an all equities or emerging markets portfolio is providing different solutions. But neither solution was likely constructed based upon that investor's needs only their perceived risk tolerance. What's the difference? Sometimes not much, but usually quite a bit!

If you ask a prospective investor to mentally divide their pool of investment capital into three buckets:
1. Basic needs: food clothing and shelter
2. Enhanced lifestyle: cottage, vacations, French rather than Chilean wine
3. Legacy: grandchildren's education, philanthropy.
a typical split may be 1.(60%) 2.(25%) 3.(15%).

Now assign risks to each bucket.
Bucket 1 is pretty important so you can't take much risk with that one. Perhaps you buy all bonds with this portion.
Bucket 2 gives you more flexibility. Perhaps a 60% equity 40% bond portfolio will address this need.
Bucket three is a long time horizon goal so perhaps 80% equities and 20% bonds works for this piece.

Now you have addressed client goals but investing time horizon needs to be accommodated. More on this in the next installment.

Goals-based asset allocation: Part A

2009-07-02T13:30:00.005-04:00

There is not much new in the world of asset allocation despite the drubbing portfolios sustained last year. The best and the brightest minds and the most researched and supported techniques failed to save Humpty Dumpty from shattering on impact as he fell from that wall.

The Harvard and Yale Endowments, and in Canada, the Ontario Teachers' Pension Plan and le Caisse de depot et placements with extensive risk budgeting tools and an enviable record of success, succumbed to the same gap in the system that eliminated 30-40% of the value of stock portfolios globally. Capital markets went into "rectal lock" and values plummeted in the ensuing vacuum.

What were the goals of these institutions? Did they achieve what they set out to achieve? What could have been done differently? All these questions are being asked and the industry, its observers and consultants have been offering opinions. The "finger pointing" has been extraordinary. The only question that is meaningful for most of us is: what can investors and investment professionals learn from this experience?

Asset allocation describes the strategy investors follow to divide their money between different assets like stocks, bonds and cash. The underlying principle is that the prices of different assets move in different (uncorrelated) ways leading to the idea that "diversification" protects against risk, as defined as volatility.

The obvious problem is that this approach says little about the objectives of the investor. Volatility is an abstract concept for most retail investors. After the extreme volatility of capital markets last year, I suspect it is a more distant concept for many professionals also.

Goals-based asset allocation attempts to match the volatility of a group of assets to the broad goals of an investor. I'll explore how to do this in future posts.

Leveraged and inverse ETFs

2009-06-09T14:22:00.002-04:00

The controversy over ETFs that offer 2 or 3 times the daily price movement of an index (up or down) is rooted in the wonky returns from an unprecedented period of volatility in capital markets in 2008 and early 2009.

The Foundation for Advancement of Investor Rights (FAIR) executive director Ermanno Pascutto has been clear in criticizing these products as misleading. His statement in the May 15, 2009 Jonathan Chevreau Financial Post article "Investor group blasts makers of leveraged ETFs" could be, with respect for the goals of the organization, better informed.

"There's a lot of detailed disclosure in the prospectus about risk but nowhere does it bluntly tell you you could be completely right in your selection of an ETF and find out that despite being right, you lose money". He goes on to say "In several cases, no matter which way you bet over the past year, you would have lost money."

One of the examples cited is the case of the Horizon BetaPro Global Gold + ETF. The underlying index, the S&P/TSX Gold Mining Index was up 0.9% for the year ending March 31, 2009 while the Bull + (2X) ETF was down 46.4% and the Bear + (-2X) was down 86.7%. At first glance this doesn't seem right. The fact is that each ETF delivered pretty much what they said they would, 2X the daily price movement of the index. The issue is the difference between arithmetic daily returns and geometric compounded returns.

It doesn't take much volatility to get these two different returns out of alignment. When volatility is as wild as it was for the 12 months ending March 31, 2009, the extreme results mentioned earlier are possible.

A way to estimate the impact of volatility on the returns of leveraged ETFs is as follows:

daily geometric return = daily arithmetic return - (0.50 X SD^2)

In the case of the S&P/TSX Gold Mining Index, the daily volatility was 5% and that of the HBP Bull and Bear + ETFs was 10%! Working through the above formula one derives an estimate of 0.50% per day. This translate into 72% per annum of volatility drag. In other words, assuming zero index movement for a year, an investor could expect a -72% return from volatility in this ETF. The investment strategy is very clear, if an investor expects a high level of volatility to persist; short the ETF.

