Don't pick your nose with a power drill

Derivatives offer useful and cost-effective ways for investors to manage risks. In the ETF world, derivatives have democratized investor access to asset classes like commodities and currencies, and to strategies like covered-call writing, use of leverage and short selling. Previously the sole domain of professional and sophisticated investors, this freedom has come with the expected consequences of misuse and plain ignorant use of some or all of these products.

Three questions arise from the increasing use of synthetic structures in retail products.

1. Are the benefits and costs associated with these products adequately understood by users?
2. Are there potential systemic risks arising from the growing popularity of these instruments?
3. 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 the job

Having a plan is as basic to portfolio construction as it is in the workshop. What will the portfolio have to do? What characteristics must it have? Selecting the appropriate tools and materials and understanding the capabilities and inherent risks with each is simply common sense. While possible to drive a nail with a screwdriver, it isn’t always as effective as using a hammer. Selecting ETFs is no different.

Returns are difficult to predict, but costs are different. The ETF Screener on the TMX Money website offers two basic ETF classifications: those using passive strategies and those using embedded strategies and costs are behind each.

Passive

These are straightforward ETFs that replicate an index and hold the actual components or 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

All other ETFs fall into this category, suggesting additional analysis may be required. We have broken these into three subsets with additional costs associated with each.

Strategic: Holding equal dollar amounts of index components is one example. Proponents claim reduced large capitalization company bias in an index allows smaller faster-growing companies to contribute equally. Whether or not you believe this (there is research supporting both sides), more frequent rebalancing incurs more trading costs. This holds true for so-called fundamentally weighted indexes and active ETFs. Investors must decide 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 options and futures and introduce time as a more critical investment factor. Covered-call ETFs, for example, alter risk over time; modestly for ETFs overwriting a small portion of underlying holdings (i.e. FXF) to those that overwrite all of the holdings (i.e. ZWB). Commodity ETFs can hold the underlying commodity, but many use futures. This subjects these ETFs to liquidity, basis, contango and backwardation risk. ETFs using exchange-traded derivatives introduce some elements of additional cost from liquidity, basis, timing (backwardation/contango) in addition to possibly higher management costs. 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 upon total return swaps. A dealer commits to pay the return of an index over a particular time period in exchange for collateral. This introduces a potential cost as credit risk because the dealer or counterparty is promising to pay. It also 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%

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

Pension Breakthrough for the Rest of Us

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

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

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?

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.