SL-Advisors http://www.sl-advisors.com Investment Strategies for a Low low Interest World Mon, 28 Jul 2014 11:00:00 +0000 en-US hourly 1 http://wordpress.org/?v=3.9.1 IBM, The Stock That Gets No Respect http://www.sl-advisors.com/ibm-stock-gets-respect/ http://www.sl-advisors.com/ibm-stock-gets-respect/#comments Mon, 28 Jul 2014 11:00:00 +0000 http://www.sl-advisors.com/?p=3553 IBM must be one of the least liked large cap stocks around. The criticisms are easy and familiar: they haven’t grown revenues in years, they are involved in financial engineering to prop up earnings, they are taking on lots of debt to support cashflows. Recently, Barron’s Roundtable noted that Fred Hickey had IBM as a […]

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IBM must be one of the least liked large cap stocks around. The criticisms are easy and familiar: they haven’t grown revenues in years, they are involved in financial engineering to prop up earnings, they are taking on lots of debt to support cashflows. Recently, Barron’s Roundtable noted that Fred Hickey had IBM as a short recommendation.

It’s true IBM has been a poor performer against the S&P500 over the past year. However, it has less volatility than the market with a trailing Beta of 0.66 so all other things being equal you would expect it to lag somewhat when prices are rising. And it’s true that revenue growth for years has been non-existent, hovering frustratingly around the $100BN annual level. However, earnings have grown nicely over the past ten years aided by improving margins and a reduced share count. So although revenues are flat since 2004, over that time EPS has more than tripled from $4.93 to an estimated $17.90 consensus forecast. The sharecount has dropped from 1.7 billion to around 1 billion as they relentlessly return cash to shareholders through buybacks.

As for debt, it’s true that it’s risen although IBM is hardly a leveraged company. They’re expected to finish the year with $48BN of long term obligations less Cash of $17BN for $31 BN of net debt, supporting pre-tax operating income of $21BN. This hardly seems like reckless leverage. Meanwhile, they still look to be on track to hit their target of $20 in operating EPS next year. At $194 a share it just doesn’t seem ridiculously expensive.

As for innovation, in 2013 IBM inventors received 6,809 patents, the 21st consecutive year of being the most prolific recipient of such awards.

So IBM isn’t that exciting on a daily basis, but it does look like a fairly compelling place to invest some of your money if you’re not one of those people who requires daily gratification on your stock picks. Fred Hickey’s price objective on his short IBM was $150 in the abovementioned article. At the time of his interview it was trading at $182 but has since risen $12, over a third of Hickey’s sought after gain. Shorting isn’t easy, and don’t imagine we’re claiming victory because we still own IBM and anything can happen. But there must be better ways to make money than trying to short IBM. They just keep generating cash, $18.1 BN in Cash from Operations (less change in Financing receivables) over the past 12 months, or about $18 per share.

For excitement, watch Amazon (AMZN) as they continue to break records for the most inefficient converter of revenues into profits. In ten years sales have increased sevenfold while EPS has halved. In their most recent quarter over $19BN in revenues, up 23% year on year, generated a small operating loss. The best investment you can make in Amazon is to sign up for Amazon Prime. Being a customer is far more likely to be satisfying than being an owner.

 

 

 

 

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Why Are Investors Mistrustful? http://www.sl-advisors.com/investors-mistrustful/ http://www.sl-advisors.com/investors-mistrustful/#comments Tue, 22 Jul 2014 11:15:57 +0000 http://www.sl-advisors.com/?p=3550 In reading the July/August edition of the CFA Institute’s magazine, an article called “Fragile Trust” by Susan Trammell caught my attention. There’s no doubt that popular confidence in financial services firms was sorely shaken by the 2008 crisis. But it’s still sobering to consider the results of a 2013 survey by Edelman Trust  showing that […]

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In reading the July/August edition of the CFA Institute’s magazine, an article called “Fragile Trust” by Susan Trammell caught my attention. There’s no doubt that popular confidence in financial services firms was sorely shaken by the 2008 crisis. But it’s still sobering to consider the results of a 2013 survey by Edelman Trust  showing that only 46% of respondents expect financial services firms to do the right thing, dead last out of 18 industries considered.