If FAIR wanted to help the broadest base of individual investors, they would be doing better to demand that Canadian mutual fund prospectuses display costs on the front page in a type size that everyone can read so that Canadian investors would know that they are being charged the highest mutual fund fees in the world.

Canada Cup of Investment Management 2009

2009-06-05T17:18:00.005-04:00

This two day event, held in Toronto, has just ended. It was a subdued gathering compared to similar events several years ago when capital markets were more sanguine. The bloodied financial system and subsequent economic consternation has left investment professionals bewildered and chastened. This is quite significant when considering few stadiums could accommodate their collective egos in better times.

The presentations were good. Even mine, I am told! But most surprising was the attention attendees paid to the messages from sessions titled: Critical issues facing pension funds for the next year/Global economic crisis and its impacts on investment and risk management decisions. In better times, one can't tell portfolio managers anything. They are gods in bull markets! Today, gods in training.

The double barreled kick off speakers were Dwight Duncan, Finance Minister, Ontario followed by Iris Evans, Finance Minister, Alberta. We were reminded why we all should live in Alberta. One could conclude from this small sample of two people that there seems to be some intelligent life among politicians in that province.

Big public sector pension money was represented. Ontario and Alberta Teachers Pension funds, Hospitals of Ontario Pension Plan, OMERS, OPSEU, and others. Folks were in shock that their well constructed portfolios designed for diversification all took a bath. "Correlations all rose" they complained. The tools failed, VaR failed, alternatives failed, leveraged and inverse ETFs disappointed and the only way back is if the markets float funds into solvency. In other words, their is no resolution.

Everyone shuffled through the sessions looking for answers finding solace only in group commiseration.

The best hope for salvation was mentioned several times but usually out of context. It was as if nobody wanted to admit they were spooked by volatility and that it was too early after the disaster to face the perpetrator. Consultants failed to boost spirits with predictions of a long and uncertain road back. (Check this space in the future for more about the "answer").

The only bright event was the announcement that the Bank of Montreal had listed four exchange traded funds on the TSX Thursday. Their first. This is important because it marks a validation of this lower cost alternative to mutual funds. The mutual fund industry was only muddling along in Canada until 1990 when the banks entered the market that they now dominate, and validated that product. How many other banks will follow suit by January 2010?

“Are we there yet?”: the dynamic risk glide path approach to target date fund construction.

2009-04-19T18:14:00.002-04:00

Today’s “target date funds” offer tremendous potential for self-directed pension schemes and employer-sponsored defined contribution plans in particular. Reducing the decision-making burden for investors and streamlining administration are worthy goals indeed, but at what cost to investment outcomes?

Shortly after takeoff from Heathrow, the pilot’s voice crackles through the cabin.

“We will be flying at an altitude of 35,000 feet and our flight time to New York City will be 7 hours 56 minutes. Stronger than expected head winds are possible in which case we may be landing up to 1200 miles short of the airport. Nevertheless, we are pleased to offer you another ‘on time’ arrival!”

Such is the case with today’s fleet of “target date” funds that change their asset mix on a predetermined “glide path” towards a specified future date. The problem is, as with our pilot above, that adverse market head winds promise to ditch unit-holders and passengers in the ocean, short of their destination.

Executive summary

Having a flight plan at take off is essential. But making no adjustments for developments along the route seems irresponsible at best and negligent at worst.

Target date or lifecycle funds (TDFs) attempt to simplify decision making for individual investors by automatically shifting to more conservative asset mixes (“soft landing”) as the “target” date approaches. Investors pick a fund with a terminal date closely corresponding with their retirement date and are spared rebalancing and asset mix shift decisions. This approach is increasingly popular among defined contribution (DC) pension and other self-directed schemes.

Predetermined asset mix changes vary somewhat from manager to manager, but each has a “glide path” that shifts from primarily equities in long dated funds to mainly fixed income and cash equivalents later on. Funds with near targets (like 2010), caught with 40%-60% in equities, have been severely damaged by the 2008 market downdraft, with little prospect for meaningful recovery given the increasingly conservative trajectory of their asset mixes. Disappointment, consternation, and questions are understandable.

We argue that the real objective of retirement schemes should be adequate replacement income in retirement, not “maximizing returns” within a fixed risk structure. We revisit TDF tactics and, using passive strategies, suggest that a dynamic risk glide path based upon actual return experience relative to a predetermined dollar target (safety net) and constant volatility rebalancing increases the probability of meeting capital accumulation targets compared with fixed trajectory funds that dominate the market today.

