Archive for the 'ETFs Vs. Mutual Funds' Category

risk controls at UBS: the case of trader Kweku Adoboli

Published September 20, 2011 Banks , Current Market Thoughts , Derivative instruments , ETFs Vs. Mutual Funds , Industry Analysis , Recent Market Action , Trading Leave a Comment
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Kweku Adoboli is the UBS trader who ran up losses of $3.2 billion through unauthorized trading in stock index futures over a three-month period without being discovered.  Both the Financial Times and the Wall Street Journal have extensive accounts of what Mr. Adoboli did.

Here are my observations:

background

Legally, traders act as agents for the institution they work for.  Once an employer introduces an employee to counterparties as being authorized to trade for the firm, the counterparties have no obligation to try to figure out what the trader is doing.  Until the employer informs them otherwise, the counterparty’s job is simply to execute the orders they receive.

Mr. Adoboli worked on a small trading desk called Delta One, that processed buy and sell orders that UBS received for ETFs.  For this story, the most important characterisitics of ETFs (see my posts on ETFs vs mutual funds for more information) are that:

–ETFs trade continuously throughout the day, in large aggregate amounts but typically in many small orders

–firms that run ETFs have no direct dealings with the investing public.  They keep their costs low by having brokers do virtually all trade processing and record keeping for them.

Brokers recoup the administrative expenses they incur through the commissions and bid-asked spreads they charge customers.  Once they amass a large net position in a given ETF, they can close their exposure out by transacting with the firm that runs the ETF.  They may also attempt to make additional gains through the timing of these transactions.

Brokers routinely hedge part or all of their ETF exposure through derivatives markets.  The name of Mr. Adoboli’s unit, Delta One, signifies that the trading desk “delta,” or the change in value of the hedges for a given change in the underlying position UBS held, should be “one.”  That is, the two should match exactly; there should be no net exposure.

Mr. Adoboli

Mr. Adoboli’s initial job at UBS appears to have been in the back office, as one of the administrative employees processing and recording the activities of the Delta One desk.  One of his unit’s jobs would have been to reconcile the desk’s accounts of the trades it made each day with the confirmation notices sent by counterparties. 

Mr. Adoboli was a good enough employee to be promoted to the much higher status job of trader.  One key fact that he learned from his back office time was, surprisingly to  me, that for a whole class of plain vanilla short-term derivative contracts, counterparty banks never sent confirmations on the day of the trade.  Apparently, standard procedure was to only to send settlement instructions a few days before the contract came due.

on the Delta One desk

Despite the name, the Delta One desk had to take risk.  And, from Mr. Adoboli’s behavior we can conclude that the desk rewarded traders for successfully taking risk.  But these risks would have been small, like:

–widening the bid-asked spread slightly, or

–delaying making a hedging transcation by five or ten minutes in hopes of getting a higher price, or maybe even

–by “anticipatory hedging,” over-hedging at a favorable price, figuring that new orders would soon come in.

three months ago

That’s when Mr. Adoboli exceeded the risk limits specified by his desk.  Who knows what happened?  He may have accidentally added an extra zero to a trade.  More likely, he may have decided he wanted to quickly make enough trading profit to get a higher bonus, or to be recognized as an astute trader and promoted to a “prop trading” desk whose principal job is to try to make trading profit (“prop” is short for proprietary, meaning it trades with the firm’s own money).

In any event, at some point Mr. Adoboli’s trading went badly and he began to make substantial losses.  Rather than reporting what he’d done to his boss, he used his back office knowledge to record fake trades that offset his losses.  He selected instruments where he knew no confirmations would be sent–buying him time until close to settlement day for him to recoup his losses and enter more, counterbalancing, fake trades to erase them from the records.

Apparently, toward the end, Mr. Adoboli was making speculative trades covering as much as $5 billion in securities, all without being detected.

What appears to have tripped Mr. Adoboli up was that the back office noticed it was not receiving settlement instructions for fake trades set to settle on September 22nd.

observations

In the mid-1980s as I was beginning to learn about bank stocks, a colleague who was an excellent bank analyst told me she had one main criterion for separating good banks from bad.  In a good bank, when someone makes a mistake and reports it, he’s rewarded; in a bad bank, mistakes are punished, so employees hide them.

It’s hard for me to believe that Mr. Adoboli was able to conceal his unauthorized trading from his direct supervisor–in a five- or six-person section–for so long.  That person must have been asleep at the switch.