A survey by the Economist Intelligence Unit last year asked financial services executives about the benefits of improving ethical conduct at their firms, and the most popular choice was that it would improve their ability to “withstand unexpected and dramatic risks”. People who work in Finance recognize the value of high ethical standards, and yet the public doesn’t perceive that the industry operates in this way.

Part of it relates to confusion or simply misunderstanding of the difference between brokers-dealers versus investment advisors, or “sell-side” versus “buy-side” in Wall Street parlance. And indeed, why should non-institutional investors even need to know the difference? The structure of  U.S. financial regulatory oversight need not be a concern of those outside it. Most investors simply want to invest their money through people whom they can trust. And while that does qualify a pretty healthy majority of finance professionals, the lower standard applied to broker-dealers (sell-side firms) versus investment advisors (buy-side) can expose unwitting investors to abuse.

Broker-dealers don’t have a fiduciary obligation to their clients, simply a requirement to meet a lower standard of suitability and disclosure. Their clients are regarded as being responsible for their own decisions, so while a broker can offer advice (“I think this is a good investment”) he’s not under the fiduciary obligation of an advisor to put the client’s interests before his own.

Many investors find this subtle distinction meaningless or are unaware of it. But it’s what enables, for example, unlisted registered REITs (Real Estate Investment Trusts) to be sold to clients in spite of underwriting fees that can reach 15% of the invested amount. I wrote about just such an example, of Inland American Realty and its underwriter Ameriprise, last year. The fees were in the prospectus so deemed to be disclosed, although it’s expecting a lot to think people will wade through 100+ pages of a legal document. And the regulators were not totally absent as subsequently Massachusetts settled civil claims with Ameriprise on just this security, complaining of high fees and conflicts of interest. The conflict of course comes from the fact that the broker recommending (i.e. selling) the security to their client is receiving the egregious underwriting fees. A fiduciary standard would disallow such a transaction. Such applies to investment advisors but not to broker-dealers.

It seems to me that for the financial services industry to raise itself from being 18th out of 18 industries in surveys of public trust, more and more individuals will need to willingly behave as if the fiduciary standard applies to them even if it does not. Every profession needs to retain the trust of its clients, and Finance needs to as much as any other. The CFA Institute’s Future of Finance Initiative is a good place to start, and professionals on both the sell-side as well as the buy-side can choose to conform to its principles voluntarily. Many already do – the rest ought to.

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How Fund Managers Who Invest Elsewhere Exploit Their Clients http://www.sl-advisors.com/fund-managers-invest-elsewhere-exploit-clients/ http://www.sl-advisors.com/fund-managers-invest-elsewhere-exploit-clients/#comments Tue, 15 Jul 2014 11:15:16 +0000 http://www.sl-advisors.com/?p=3546 If you didn’t have the data, you might reasonably assume that any fund manager worth his salt was heavily invested in his own fund. This ought to apply to an overwhelming percentage of all the actively managed funds out there. In fact, as a recent article in Barron’s points out, it’s the exception rather than […]

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If you didn’t have the data, you might reasonably assume that any fund manager worth his salt was heavily invested in his own fund. This ought to apply to an overwhelming percentage of all the actively managed funds out there. In fact, as a recent article in Barron’s points out, it’s the exception rather than the rule. Using data from Morningstar, they find that almost half the funds tracked were led by a manager with no money invested at all. This sorry bunch may think they’re good, and their marketing materials presumably make the case, but by investing their own money elsewhere they tell you what they really think.

And of the 7,700 funds tracked by Morningstar, only 910 had a personal investment by the manager of at least $1 million. This isn’t a high hurdle; less than this threshold either means the manager doesn’t have $1 million to invest, a paucity of personal resources that should give any potential client pause, or chooses not to.

It’s not just that it feels right to know your manager is invested alongside you. For the client, this is the only way to ensure alignment of interests and protect themselves from the principal-agent problem so prevalent in finance. If you’re a fund manager only managing OPM (Other People’s Money), your compensation is fully linked to the size of the fund you manage. The most reliable way to grow your fund is to outperform your competition. A seductively simple way to outperform is to take more risk than the others. Because if you take more risk in a rising market, you will assuredly do better than most and money, which chases performance, will follow. If the market goes down and you underperform, you haven’t lost much because it’s only your clients that suffer the returns. And if performance is really bad, you can always start a different fund.