Defined contribution and other self-directed pension schemes

A massive unfunded defined benefit pension liability (perhaps $257 billion for S&P 500 companies at the end of 2008 for an aggregate funding level of 82.1%1) in part explains the shift to defined contribution as a dominant form of pension growth globally. Globalization itself has forced corporations to lower costs to stay competitive. Only 367 of S&P 500 companies had defined benefit (DB) plans at the end of 2007 and fewer are expected to have them after 20081. DC plans are the primary retirement plan for 64% of private sector employees in the U.S. (2007). The number of active participants in private DC pension plans surpassed those in DB plans in 19842. Corporations and governments look to control and reduce liabilities by shifting more responsibility to employees. This trend has been in place for over two decades but only within the last year have U.S. DC and Individual Retirement Account (IRA) assets exceeded private DB, Government pension plan and retirement annuity assets.3

Self-directed pension plans’ problems include participants’ failure to save adequately or to start early enough to build sufficient assets for retirement. Mandatory participation and portability are addressing the first issue, but current economic challenges threaten the latter as corporations trim matching contributions, and immediate participant needs supersede retirement goals.

Shifting investment decision-making responsibility to employees has also been a challenge for plan sponsors addressing varying participant ages, aptitudes, inclinations, and resources. More investment choice, once believed the best way to limit liability, has given way to simpler solutions that encourage fewer decisions with less investment expertise.

In summary, a competitive global business environment has led to a shifting of inadequate pension funding from corporations to individuals. DC plan sponsors are now responsible for offering participants inexpensive but effective solutions.

Target date funds

Self-directed pension plan growth is likely to persist. Plan sponsors must respond with simpler but more effective solutions at a fair price. They must, furthermore, eliminate conflicts of interest and provide full disclosure or face consequences that may include lawsuits.

Investors may prefer a simple one-decision approach to investing. Indeed, 90% of DC scheme members in the UK make no choice, ending up with a default portfolio.4 Potentially, TDFs address this need well. However, poor plan participation rates, lacklustre involvement in educational sessions and disappointing investment results from higher costs, poor diversification5, and neglect has meant that both plan sponsor and investor experience has often been less than happy.

Conceptually, TDFs are a simple and effective solution for the average investor or DC plan participant. The investor need only know their retirement date, although even this information is not clear in the new economic reality that sees changes to mandatory retirement age as a response to inadequate pensions and challenged social welfare systems in many countries.

That TDFs have varying asset mixes for the same target date from one supplier to another suggests that the goal for these products is not always clear. Not surprisingly, different parties have different objectives.

Objectives of target date funds

Plan participants want adequate and reliable replacement income in retirement. TDF investors are no different, yet this objective is not always explicitly incorporated into TDF investment strategy. Is it sufficient to provide a declining risk level over time? Should the current funding status be considered when determining a target risk level?

In common TDF schemes, the portfolio is rebalanced to progressively more conservative asset mixes ignoring the realized market experience of fund participants. Over-funded plans following a roaring bull market and under-funded plans in the wake of a bear market are treated to identical glide paths. The shortcoming of this deterministic approach has been observed by others.6

Misalignment of interests explains part of the problem. Investment managers want to win mandates. Demonstrating better historical performance than their competition is one way to do this (although everyone knows that past results are no indication of future performance). These higher returns usually come with higher risk over time (usually via higher equity exposure). Plan sponsors fall into the trap of chasing historical returns for DB schemes all the time. However, the passage of time has a real impact on self-directed plans. Individual portfolios lack homogeneity and have rapidly shortening time horizons compared with DB plans that often have younger workers replacing older retirees, thus maintaining a more stable investing horizon.

When the recent bear market materialized, many TDFs found themselves irreparably under water. Static-predetermined glide paths failed to consider actual market experience and changing risk levels. The results have been tragic for many about to retire.

Purpose

We test the hypothesis that dynamic risk glide paths can increase the probability of providing sufficient retirement funds by:

 establishing a return floor;
 directing asset mix shifts driven by progress towards that return floor;
 enhancing lifestyle by systematically growing assets over the return floor;
 using constant volatility rebalancing to maintain consistent portfolio risk.

Method

According to Maslow’s hierarchy of needs7, individuals seek first to satisfy basic needs by addressing physiological and safety requirements. We call this the “safety net”. For simplicity, the safety net is represented by an annuity purchased at age 65 sufficient to cover basic needs (assumption used in these simulations is $20,000 a year). Purchase of an annuity is not being specifically recommended, but is used as a conservative estimate of the required size of retirement savings to achieve this objective.