It’s also surprising that there was such an unaddressed loophole in UBS’s trade reconciliation procedures–and that no one noticed that one person was doing so much unreconciled trading.

why September’s such a bad month for stocks

Published September 7, 2011 Cash position , Portfolio management , Recent Market Action , Securities regulation , yearly distributions 1 Comment
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welcome to September 2011

This year, September has opened to a mini-swoon in world stock markets caused by a poor jobs report in the US, worries about the government suing banks over past sub-prime mortgage sins, and general panic about Greece (the EU political “plan,” if you’d call it that, appears to be to let the situation deteriorate to the point that voters will be grateful for even a painful rescue and not kick out the politicians who caused the problem in the first place).

the annual September equity decline

Who knows how long this downdraft will last–as I’m writing this, global equities appear to be rallying a bit, but this isn’t the normal seasonal decline in stocks.

It’s really not just September when stocks go down, either.  There’s a several-week period of selling that typically starts each year in mid-September and ends in mid-October.  But there’s usually a rally toward the end of October, so the early-month decline is less obvious.

This decline has nothing to do with the macroeconomy or stock valuation.  It’s all about mutual fund taxes.

here’s why

Mutual funds in the US (ETFs, too) are a special type of corporation.  Their activities are limited to investing, and they’re required to distribute to shareholders virtually all of their net realized profits soon after the end of each tax year.  In return for these restrictions, they’re exempt from corporate tax on their gains.  Only shareholders pay.

The tax year for virtually all mutual funds, which determines how much they must distribute, ends on October 31st.

adjusting the distribution

Shareholders like to get a distribution, which they take to be a sign that things are going well.  This makes no sense to me–better to “ride your winners” and let gains compound without paying tax–but that’s what the customers want.

On the other hand, people don’t like to pay taxes, so they don’t want a gigantic distribution (over 5% of the fund’s assets), either.

So mutual fund managers start to adjust the size of their potential distributions sometime in September.

This involves a lot of selling. 

If the required distribution is too big, a manager will scour his portfolio for stocks where he has a loss that he can sell.  If there’s no distribution, or if the payout will be too small, he hunts around for positions where he can justify taking a partial profit. 

It’s not about actually sending money to shareholders,

as I’ve heard “experts” on finance talk shows say.  An overwhelming majority of mutual fund shares, say, 95%+, sign up for automatic reinvestment of distributions.  So if the yearend gains add up to 5% of the fund assets, the amount of money that actually leaves the fund is .05 x .05 = .0025, or .25% of the assets.  That’s far less than the frictional cash a manager needs to have on hand to ensure smooth settlement of trades.  So the transfer of funds is not a big deal.

this tax planning is healthy, in my view

It gives a reason for a manager to step back and take a hard look at all the fund’s positions.  It also gives him a psychological excuse to dump out stocks where he’s hoping against hope that they’ll work out (trust me, even the top managers have one or two of them).

one caveat

If a fund has unused tax losses left over from prior years–and many still have them as scars from panic redemptions by shareholders in late 2008-early 2009–it can’t make a distribution until those losses are gone.  Either the fund makes offsetting gains (which won’t be subject to tax–a good thing) or the losses expire.

In either case, there’s no need to take part in the yearly September-October tax selling ritual.

this year?

My guess is that tax selling season will be relatively mild.  The S&P 500 is showing about a 1% loss since last Halloween.   So unless a manager made very large adjustments to his portfolio positioning a few months ago, when stocks were considerably higher, the gains generated in day-to-day portfolio activity shouldn’t be large.  Also, at least some funds will continue to be in a net loss position, so they won’t be able to make distributions no matter what.

 

 

synthetic ETFs

Published July 4, 2011 ETFs Vs. Mutual Funds , Portfolio management Leave a Comment
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what they are

They’re ETFs that contain derivative contracts, not by physical securities.

using a subset of an index

Synthetic ETFs are the extension of an idea that’s been around for a long time.  Provides of index-tracking products, like index mutual funds, know that they don’t need to buy and sell every  component of the index they mimic in order to have an acceptable commercial product.  In fact, in the case of broad indicies, like the Russell 2000, the MSCI EAFE, or the S&P 500,results can be improved by transacting only in a subset consisting of the most liquid names.

After all, if an index has 1,000 constituents, the average weighting is .1%; for the bottom 10%, weightings will be much tinier.  So the act of a big index fund buying and selling may move the prices of those small stocks significantly.  The index fund’s tracking error, the difference between the performance of the fund and that of the index may well be smaller by dealing with a more liquid subset than with the entire index.

using futures

It’s also a standard technique for managers of all stripes to use a stock index future overlay on top of physical securities to protect their portfolios against adverse market movements over the time while they’re buying or selling to deal with large inflows or outflows.

combining these ideas

So conceptually it’s not much of a stretch to think of index-tracking products that contain no physical securities, but just derivatives contracts instead.  Voilâ!…synthetic ETFs.

mostly in Europe

So far, synthetic index ETFs are by and large products offered in Europe.