The money manager who’s invested elsewhere has a free option at the expense of his clients. He has far more to gain from outperforming than he has to lose from underperforming. For the investors, their risk is linear. Bad returns hurt, and good returns help.

The analysis of the Morningstar data supports other research which shows that active managers in aggregate take more risk than the overall market. They are biased towards stocks with more volatility than average, and as a consequence their actions underpin the Low Beta Anomaly, the tendency of low volatility stocks to outperform over the long run. This is because high volatility stocks draw more demand from active managers which raises their prices, thereby depressing future returns. An active manager owning low volatility stocks is failing to exploit the optionality that his role as agent provides at the expense of the principal (i.e. client). It’s one of the reasons we like low volatility stocks – because although they’re widely owned, they’re not widely owned by active managers. And we think that active managers under-invested in their own funds are likely to continue exploiting their advantage which will cause the low volatility bias to persist.

For the investor, it’s not a bad rule to simply eliminate from consideration any investment manager not personally and significantly invested in his own strategy. It makes intuitive sense but it also provides for an alignment of interests. Don’t let the uninvested take advantage of you.

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Why Dividend Payers Aren’t Boring http://www.sl-advisors.com/dividend-payers-arent-boring/ http://www.sl-advisors.com/dividend-payers-arent-boring/#comments Tue, 08 Jul 2014 13:00:04 +0000 http://www.sl-advisors.com/?p=3541 Recently the Financial Times (FT) noted that the number of U.S. companies raising their dividends had hit the highest level since 1979. Much research has been done on the merits of companies that pay out a large percentage of their profits in dividends (high payout ratio) and those that retain most of their earnings so as […]

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Recently the Financial Times (FT) noted that the number of U.S. companies raising their dividends had hit the highest level since 1979. Much research has been done on the merits of companies that pay out a large percentage of their profits in dividends (high payout ratio) and those that retain most of their earnings so as to reinvest in their business. Payout ratios have been falling steadily for decades and currently the FT notes that S&P500 companies pay out only 36% of their profits. However, share buybacks have increased over that period so one can’t conclude that the total cash returned to shareholders as a percentage of profits has fallen.

Buybacks are a more efficient way of returning cash because they create a return (through a reduced share count and therefore a higher stock price) without forcing each investor to pay tax on the cash distributed (as is the case with a dividend). Theoretically, publicly listed companies need never issue dividends since any shareholder desiring, say, a 2.5% dividend can always sell 2.5% of his holdings.

One might think that companies with low payout ratios are retaining more of their earnings so as to invest in the high return opportunities they see in their business. This ought to lead to faster dividend growth in the future as the projects provide their payoff. I’m currently reading Successful Investing is a Process by Jacques Lussier, PhD, CFA. The author kindly sent me a copy as I’ll be speaking at a CFA event in Montreal he’s organizing later this year. Mr. Lussier notes some interesting research by Arnott and Asness in 2003 that sought to compare low dividend payout ratios with faster subsequent growth.

In fact, they found just the opposite, that low dividends don’t lead to higher dividends later on. In too many cases it seems that managements are overly optimistic about the opportunities to deploy capital either internally or on acquisitions. And in fact this is the real power of stable dividends with a high payout ratio. Rather than suggesting the company has few interesting projects and therefore nothing better to do than return capital to owners, it imposes a level of capital discipline on management that ultimately leads to higher returns. Companies that return more cash to shareholders have less to squander on ill-judged investments, and the shareholders ultimately benefit.

Incidentally, Master Limited Partnerships (MLPs) represent an extreme case of this. Since they routinely distribute around 90% of eligible cashflows they have very little retained earnings and therefore have to raise new debt and equity capital for any project. This imposes a wonderful discipline on MLP managements in that they’re always having to explain to underwriters and investors what exactly they’re planning to do with the proceeds of a debt or equity offering. It’s one of the reasons MLPs have had such consistently strong performance; so many of their management really focus on return on capital.

It’s all part of the Low Beta Anomaly, the concept that low volatility (or low Beta) stocks outperform on a risk-adjusted basis and even on a nominal basis. So far this year the returns to low volatility investing have been good (for example, the S&P500 Low Volatility ETF, SPLV, is +8.6% through June) as many of the high-flying momentum names crashed during the first quarter. Slow and steady dividends with growth may not appear that exciting, but boring is often better where you’re money’s concerned.