Once the amount is reached and the “floor” for retirement is secured, the safety net amount is invested in lower risk inflation-linked vehicles. Remaining funds are invested to improve life style in retirement with the peace of mind that basic needs are secured.

There are two key considerations:

 risk allocation is not equivalent to asset allocation. Over time, the risk of asset classes change in a more predictable and manageable manner than returns;

 incorporating the realized experience of the fund in setting asset allocation significantly increases the probability of achieving retirement objectives.

Risk allocation
In our experience, rebalancing to a constant volatility yielded 3%-4% per annum higher returns than rebalancing to a fixed asset mix (using back-tested data over the last ten years ending December 2007). While actual returns may differ, this is a meaningful difference worthy of every investor’s consideration.
Risk changes over time, and so should a portfolio’s asset mix. We are not suggesting chasing performance or timing markets. But adjusting downward the proportion of asset classes that are becoming more volatile, whether in a bull or bear market, can help to preserve capital. Conversely, increasing risk during quiet markets increases opportunities. Simply, time the risk, rather than the return.
This is possible because risk is persistent. If markets were volatile in the previous month, they will likely be volatile in the following month and vice versa. One measure of persistence is autocorrelation. The autocorrelation for monthly volatility of the S&P 500 is around 60%; the autocorrelation for monthly returns is close to 0%. Translation: risk is persistent, return is not. The persistence of volatility is the raison d'être for the whole risk modeling industry, an increasingly important part of professional investment management.
Ideally, investors should employ asset allocation with the help of a regularly updated risk model, putting overall portfolio risk in the context of each individual investor’s risk tolerance. Do-it-yourself investors, without access to a risk model and the expertise necessary to use it, could look to the CBOE Volatility Index [VIX] which measures the implied volatility of S&P 500 index options. The chart below shows the 252 day (one year) rolling average of the annualized standard deviation of the S&P 500 Index. Persistently higher levels for this index suggest rebalancing to a more conservative asset mix. Persistently low levels may suggest that an increase in equity weight is indicated.

Maintaining a consistent level of risk in the portfolio makes more sense than subjecting clients to often wild swings in volatility. 2008 has shown how dramatic volatility can be!

Dynamic risk glide path

In devising a glide path, several observations are made that will be quantified into a few simple and intuitive investment rules.

Assets are moved to a conservative mix once the safety net amount is achieved (or gets close). Gains are locked in and earned capital is preserved. Conversely, if the fund is short of the goal, more risk would be assumed. Hence, the level of risk assumed by the fund is inversely proportionate to the funding status. To test this hypothesis, Monte Carlo simulations are run making some basic assumptions about salary levels and growth rates (U.S. Census Bureau), inflation rate, contribution rates and annuity quotes as a proxy for the security net lump sum (see Appendix). The resulting glide path is dynamic. It depends on plan funding status and realized market experience. Results are compared to prevailing predetermined glide path returns.

Results

A successful design should improve the probability of securing the safety net. Table 1, below, summarizes results of the Monte Carlo simulations. While the static predetermined path gives us a probability of secure retirement that is virtually the same as a flip of a coin (45%), the dynamic risk path results in a comfortable 91% probability. Furthermore, the worst 10th percentile of dynamic risk glide path outcomes is almost twice as good as for the predetermined glide path example.

Fund Value at Retirement (table 1)

Predetermined Glide Path Dynamic Glide Path
Mean $802,159 $961,233
Median $708,821 $968,967
Standard Deviation $405,868 $223,690
Probability of achieving target 45% 91%
10th percentile (low outcomes) $407,196 $781,514

The impact of the adjustable glide path can also be seen in the changed shape of the return distribution. The dynamic distribution is more compact, substituting low probability positive extreme returns for an improved chance of securing the security net.

Observations

Plan participants want adequate and reliable replacement income in retirement. Reliable cash flow after retirement is best afforded by an annuity from a reliable carrier. A balanced self-directed portfolio may provide similar cash flow at lower cost. Nevertheless, there are advantages to targeting a fixed dollar amount at retirement:

a) purchasing an annuity to provide a reliable income stream remains an option;
b) restructuring the portfolio to address post-retirement investment needs is also an option;
c) if projected rates of return are insufficient to provide required replacement income (or risk is too high), plan participants can be better motivated to save more and to start earlier;
d) interest rate changes over the accumulation phase can lead to adjustments to the target goal so that savings and/or risk profile can be modified as required;
e) funding a post-retirement income stream addresses one of the advantages of DB plans.