However, just as the concepts behind them are familiar, so too is the main risk associated they entail–namely, counterparty risk.  In the case of a “normal” index ETF, if the fund were to somehow fail, owners would still possess the underlying index securities.  Holders would recover net asset value–or something close to it–by selling the securities and receiving the proceeds.

In the case of a synthetic ETF, it’s possible that the investment bank or other counterparty could fail–as the recent financial crisis amply illustrates.  But this would leave the ETF owners with one side of a contract with a now-defunct entity.  At best, they could face a protracted bankruptcy proceeding before they’d be able to collect anything; at worst, they’d have nothing.

To address this issue, banks have been offering to collateralize their derivatives contracts, arguing that this will safeguard holders against counterparty risk.  But the collateral won’t be shares of the securities underlying the index.  To do this, banks would have to set up the expensive index fund infrastructure they’re trying to avoid by creating the synthetic ETFs in the first place.  Instead, shares in an EU-oriented index might be collateralized by a mortgage on an office building in Tokyo or a project loan to a government in Latin America.

The question is:  is this good enough?  Personally, I’d prefer not to have a “normal,” not a synthetic, ETF.

are South Korea and Taiwan emerging markets?: implications for index mutual funds/ETFs

Published June 12, 2011 Current Market Thoughts , emerging markets , ETFs Vs. Mutual Funds , Purchasing power parity (PPP) Leave a Comment
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Korea and Taiwan aren’t emerging economies…

Korea has been a member of the Organization for Economic Co-operation and Development, the association of developed nations, since 1996.  Taiwan would presumably be a member, too, if it were not for China’s insistence that Taiwan is not a separate country, but a prodigal province of the mainland.

On a GDP per capita basis, Korea and Taiwan rank #33 and #37 in the world, respectively, just above the Czech Republic, which is also an OECD member.  On a Purchasing Power Parity basis, the two rank #25 and #20 by their per capita GDP–around the same level as the UK, France and Japan.

Looking at their place in world trade, neither is an exporter of raw materials or agricultural products in the way Australia or New Zealand (both classified by index compiler MSCI as developed countries) are.  Instead, both sell advanced technology and machinery products, like computers and smartphones.

…but their stock markets aren’t well-developed.

My experience is that company financial statements aren’t reliable in either country.  Neither governments nor company managements in either country care to have foreigners as shareholders, and treat them poorly.  There’s also a significant amount of intrusion into market workings by politically powerful entities in both.  The fact of this interference isn’t the issue; that happens everywhere.  It’s the extent–and maybe my lack of familiarity with the local rules–that bothers me.  In this regard, both Taiwan and Korea seem to me like Japan, only on steroids.

Every one of these factors is characteristic of emerging markets, not developed ones.

is MSCI about to reclassify both stock markets as developed?

There’s nothing new about what I’ve written above.  It’s been the situation for at least a decade (in stock market terms, it was worse before).

What is new, however, is that both the Wall Street Journal and the Financial Times have published recent feature articles suggesting that the MSCI will reclassify both Korea and Taiwan as developed markets later this month.

that might be an issue for holders of emerging markets index funds/ETFs

I’m most familiar with these entities in the US, but I think what I’m saying holds true for EU funds/ETFs as well:

Mutual funds/ETFs are both instances of a special type of corporation that is exempt from corporate tax.  It gains this exemption by, among other things, distributing all income (net of expenses) and realized capital gains to shareholders–who must pay tax on them.  Typically, distributions are made once annually, shortly after the tax year for the fund/ETF ends.

Together, Taiwan and Korea make up about a quarter of the MSCI Emerging Markets stock index (the largest other index constituents are China and Brazil).  If both countries are reclassified, index funds/ETFs will be required by their charters to sell all their Taiwanese and Korean holdings and reinvest the proceeds back into the revised Emerging Markets index.  That will presumably generate a large capital gain to be distributed to shareholders.

four quirks about a possible distribution

1.  It’s a fact of life about funds/ETFs that the holder who pays tax on a fund’s capital gain is the person who receives the distribution–not necessarily the person who enjoyed the rise in price of the stock that’s been sold.  If you buy a fund/ETF share today and receive a massive capital gains distribution tomorrow, you’re on the hook for any tax due, not the holder of the share while the capital gain was being amassed.

2.  Any distributions are net of any accumulated realized losses.  In the case of the Vanguard emerging markets index fund, which I hold, it had unrealized gains of $7.5 billion on April 30, 2011, the date of the most recent semi-annual report, but accumulated losses of $2.4 billion.

3.  Distributions are usually made at the same time every year.  For US funds, which typically have an October tax year, distributions come most often in late November or early December.  But a distribution can be made earlier–and often is, if the fund manager fears shareholders intend to sell their holdings to avoid receiving a large taxable distribution.  In other words, a Taiwan/Korea-related distribution could come as early as in July.