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How Central Banks are Ruining the Insurance Business http://www.sl-advisors.com/central-banks-ruining-insurance-business/ http://www.sl-advisors.com/central-banks-ruining-insurance-business/#comments Mon, 30 Jun 2014 20:36:41 +0000 http://www.sl-advisors.com/?p=3523 Denis Kessler, CEO of Scor, a large reinsurer, is the most recent critic of today’s low interest rate environment. It’s not only the stereotypical retiree clipping bond coupons that is suffering from current interest rate policy. Insurance companies typically hold substantial amounts of their investment portfolios in bonds, both because of regulatory requirements as well […]

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Denis Kessler, CEO of Scor, a large reinsurer, is the most recent critic of today’s low interest rate environment. It’s not only the stereotypical retiree clipping bond coupons that is suffering from current interest rate policy. Insurance companies typically hold substantial amounts of their investment portfolios in bonds, both because of regulatory requirements as well as the need to respond to claims whose timing is often unpredictable. Kessler claimed that central banks were “ruining” the insurance industry, and claimed that insurers were the unwitting victims of the aftermath of the financial crisis even though they didn’t create it (AIG and its credit derivatives portfolio presumably notwithstanding).

Warren Buffett has described an insurance company’s “float”, that is, the premiums they receive in return for making payments in the future, as akin to being paid to borrow money. This is true to the extent that insurance companies can operate with a Combined Ratio below 100% (that is, the sum of underwriting losses plus operating expense as a % of net earned premiums). If they spend more than their premiums then of course the float costs money and the difference needs to be made up on the investment side.

Most insurance companies either through poor underwriting or competitive pressure slipped into just this model, whereby positive investment results were needed to cover a Combined Ratio above 100%. One of the capital disciplines practiced by Warren Buffett’s Berkshire Hathaway (BRK) in its insurance business is to separate out the management of the float from the underwriting, so as to prevent success at the former from compensating for poor execution of the latter. BRK’s insurance businesses have generated a net underwriting profit for eleven straight years. One clear benefit of separating underwriting from investing is that the insurance executives at BRK have  little incentive to grow via unprofitable business expecting to rely on strong investment results as support.

However, for many insurers persistently low interest rates have heaped pressure on one side of this equation. One might have expected the market to adapt, through a “hardening” market (insurance-speak for rising premiums) given lower investment returns, and while this has happened to a degree pricing hasn’t adjusted as much as needed. This is why so many insurance companies trade at a discount top book value – because while profitable, they’re not yet earning an appropriate return on equity.

Aspen Insurance (AHL) is one that we have liked in the past because of their well regarded management but it still trades at only 87% of book value (we don’t currently own AHL). Another name we have owned in the past but don’t at present is CNA also at 87% of book value. We continue to own AIG which is valued at 83% of book value excluding unrealized investment gains (or only 76% of book value if you include such mark-to-market gains, which isn’t an unreasonable approach). And we also own BRK, which trades at around 140% of book value but is of course a diverse conglomerate with  large operating businesses and a substantial investment portfolio. You don’t often hear them complaining about low interest rates, either.

Our Hedged Dividend Capture Strategy is designed to extract dividend income from equities while mitigating equity market risk through hedging. It’s designed for investors used to better returns from high grade bonds.

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How to Short A Stock and Get Others to Join You http://www.sl-advisors.com/short-stock-get-others-join/ http://www.sl-advisors.com/short-stock-get-others-join/#comments Mon, 23 Jun 2014 18:31:57 +0000 http://www.sl-advisors.com/?p=3513 Although the equity research business is dominated by large, sell-side firms hoping to generate trading commissions from their (usually bullish) recommendations, there are alternate business models out there. Prescience Point is a hitherto unheard of research firm with no known location (so presumably outside the U.S. since they’re not registered) and no publicly disclosed employees. […]

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Although the equity research business is dominated by large, sell-side firms hoping to generate trading commissions from their (usually bullish) recommendations, there are alternate business models out there. Prescience Point is a hitherto unheard of research firm with no known location (so presumably outside the U.S. since they’re not registered) and no publicly disclosed employees. They focus on research uncovering companies’ fraudulent activities. Although they write about what they find, so as to (presumably) sell their research to subscribers, they also short the stocks they cover.