While the dynamic glide path approach is a form of actively managing the course of the portfolio towards a target destination, it is not active management. By maintaining a consistent level of risk that is appropriate for the investor, the portfolio is simply optimizing the opportunities and avoiding the high volatility that markets present over time. This is a prudent approach that should be considered regardless of the mandate.

Conclusion

The distance between Heathrow and JFK is 5,560 kms with an approximate flying time of 8 hours. Flying for exactly 8 hours and landing or putting down after precisely 5,560 kms without accounting for conditions along the way or where you happened to be en route would be silly. Yet today’s target date funds would have investors sign on for just such a journey.

Self-directed investment schemes dominate the global pension space and target date funds are increasingly popular. Target date funds’ appeal is simplicity. Disinterested plan participants are asked to make important investment decisions about a distant abstract event (retirement) that is low on their list of priorities. Target date funds ask a question that most can answer, “When do I retire?”. The logical appeal of an increasingly conservative set of predetermined asset mixes is not borne out in theory and the practical example of funds maturing within the next several years is equally discouraging.

Suppliers and plan sponsors need to revisit the investment construction process to assure more than just a disciplined asset mix procedure is in place. A dynamic risk glide path is only one way to tailor the plan to the real needs of investors, but making shifts to reflect consistent volatility rather than fixed asset mix is a promising approach. The simple trading rules pursuant to funding status are:

 once the safety net amount is achieved (or gets close), move assets to a conservative mix;
 if the fund falls short of its goal, assume risk inversely proportionate to the funded status.

The diversification possibilities afforded by risk dampening index and exchange traded funds (ETFs) can help fine tune and target risk in these portfolios although the use of futures and proxies for groups of securities may be more applicable to pools.

Establishing a return floor that addresses the investors’ key goal of reliable replacement income is a good way for plan sponsors to engage participants in a discussion of the most powerful retirement options: saving more and starting sooner.

Plan sponsors choosing to remain with the existing crop of target date funds may be well advised to issue flotation devices to participants for those “on time” landings that fall short of their mark.

Ioulia Tretiakova, Director of Quantitative Strategies, PŮR Investing Inc., M.Sc. in Mathematics, University of Toronto, C.F.A, the C.F.A. Institute, Financial Risk Manager (F.R.M.), Global Association of Risk Professionals. Ioulia specializes in portfolio engineering using statistics, econometrics, and behavioural finance.

Mark Yamada, President and Chief Executive Officer, PŮR Investing Inc., B.A., University of Toronto, founder of PŮR Investing Inc. (PŮR), an investment management company providing tailored private-client portfolio solutions for banks, brokerage firms, investment advisors and individuals. PŮR offers web-based mass-customized ETF portfolios on a multi-currency/multilingual ready platform. www.purinvesting.com

Appendix

Assumptions

3.43%, the long term average inflation rate (U.S.) is used for inflation: http://www.inflationdata.com/Inflation/Inflation_Rate/Long_Term_Inflation.asp

Monte Carlo simulations (10,000 iterations):

• The portfolio’s value is simulated for a representative employee starting at age 30 through retirement (age 65) resulting in a 35-year investment period.

• A target safety net amount is estimated using the cost of an annuity as a proxy. The annuity quote is obtained from http://www.immediateannuities.com/information/rates.html for a 65-year-old male and $20,000 annual income amounting to $230,696. The cost of the annuity is then adjusted for inflation of 3.43% over 35 years resulting in a target “safety net” estimate of $751,048.

• Using target levels of risk, expected returns are determined using standard deviation as a departure point assuming a risk-free rate of 4% and a Sharpe ratio of 0.30. For example, for a target risk of 10%, the expected return is 4% + 0.30*10% = 7%. Returns are assumed to be normally distributed.

• Employee income levels and growth rates, are estimated using the U.S. Census Bureau Current Population Survey (CPS) 2007 data. The staring salary value is taken as $30,127, according to the CPS, and the annual growth rate is calculated as the percentage difference in income between age groups linearly interpolated for annual values. This approximates the salary growth rate due to experience. The second component is an inflation adjustment accounted for as the inflation rate (3.43%) added to the growth rate above.

• The plan’s contribution rate is assumed to be 8%.

