Category Archives: ETFs Vs. Mutual Funds

TVIX: an expensive lesson about an exotic exchange traded note

March 30, 2012 By in Derivative instruments, ETFs Vs. Mutual Funds, Getting financial advice, short selling, Where are the customers' yachts? Tags: , , , , , , , , Leave a comment

TVIX

TVIX is the ticker symbol for “Velocity Shares Daily 2x VIX Short-Term” ETNs (exchange traded notes), sponsored by Credit Suisse.  What a mouthful!

They’ve been in the news recently because of very big losses some buyers of them have suffered.

what it is (hang onto your hat)

An ETN is something like an ETF, except that what the holder is buying is not an ownership interest in a collection of equity securities but rather a piece of a debt security issued by the investment bank that sponsors the ETN.

In the case of TVIX, the debt instrument in question is a promise by Credit Suisse to pay the holder an amount that’s tied to the performance of futures on the CBOE Volatility Index, or VIX.  Although in form the actual note issued by CS is a debt instrument, in function it’s very much like an OTC derivative contract.

The 2x in the name means the ETN is leveraged.  It’s designed to deliver 2x the return on the VIX.

Daily means it’s re-leveraged each day to deliver 2x the return on the VIX.  The significance of this daily recalibration is that the return over longer periods of time can be significantly different than 2x leverage over that span, depending on the sequence of daily gains and losses.

The VIX is a measure of expected volatility, or movement of the S&P 500 index away from the current level–up or down–over the coming 30 days.  It’s calculated based on the prices of near term puts and calls on the S&P.

what happened

ETFs and ETNs typically act like open-end mutual funds.  When new buyers want the securities, the sponsor satisfies demand by issuing more.  When sellers want to redeem, the sponsor cashes them in.

In the case of TVIX, Credit Suisse hedges the risk it takes in issuing the note by maintaining an offsetting position in the actual VIX futures contract. A month or so ago, however,  CS reached the maximum position size allowed by the Chicago Board of Exchange.  When it did, CS stopped issuing new ETN shares.  At that time the net asset value of TVIX was about $15/share.

Over the ensuing weeks, as the S&P 500 meandered, the VIX fell sharply and the NAV of TVIX plunged to about $7 a share.

And here’s the strange part…

…retail buyers didn’t notice. 

They continued to pay $14-$15 a share for TVIX, despite the plunge in value of the underlying note!.   At the worst point investors were paying over 2x NAV!!!   That’s like going to the bank to get change for $20 and being satisfied with $10 in coins.  Who would do that?  From looking at the charts it appears that at least a million shares or so traded at this level of misvaluation.

Then short sellers appeared and the bottom fell out. TVIX, which is trading a bit below $7.50 now, bottomed around $6.

the lesson(s)?

1.  Unlike mutual funds, ETFs and ETNs don’t trade at net asset value.  They trade at whatever price willing buyers and willing sellers meet.

2.  As far as I’m aware there’s no publicly available data on average bid-asked spreads for any ETFs or ETNs.  But the VIX price is available in real time, so it should have been easy to make a rough guess at NAV–and theefore the premium one would be paying.  It’s hard to believe that no buyer did any homework.  The broker acting as an agent in the transaction certainly knew what net asset value was.

3.  The broker you place the order with is an agent.  He has no obligation to tell you you’re doing something incredibly stupid.  (Caveat emptor.  Welcome to Wall Street.)

4.  I wonder who the short sellers were and how they got the idea to sell TVIX short.

5.  Where do you think the stock the short sellers borrowed to sell came from?   …from the accounts of the retail investors who held TVIX and whose brokerage agreements allowed their firms to led out their holdings, that’s where.  Translation:  from just about any retail holder.

According to the Wall Street Journal, which doesn’t seem to get the misvaluation–which I think is the most interesting part of the story–the SEC is investigating.  Why?   …because the shares plunged just before Credit Suisse announced it would begin to issue new TVIX shares.

a price war among ETFs?: implications

March 13, 2012 By in ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, Portfolio management, securities markets, Strategy Tags: , , , , , , , , 2 Comments

the ETF phenomenon

To my mind, the ETF phenomenon is not just a story about price advantage.  I think the popularity of ETFs is an indicator of a fundamental sea change in sentiment on the part of individual investors.  For me,ETFs mark the end of the almost twenty-year love affair of individuals with actively managed mutual funds–and maybe with mutual funds, period–that began after the stock market crash in 1987.

Just as individuals shifted from relying on retail brokers to puting their faith in mutual fund portfolio managers after Black Monday, the trigger for the change in direction has been the Great Recession.  Its cause is the continuing failure of even the most highly publicized active managers to beat their benchmark indices-or, even if they did, to preserve during the downturn of 2007-2009 what their clients thought of as enough of their wealth.

The new trend is for individuals to take responsibility for themselves and to allocate their portfolios by sector through narrowly focused passive vehicles, that is, ETFs.

price war?  yes and no

Exchange traded funds, which now control over $1trillion in assets in the US, appear to be entering a new phase of competition, one marked by sharp reductions in their management fees.  The media are calling this a “price war.”

It’s not a price war in the most dramatic sense–where firms with excess production capacity slash selling prices in a desperate bid to keep their heads above water, or to generate cash flow needed to repay debt.  But it still is one, in the sense of a widespread fall in fee levels.

What do the fee reductions mean? 