4.  Virtually everyone who buys a fund/ETF signs up for automatic reinvestment of distributions, so that the distribution itself results in almost no outflows. Only anticipatory sales, made to avoid a distribution, do that.

fund groups aren’t talking

I called up Vanguard the other day to ask about this issue.  My own back-of-the-envelope reckoning is that a distribution from the Vanguard emerging markets fund, if any, will be small (25% of the accumulated unrealized gains of $7.5 billion would be $1.9 billion, less than the $2.4 billion in accumulated losses).  And I own my fund shares in an IRA, so a distribution doesn’t affect me, in any event.  But I was curious.

My Vanguard representative was aware of the issue, but said everything depended on what MSCI does later this month.  I asked for the April 30th tax situation for the fund, but she wasn’t able to find it.  I looked it up online after I hung up.

relevant tax data are easy to find

Look for the latest annual/semiannual/quarterly report for your fund/ETF.   It will have a list of holdings and their market value (but not their individual cost basis).  At the end of the list, there’ll be aggregate cost and market value data.  In a section following right after that, the fund will show its accumulated realized losses.

2008 is a key year

The emerging markets index lost over half its value that year.  Although there’s no way of being certain with any individual fund, twenty some years of managing this type of money tell me that all the redemptions that created Vanguard’s accumulated losses came at the bottom or shortly after–probably in large part from people who bought shares in 2007.

Any fund/ETF that’s large now but was just getting started in 2008 probably has little in the way of accumulated losses to offset realized capital gains.  Entities like this are where the risk of a large taxable distribution are highest, in my opinion.  We’ll know more on June 21st, when MSCI does its next revision of the index.

 

is a bond fund exodus beginning?

Published December 23, 2010 Current Market Thoughts , ETFs Vs. Mutual Funds , Portfolio management , Shaping a portfolio for 2011 , Strategy Leave a Comment
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money is starting to flow out of bond funds

The Investment Company Institute, the trade organization of the the mutual fund industry, reported on Tuesday its weekly estimate of the money flowing in and out of the industry’s products.  The current report covers the week ending December 15th.

The equity news is the same as it has been for a long while–investors are taking $2 billion or so out of domestically-oriented funds each week and putting a somewhat smaller amount into foreign/global funds.

The real changes are coming on the bond side, both taxable and tax-exempt.

Over the past month or so, municipal bond funds have lost a total of $14 billion to net redemptions, presumably on worries about credit quality

For the past two weeks, for the first time since the collapse of Lehman in late 2008, taxable bond funds have had sizable withdrawals–$1.3 billion in the period ending 12/8 and $4.9 billion in the week of 12/15.

Why is this happening?

Bond yields are rising, as investors sense that the worse cyclical effects of the financial crisis are behind us.  Economic indicators and corporate reports are suggesting the US economy is stronger than the consensus had thought.  Markets are concluding that we’re past the cyclical lows for interest rates and that the Fed may begin to restore a normal (read: higher) level of rates sooner rather than later.

This means bond funds are potentially facing a headwind that will likely produce capital losses.

Where is the money going?

That’s not clear.  Some mutual fund consultants, like EFPR of Cambridge, Massachusetts, say the bond fund withdrawal money is going into equity funds.  Others are suggesting that it’s being parked on the sidelines in money market funds.

The ICI data, which cover the entire US mutual fund industry, don’t show either.

The ICI releases a separate weekly report on money market fund assets. That shows money market fund assets as being flat since the beginning of the month.  Assets held by retail investors are actually up slightly.

As mentioned above, the ICI data have shown a continuing small loss of money from equity funds over the past couple of years.  There’s a sharp shift within the equity category from US to non-US, but a net drain nonetheless.  That hasn’t changed.

So where is the money going?

A Bloomberg article that talks about he ICI numbers speculates that some is going into direct purchases of bonds.  This makes some sense:  you avoid the management fee mutual funds charge; and, unlike funds, individual government bonds mature–and you get your principal back.  I  suspect this is being done by individuals, not the institutions the article suggests, however.

I think a large chunk of this “lost” money will eventually end up in the stock market, either through individual equity purchases or stock ETFs.  Why?  Historical patterns suggest stocks are flat to up during a cyclical rise in interest rates, while bonds fall.  Also, to the extent that customers are withdrawing money from load mutual fund organizations–and Bloomberg suggests this is happening at places like Pimco–and forfeiting the sales charges they have paid, this suggests a certain finality to their actions.  My guess is that such investors are taking out a fresh sheet of paper and rethinking their asset allocations.

If so, we should see evidence of a more equity-friendly attitude as the new year begins.  Given that taxable investors typically greet January by selling winners they have nursed into the new tax year, a large inflow of new money should be easy to detect.

 

 

 

 

 

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