Footnotes

1 “Funding Woes”, Jennifer Byrd, Pension & Investments, December 2008.
2 Department of Labor Form 5500, Pension Plan Bulletins, 1998-2001.
3 “U.S. Retirement Market, First Quarter 2008”, Investment Company Institute, October 2008, Vol.17, No.3-Q3.
4 “Pensioners at risk in ‘defined contribution’ pensions environment”, David Blake, Cass School of Business; Debbie Harrison, Visiting Fellow, April 2007.
5 “Patience is a Virtue, Asset Allocation Patterns in DB and DC Plans”, Boive and Almeida, Issue Brief July 2008, National Institute on Retirement Security.
6 “Dynamic Lifestyle Strategies for Target Date Retirement Funds”, Anup Basu, Queensland University of Technology, Alistair Byrne, University of Edinburgh, Michael Drew, Griffith University, 2008.
7 “A Theory of Human Motivation”, A.H. Maslow, Psychological Review, 1943.

Tribalism on the Board

2009-04-06T14:00:00.003-04:00

Whether boards of directors are responsible to shareholders or not can be debated. More clear, is director responsibility to the best interests of the corporation. When bad decisions are made, or lead to negative consequences, we all understand that nobody is perfect, but we hold boards to a high standard. This is fair because, in theory, an assemblage of smart people decreases the likelihood of poor choices.

In this spirit, directors of public companies should have their voting records made available to the public or at least to registered shareholders on issues of substance like executive and director compensation, mergers and acquisitions, non-standard accounting practices and anything else that might be considered worthy of shareholder note. Perhaps any item that requires a note to the financial statements could be included. If shareholders are to select board members, we must be given the tools to assess and evaluate directors effectively.

That governance is lacking in boardrooms is obvious. The current financial crisis is a direct result of U.S., UK, and European bank boards who did not understand the most important duty they have; the safeguarding of their corporations. Directors may argue that their voting records should be kept secret either because board solidarity is important (hogwash) or that the CEO may be constrained by such disclosure (also hogwash). As shareholders, we hope that dissent and discussion will keep management's feet to the fire and forge the right balance between short term needs and long term goals. If we don't see evidence of this discussion, how can we properly vote for a slate of directors based only on reputation. Boards continue to rely too much on the old boys network.

Tribalism is no excuse for bad governance.

U.S. Treasury Bailout

2009-03-23T10:24:00.004-04:00

The Treasury's plan to isolate toxic assets appears to be thoughtful. Its strength is the reliance on private sector valuation of assets, the weakness may be having the private sector administer the assets under FDIC guarantee.

The document correctly identifies the lack of liquidity as the colonic blockage of the system and is on the right track in trying to arbitrage or bridge the time needed to find a more realistic balance between information and valuation. Inviting private investors is a good move to assure those with "skin in the game" are valuing these assets and not politicians! Nevertheless, only the details of the contracts will tell if terms sufficient to offset the risks inherent in the worst paper will attract speculators. There is not enough evidence that long term investors would be interested at this time because the banks are most likely to dump the worst quality paper into this program first and retain the better ones.

No bank wants to incur more massive write downs or have write downs already taken to be determined as having been insufficient. Already exhausted stockholders would muster another breathe to whip them anew in the marketplace.

While it will be in the best interest of the new equity owners of these assets to maximize their returns, with the 6 to 1 leverage, this may mean selling quickly or foreclosing rapidly to realize any value above the bid. This may not serve the public policy piece as the Administration may have hoped. Earlier foreclosures are a blessing and a curse. The blessing is the more direct resolution of poor loans, but the curse of exacerbating additional negative public sentiment does little to bolster consumer confidence.

On balance, getting bankers to lend again is an essential first step and providing greater clarity about their real capital levels is important. Nevertheless, it would have been nice to see some extra discipline implemented in the governance of the banks themselves when the opportunity is most ripe. Bank boards have not been held adequately responsible for their role in the financial "train wreck".

Perhaps we can look forward to additional measures in the future if this plan works. If it doesn't, I suppose no rules or discipline will matter very much at all.

AIG Bonus Issue

2009-03-17T18:55:00.002-04:00

It looks bad, smells worse and feels slimy, but AIG executives have been asking for this day since they partied the night away to celebrate the first of many government injections of capital to keep the "too big to fail" organization alive.

What these "bozos" did is no worse than any of the Wall Street investment bankers have done in looking out for themselves first, their families second and their Porsche lease payments third. That the AIG transgressors speak with English accents (it was the London office that masterminded the fiasco) or with Connecticut clipped phrasing is not important. The disconnect from "Main Street" is laughably tragic.

The fact that the Government is least likely to succeed at managing a business of any kind is worrisome. They screwed up the management of the Mustang Ranch outside of Las Vegas when they assumed ownership after a tax issue. If they couldn't make a brothel that served booze make money, we all have to worry if they try to manage anything more complex than a lemonade stand in the desert.