Two aspects:

a maturing industry

1.  At one time, ETFs were competing for investor dollars primarily against their cousins, index mutual funds.

During this period, simply having an expense ratio lower that that of an index fund was all an ETF needed to succeed.  Today, despite the fact that their per share expenses are already far below those of index funds, ETF companies are beginning to slash their fees further.

(An aside:  to some extent, the ETF fee advantage is offset by the commission charges that ETF transactions bring with them.  More important, buyers pay more than net asset value at the time of purchase, sellers collect a bit less.  There isn’t enough data available for third parties to determine what this bid-asked spread typically amounts to.  Comparisons of ETFs vs. index funds usually deal with this issue by ignoring it, making ETFs look somewhat more attractive on a cost basis that then actually are.)

That’s because competition between ETFs and index funds is over.  Index funds have been defeated.  The new contest for customers is between one ETF and another.

closing the door to newcomers

2.  Investment products like mutual funds and ETFs have substantial up-front fixed costs, mostly computers and professionals to manage the money and safeguard it.  So they initially run at a loss.  Once a fund gets to the point where fees cover these costs, however, new assets bring almost pure profit.  Margins expand fast.

At some point high margins become a negative, not a positive.  They act as a lure for new competition.  And they allow new entrants to become profitable quickly.

Therefore, lowering fees has a second purpose.  It lengthens, possibly by an enormous amount, the time a potential new entrant must operate at a loss–and increases proportionally the amount of assets he must gather in order to reach profitability.  Naturally, this decreases the attractiveness of the industry to newcomers.  So, as counter-intuitive as it may seem, the fee reductions also serve to preserve the long-term profit profile of at least today’s very largest players.  It makes no economic sense for anyone else to enter the fray.

It’s interesting to note that of the three largest sellers of ETFs in the US, BlackRock, Vanguard and State Street, only Vanguard has a significant actively managed mutual fund complex.  All the other last-generation investment companies have had their heads in the sand.  Internal forces of the status quo have preferred to let assets leave rather than create an ETF divisions that might be headed by a political rival.

another sign of a toppy bond market in the US

February 28, 2012 By in Constructing a Portfolio, Current Market Thoughts, ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, Recent Market Action, Strategy Tags: , , , , , Leave a comment

running an ice cream stand

One of the most useful tips on company analysis I’ve ever gotten came from a former P&G marketing executive who was working for a hotel company when I heard him speak.

He said that if you run an ice cream stand that sells vanilla ice cream, you don’t start to sell strawberry (my favorite, by the way) until the market for vanilla stops growing.  In other words, once you see a company begin to segment the market for a product (by offering several varieties), you know that sales of the “plain vanilla” version are tapping out.

the new Pimco Total Return ETF

That’s my take on the Pimco announcement that it’s launching an ETF version of its total Return bond fund, the largest actively managed bond mutual fund on the planet, two days from now.  It means investors have stopped buying bond mutual funds from Pimco.  Since Pimco is the biggest bond manager and has the best long-term record, I think this also means investors have stopped buying bond mutual funds, period.

Remember, too, that Pimco–a unit of Deutsche Bank–is a marketing monster.  It’s executives are constantly pounding home their message, often packaged as “economic” commentary, that now is the best time to buy more bonds.  During the two decade+ period of secular long-term interest rate decline that ran from the early 1980s until recently, that stance was 100% correct.  Not anymore, though.

True, Pimco had a year to forget vs. peers in 2011.  But I don’t think that’s the issue.  Pimco’s long-term record is strong.  And the company had begun laying the groundwork for the new ETF before its performance weakness unfolded.  Despite Pimco’s relentless sales efforts, I think investors are finally catching on that bonds may not be the one-way street that they’ve come to expect.  Even if the light bulb hasn’t gone on, investors are at least signalling that they don’t think they need any more bonds.

ETFs aren’t a walk in the park

performance differences

Many bonds are surprisingly illiquid.  Pimco won’t be able to use the much more easy-to-trade derivatives market to change the shape of its ETF holdings in the way it does in its mutual fund portfolio, however.  So it’s possible that the ETF won’t track the mutual fund very closely.

That’s potentially a big concern.  Holders of the vehicle that’s doing less well will always be unhappy.

filling a need nobody has

So far, actively managed ETFs haven’t been very popular with investors, who have preferred low-cost passive products.

cannibalization

Cannibalization of the Total Return mutual fund by the lower-cost ETF might seem to be an issue, but I don’t think it is.  Two reasons:

–taxable investors with unrealized gains on their mutual fund holdings won’t switch to the ETF because they’d trigger capital gains tax

–it’s always better to cannibalize an existing product with a new one of your own rather than have a rival do it to you with one of his.

conclusion

The new ETF will be interesting to watch, if nothing else to see how successful it is in gathering assets.   Still, I think it’s probably as close as we’ll get to a bell ringing to signal the top of the market.

risk controls at UBS: the case of trader Kweku Adoboli

September 20, 2011 By in Banks, Current Market Thoughts, Derivative instruments, ETFs Vs. Mutual Funds, Industry Analysis, Recent Market Action, Trading Tags: , , , , , , , , , Leave a comment

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

September 7, 2011 By in Cash position, Portfolio management, Recent Market Action, Securities regulation, yearly distributions Tags: , , , , , , , , 1 Comment

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.

 

 

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