Short sellers are a fascinating bunch. The odds are stacked against them. Company managements and sell side research (both of which are generally bullish) are in the opposite corner from them. In addition, short positions have almost unlimited potential loss with gains limited by the proceeds received for the sale of the stock. Markets generally rise over time, so these headwinds to success mean that short sellers need to carry out pretty detailed work, and they need to be right.

What Prescience can do (based on their website) is:

(1) Produce a bearish report

(2) Share it privately with paying subscribers

(3) Short the stock themselves prior to its public release

(4) Buy back the shorted stock when the report is out

Chicago Bridge and Iron (CBI) is a $7.5 billion market cap company that builds energy infrastructure. Nuclear plants, oil pipelines, LNG plants (for transporting liquid natural gas) and other related projects. Their contracts are lumpy since completion can take many years. They recently acquired a competitor, Shaw Group, almost doubling their revenues.

CBI’s stock recently behaved as if Prescience had imposed its business model described above on it. When CBI began to weaken in early June on no apparent news, we assumed perhaps investors were becoming more wary of their backlog of infrastructure orders given the developing tumult in the Middle East. The stock weakened further (as shown in the chart below) until Prescience released their report. At this point reasons for the earlier weakness became clear, and additional sellers unwilling to subscribe but now finally aware of the report’s insight, were convinced to sell.

There doesn’t seem to be anything illegal with this. In any event, Prescience appears to be outside the U.S. and their website is pretty clear in warning that they trade both before and after releasing their reports. And it’s not obvious that there’s even anything wrong with what they’re doing. They have a point of view; they share it with clients; they act on it; they publicize their view. And they tell you this is what they’re doing.

In fact, their research doesn’t even need to be right. To be valuable, all that’s required is for the stock price to drop after Prescience and its clients have sold. What’s needed is a group of sellers who will sell after the report is public, for it’s this last drop that creates the profit opportunity. As long as there are enough uninformed sellers willing to sell the stock on the public release of the report so that the earlier, informed sellers can cover their positions, the business model will work. This presumably limits the number of subscribers because too many of them might cause the stock to rally on the report’s publication as they overwhelmed the fewer sellers involved. It’s quite an interesting business model; not quite God’s Work, as Goldman’s CEO Lloyd Blankfein so regrettably once described what his company does, but it’s a living of sorts I guess.

We’ve held a small long position in CBI for some time. We were puzzled by the early June sell off, but when the report was published on June 17th,the reason for the stock’s weakness became clear. Warren Buffett has famously said that in a poker game, if you don’t know who the patsy is, you’re the patsy. June 17th was a day during which we guess that patsies were unusually active in CBI. We just don’t know if the patsies were the sellers (late to the party, having missed the opportunity to sell at higher prices during the prior few days) or the buyers (willfully ignoring the now public  short thesis offered by Prescience).

For our part, we didn’t find much compelling in their report and so bought more CBI on June 17th. We just don’t know yet if we’re the patsies or not.

CBI Chart June 2014

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Why the Fed Likes Bonds a Little More http://www.sl-advisors.com/fed-likes-bonds-little/ http://www.sl-advisors.com/fed-likes-bonds-little/#comments Thu, 19 Jun 2014 18:06:52 +0000 http://www.sl-advisors.com/?p=3509   The chart above doesn’t look like much, but it represents a snapshot of the thinking of the Federal Open Market Committee (FOMC) on interest rates. Their communication has come a long way since the days of cigar-chomping Paul Volcker in the 1970s, when they went out of their way to disguise their intentions. Alan […]

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FOMC YE FF June 18 2014

 

The chart above doesn’t look like much, but it represents a snapshot of the thinking of the Federal Open Market Committee (FOMC) on interest rates. Their communication has come a long way since the days of cigar-chomping Paul Volcker in the 1970s, when they went out of their way to disguise their intentions. Alan Greenspan inherited this culture and while in his early years he clearly relished confounding Senators with his unintelligible responses during Congressional testimony, over time he initiated a move towards greater transparency around the Fed’s decision making process and objectives. Ben Bernanke continued this and no doubt the trend will be maintained under Janet Yellen.