The blame should be kept separate from the solution. The blame is Hank Paulson and the deregulating regulators. Andrew Cuomo as head of HUD under Clinton bears some responsibility also but Donaldson and Cox at an SEC that allowed for the abandonment of common sense need to be fingered for sure.

A solution is to arbitrage time. Taxpayers bridge the bad paper until it is worth something and be sure the bridge loans are properly valued and that the spread on the inevitable public offering that Goldman Sachs underwrites, reflects the fees paid to that organization to keep it alive. In fact the fees that GS makes on government offerings should be gratis even if Paulson coughs up his ill gotten $700 million that he picked up during the last few years at GS.

2009-03-11T15:39:00.002-04:00

I can't take credit for this but it is pretty cute.

The Credit Crunch Explained

Heidi is the proprietor of a bar in Berlin. In order to increase sales, she decides to allow her loyal customers, most of whom are unemployed alcoholics, to drink now
but pay later. She keeps track of the drinks consumed on a ledger (thereby granting
the customers loans).

Word gets around and as a result increasing numbers of unemployed alcoholics
flood into Heidi's bar. Taking advantage of her customers' freedom from immediate payment constraints, Heidi increases her prices for wine and beer, the most popular drinks. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes these
customer debts as valuable future assets and increases Heidi's borrowing limit. He
sees no reason for undue concern since he has the debts of the alcoholics as
collateral.

At the bank's corporate headquarters, expert bankers transform these customer
assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are
then traded on markets worldwide. No one really understands what these
abbreviations mean and how the securities are guaranteed. Nevertheless, as their
prices continuously climb, the securities become top-selling items because (insert
here the name of your financial advisor) recommended them as a good investment.
One day, although the prices are still climbing, a risk manager of the bank,
(subsequently of course fired due to his negativity), decides that the time has come to demand payment of the debts incurred by the drinkers at Heidi's bar. But of course
they cannot pay back the debts.

Heidi cannot fulfill her loan obligations and claims bankruptcy.DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. The suppliers of Heidi's bar, having granted her generous payment due dates, and having invested in the securities, are faced with a new situation.
Her wine supplier claims bankruptcy, her beer supplier is taken over by a
competitor.

The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties. The funds required for this purpose are obtained by a tax levied on the non-drinkers.

NEWS ALERT : AIG

2009-03-02T12:11:00.002-05:00

From the Treasury statement:

Washington, DC – The U.S. Treasury Department and the Federal Reserve Board today announced a restructuring of the government's assistance to AIG in order to stabilize this systemically important company in a manner that best protects the US taxpayer. Specifically, the government's restructuring is designed to enhance the company's capital and liquidity in order to facilitate the orderly completion of the company's global divestiture program.

The company continues to face significant challenges, driven by the rapid deterioration in certain financial markets in the last two months of the year and continued turbulence in the markets generally. The additional resources will help stabilize the company, and in doing so help to stabilize the financial system.

As significantly, the restructuring components of the government's assistance begin to separate the major non-core businesses of AIG, as well as strengthen the company's finances. The long-term solution for the company, its customers, the U.S. taxpayer, and the financial system is the orderly restructuring and refocusing of the firm. This will take time and possibly further government support, if markets do not stabilize and improve.

Given the systemic risk AIG continues to pose and the fragility of markets today, the potential cost to the economy and the taxpayer of government inaction would be extremely high. AIG provides insurance protection to more than 100,000 entities, including small businesses, municipalities, 401(k) plans, and Fortune 500 companies who together employ over 100 million Americans. AIG has over 30 million policyholders in the U.S. and is a major source of retirement insurance for, among others, teachers and non-profit organizations. The company also is a significant counterparty to a number of major financial institutions.

AIG operates in over 130 countries with over 400 regulators and the company and its regulated and unregulated subsidiaries are subject to very different resolution frameworks across their broad and diverse operations without an overarching resolution mechanism. Within the options available, the restructuring plan offers a multi-part approach which brings forward the ultimate resolution of the company, has received support from key stakeholders and the rating agencies, and provides the best possible protection for taxpayers in connection with this commitment of resources.

The steps announced today provide tangible evidence of the U.S. government's commitment to the orderly restructuring of AIG over time in the face of continuing market dislocations and economic deterioration. Orderly restructuring is essential to AIG's repayment of the support it has received from U.S. taxpayers and to preserving financial stability. The U.S. government is committed to continuing to work with AIG to maintain its a bility to meet its obligations as they come due.