On the chart above (reproduced from the Fed’s website), each dot represents the view of a single FOMC member on the year-end level for short term interest rates (specifically, the Fed Funds rate). There are 16 voting members and each provides a forecast for the end of this year, 2015, 2016 and the long term. I’ve been watching these releases for nearly three years because over time they provide a fascinating picture of their evolving interest rate views.

The first three annual forecasts (2014-2016) can almost be used to construct a yield curve. Indeed, interest rate futures contracts are now often described as priced above or below the Fed’s forecast. Of course, their rate forecast can be wrong, just as the economic forecasts on which it’s based can be. Circumstances change, and there’s nothing intended to be inflexible about these figures. But it does allow us to see more clearly whether economic events alter their view. For example, U.S. GDP growth in the first quarter was quite weak at -1.5%, due largely to the harsh winter those of us in the north east endured. However, the FOMC has a reasonably positive view of growth for the remainder of the year (2.1%-2.3% for all of 2014 which implies around 3.4% on average for the remaining three quarters). As a result, they very modestly tweaked their rate forecasts higher over 2015-2016 (by about 0.07%-0.10%).

More significantly in my view, their long run forecast of interest rates fell from 4.0% to 3.75%. This is the equilibrium rate at which they think rates should settle assuming they had no bias to run monetary policy with either an accomodative bias (as it is now) or a restrictive one. 3.75% is neutral. It takes account of their long run estimate of inflation and of GDP growth.

Back in early 2012, their median long run forecast for rates was 4% and they raised it to 4.25%. They brought it back down to 4% last Summer and then 3.75% yesterday. If their forecast is right (and their forecasts are more important than anybody else’s) it means the fair value yield for, say, a ten year treasury security is a little lower. An investor now ought to be willing to hold it at a somewhat lower yield than before since in theory a ten year bond represents roughly the average short term yield over that period of time.

Steve Liesman from CNBC picked up on this and asked Janet Yellen in her press conference yesterday what was behind this shift. She noted that the composition of the FOMC had changed since the last forecast in March which might make the comparison less meaningful (two voting members were replaced according to a rotating schedule). But she conceded that it also probably reflected a more modest view of long term GDP potential in the U.S. economy.

For investors, it confirms what we’ve long felt, which is that interest rates are likely to stay relatively low for a long time. The Fed’s not about to make bonds more attractive by pushing rates sharply higher, so they will remain a fairly unattractive investment choice. And while you can’t infer too much about equities from the Fed’s interest rate view, it still seems likely that stocks will provide superior long term returns compared with bonds over the medium term.

 

 

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Are Leveraged ETFs a Legitimate Investment? http://www.sl-advisors.com/leveraged-etfs-legitimate-investment/ http://www.sl-advisors.com/leveraged-etfs-legitimate-investment/#comments Thu, 12 Jun 2014 18:04:40 +0000 http://www.sl-advisors.com/?p=3499 Recently Larry Fink who runs Blackrock waded into the debate over leveraged ETFs at a Deutsche Bank investment conference. Fink was highly critical of such products, which he said had the potential to “blow up” the industry one day. The other side of the debate includes Direxion, a provider of leveraged ETFs (Blackrock has none). […]

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Recently Larry Fink who runs Blackrock waded into the debate over leveraged ETFs at a Deutsche Bank investment conference. Fink was highly critical of such products, which he said had the potential to “blow up” the industry one day. The other side of the debate includes Direxion, a provider of leveraged ETFs (Blackrock has none).

There’s probably little disagreement about how they actually work. Take the Direxion Daily S&P500 Bear 3X Shares (SPXS) for example. $1 invested gives you three times the inverse exposure to daily swings in the equity market. So if stocks are -0.25%, you should be up a little less than 0.75% (there are fees, after all). The leverage can sound attractive, but comes with an insidious long term result. Because the ETF targets constant leverage of 3X, it is always having to rebalance. And this rebalancing is always in the direction of the market’s most recent move; if the equity markets falls (causing the ETF to rise in value) its leverage will drop below the target of 3X. At day’s end it will need to increase its short equity position by selling stocks (or index futures) at lower prices. Conversely, if the market rises causing the ETF to lose money it will become over leveraged and will need to reduce its short position by buying stocks, just after they’ve gone up.