Treasury has stated that public ownership of financial institutions is not a policy goal and, to the extent public ownership is an outcome of Treasury actions, as it has been with AIG, it will work to replace government resources with those from the private sector to create a more focused, restructured and viable economic entity as rapidly as possible. This restructuring is aimed at accelerating this process. Key steps of the restructuring plan include:

Preferred Equity : The U.S. Treasury will exchange its existing $40 billion cumulative perpetual preferred shares for new preferred shares with revised terms that more closely resemble common equity and thus improve the quality of AIG's equity and its financial leverage. The new terms will provide for non-cumulative dividends and limit AIG's ability to redeem the preferred stock except with the proceeds from the issuance of equity capital.

Equity Capital Commitment : The Treasury Department will create a new equity capital facility, which allows AIG to draw down up to $30 billion as needed over time in exchange for non-cumulative preferred stock to the U.S. Treasury. This facility will further strengthen AIG's capital levels and improve its leverage.

Federal Reserve Revolving Credit Facility : The Federal Reserve will take several actions relating to the $60 billion Revolving Credit Facility for AIG established by the Federal Reserve Bank of New York (New York Fed) in September, 2008, to further the goals described above.

WITH THANKS, AND FOR MORE : http://markowskiglobal.com/

Last bid in size: Anatomy of market meltdowns

2009-02-26T16:57:00.007-05:00

Major market meltdowns share one critical factor: a liquidity vacuum. Liquidity vacuums occur when information is not available or is not trusted. Confidence deteriorates and markets go “no bid”. “No bid” means there is no participant willing to pay any price at that moment for any amount of a particular asset.
As investment professionals, these are surreal moments because we have come to believe in the market as the clearing house for all information, both good and bad. If a company disappoints, expectations adjust to a lower reality by reducing its quoted price. Participants rely on the market to reflect the discounted present value of “reality” and reality is the “last bid in size”. But when the market for an asset goes “no bid” as is the case for so-called toxic assets underpinned by sub-prime mortgages of unknown or questionable origin and solvency, it is theoretically saying that the asset is “worth” nothing.Even in the case of catastrophic events, there is usually some market participant willing to pay a deep discount, during an information black hole, to arbitrage the time between not knowing or trusting the facts and some future point when reality reconstitutes a value.
The current financial crisis is simply more complex than previous crises and it is so because the terms of arbitrage have been disrupted. Let’s start with an example.
If you list your house for sale and receive no offers for several months is it worth zero? Does it mean that the value of your property is zero until it was sold? The issue for some assets that are not liquid is that time is required before a market value can be established. If you bought another house before selling this one, there may be a cost to carrying or arbitraging the time until it can be sold. The same principle holds for most banks today. They must find a way to arbitrage their toxic assets to shore up their capital in the short run until the problem assets can be worked out or finally written off.
When Bear Stearns was forced to mark down the value of their mortgage portfolios to “market” was the “market” value realistic? Most market participants would say yes, because if nobody was willing to buy it at any higher price, that “marked down” price was its real “value”.If some mechanism existed to allow Bear to arbitrage the time until a work out were established, they would not be the historical footnote that they are today.
Today, bank and government officials from U.S. Treasury and the Federal Reserve Board are struggling to restore interbank confidence in the value of assets in a critical attempt to unblock the constipation in the banking system over unknown capital adequacy issues.
If banks take an immediate write down and amortize the notional loss over a reasonable period of time (say five years), there should be adequate time to restructure and/or establish better valuations in the absence of a liquidity freeze. They need a reliable mechanism to arbitrage time.Homeowners who have been caught in the crossfire of declining housing values may also need a mechanism to arbitrage time. This may be a reduction in monthly payments in exchange for longer amortization periods. It is difficult to have any sympathy for consumers who have "maxed out" their credit cards who will be seeking relief sometime later this year and perhaps only empathy for the sub-prime borrowers who were partly duped by unscrupulous mortgage originators particularly in the case of falsified mortgage applications. Nevertheless an arbitrage can be structured that creates realistic choices for those folks who feel they are "in over their heads". Losing a house is disruptive and disheartening but if the choices are food, clothing, shelter and education for the kids, vs. a 100 year mortgage (a la Japan pre-bust), perhaps more rational choices can be made.

The idea of closing ones eyes to the problems and hoping that they vanish when one awakes is obviously unsatisfactory. But in this case, arbitraging time while addressing systemic problems can buy valuable time for the banking and credit markets to do what needs to be done. What those things may be will be in a future post.