The perhaps surprising result of this is that given enough time and enough up and down moves, the value of the ETF will inexorably trend towards 0. There are certain special cases in which this may be delayed or (theoretically anyway) not happen, such as an underlying market that moves steadily in one direction with no fluctuations (i.e. the rebalancing causes less harm), but in the real world such things don’t exist. And it can lose money over time even if the underlying equity market moves as the holder expected (i.e. falls) because of the rebalancing. It is, curiously, an investment product that will cost you money with greater certainty the longer you hold it.

This is fully understood by the providers and Direxion’s prospectus (for those who read such things) provides ample warning that this is a short term, “tactical” fund. Although they do use the word “investment” as it relates to “daily investment returns”, they don’t describe it as an investment product.

So why do such things exist? The answer, of course, is that investors are consenting adults and if full disclosure is given then who’s to say that an “investor” (since real investors couldn’t possibly use these) shouldn’t be allowed to buy one? In aggregate, the holders of inverse ETFs will lose money with virtual certainty, but of course they won’t all lose money. In this regard, they are very much like blackjack or sports betting. A minority of users with skill (or luck) can profit but we all know that the casino always wins. But at least visitors to the blackjack table or the track presumably don’t for one minute confuse what they are doing with investing. Do inverse ETFs users possess the same sense of reality?

Such products no doubt sell themselves, such is the interest in short term market direction and tools with which to bet on it. In fact, one would hope that being sold by themselves is the only way they are ever used. For while Direxion and other such providers can point to the ample disclosures in their documents which almost (but not quite) advise you to not use them at all, what of the brokers or advisers who recommend them to their clients?

It’s hard to fathom why anyone would recommend that a client risk money in something that really is structured like a gambling bet. And in fact the Investment News article referenced above notes that many brokerage firms place strict limits on sales of leveraged ETFs. For those that still recommend their clients use them, one must presume that their business and demand for commissions need only satisfy the minimal standards of (1) is it legal, and (2) did the client agree.

The CFA Institute’s Future of Finance initiative which, among other things seeks a finance industry that puts investors first, clearly has plenty of opportunity.

 

 

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The Alpha Rich List Got 15% of Everything http://www.sl-advisors.com/alpha-rich-list-got-15-everything/ http://www.sl-advisors.com/alpha-rich-list-got-15-everything/#comments Thu, 22 May 2014 16:23:35 +0000 http://www.sl-advisors.com/?p=3479 There’s been plenty of press coverage of the Top 25 hedge fund earners recently, of David Tepper’s $3.5 billion haul and so on. But it’s probably even more striking to estimate what portion of total hedge fund returns these guys took home. It goes like this: Last year the industry began with $1.8 trillion in […]

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There’s been plenty of press coverage of the Top 25 hedge fund earners recently, of David Tepper’s $3.5 billion haul and so on. But it’s probably even more striking to estimate what portion of total hedge fund returns these guys took home. It goes like this:

Last year the industry began with $1.8 trillion in AUM and finished with $2 trillion (BarclayHedge), so that’s $1.9 trillion in average assets under management (AUM) for the year; the 5.5% net return to investors (HFRX) was worth $103 billion. The Alpha 25 made their money both from fees and their own investments in their funds. Let’s make the generous and simplifying assumption that average hedge fund fees are 2% with no incentive fee. Fees were therefore $38 billion. So gross hedge fund investment profits (i.e. before fees) were $141 billion.

The Top 25 retained about 15% of the entire industry’s gross profits. What a fantastic haul! That leaves the other 85% for the investors who provided most of the capital, not including of course the cut for the rest of the hedge fund industry that’s not actually in the Top 25. It’s a great business.

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Nice New Yorker piece about Hedge Funds http://www.sl-advisors.com/nice-new-yorker-piece-hedge-funds/ http://www.sl-advisors.com/nice-new-yorker-piece-hedge-funds/#comments Sun, 18 May 2014 11:10:35 +0000 http://www.sl-advisors.com/?p=3473 http://www.newyorker.com/online/blogs/johncassidy/2014/05/how-hedge-funds-get-away-with-it.html

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