TVIX: an expensive lesson about an exotic exchange traded note

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.

why is the gold price falling?

my take on gold

I have strong views on gold.  I don’t think it’s money (it used to be, but isn’t anymore in most parts of the world).  It’s no more–and no less–an inflation hedge than any other physical asset like, say, real estate or timberlands or diamonds or oil.

One exception:  in developing countries where people want to hide their wealth or don’t trust the banking system and where barter is an accepted way of doing business.  In these cases, the facts that you can bury gold in the back yard or break off a link in a 99.9% gold chain and give it to a merchant to buy stuff come in handy.  Think:  India or Vietnam.  And, of course, these transactions, like most barter, are by and large off the books.

I began to realize this in the mid-1980s when I saw that my acquaintances in Hong Kong had long since dumped all their physical gold and had forex trading accounts instead.

worldwide gold demand is an emerging economy phenomenon

Worldwide consumer demand for gold by country in 2011, as reported by the World Gold Council, breaks out in tons as follows:

India     933.4

China     769.8  (Greater China = 811.2)

Middle East     199.8

US     194.9

Turkey     144.2

Thailand     108.9

Vietnam     100.3

Everybody else     957.3.

It’s also telling that in the US, where about one in five citizens don’t have a bank account (because it’s too expensive), we’re not set up for people to plunk down a doubloon to buy a used car.

sharply increasing money creation in the developed world

Be that as it may, over the past few months we’ve seen a substantial increase in government money creation in the EU and in Japan.  We’ve also just heard Mr. Bernanke reaffirm that he intends to keep interest rates in the US at the current extraordinary low levels for a long time to come, despite increasing signs that the economy is picking up steam.

All of this spells the increased possibility of a future inflation problem.  Why, then, is the gold price falling rather than going up?

trends in India

I think the largest part of the reason lies in India, which comprises well over a quarter of worldwide consumer demand for gold.  (If we reckon that purchases of 14k or 18k jewelry isn’t investment demand, then India alone could comprise as much as 40% of the global (non-central bank) investment market for gold.)

Two factors:

–as the economy in India has been cooling down over the past half year down and inflation picks up, Indian demand for gold has gone down, not up,

–perhaps more important, in its latest budget, the Indian government is proposing two new gold taxes:  a doubling of the import tax on the yellow metal to 4%, and a new .3% levy on all gold purchases.  In response to the latter, gold shops in India have closed down on strike for almost two weeks.

a revealing insider trading ruling in Japan

insider trading in Japan

Yesterday’s Financial Times outlines a judgment made last week in a Japanese insider trading case.  The newspaper misses what I think is the main story, however.

the recent verdict

An institutional portfolio manager at Chuo Mitsui Asset Trust and Banking was found guilty of receiving, and acting on, insider information about an upcoming issue of new stock by a publicly listed company.  The PM made ¥14 million ($170,000) for his clients by trading on the tip.

penalties?

They were:

–the PM’s employer, Chuo Mitsui, was fined ¥50,000 ($600)

–there was no requirement of forfeiture of profits illegally made

–no penalty of any type either for the portfolio manager who received the tip or the broker who gave it.

The article goes on a bit about how, in the mysterious way Japan works, the nominal fine may have sent a powerful symbolic message that therefore the penalties may be more severe than a foreigner might suppose.  I think the nominal penalties do send a message, though not in the way the FT believes.

Oddly enough, the newspaper contrasts this fine with the ¥1.15 billion ($14 million) fine levied against Yoshiaki Murakami for trading on inside information about a half decade ago.  But it doesn’t realize that this contrast is the real story.

the Murakami saga

Mr. Murakami is a naive former civil servant who believed traditional Japanese corporations badly needed restructuring.  He formed an asset management company about ten years ago.  Its purpose was to be a gadfly that could prompt corporate/social change, while making money for clients at the same time.  One of Mr. Murakami’s targets–his last–was Nippon Broadcasting System.

Mr. Murakami bought a very large position in NBS.   He approached the company with suggestions about how to improve very weak corporate results.  He also asked for a board seat.

Management ignored Mr. Murakami.  It called on the “usual suspects”–suppliers, customers, domestic institutional investors–for support by buying NBS stock themselves, or at least by refusing to sell to Mr. Murakami.  Effectively isolated, Mr. Murakami approached a somewhat sketchy internet entrepreneur, Takafumi Horie of Livedoor, for aid.

Livedoor told Mr. Murakami in a private meeting that it intended to build a stake in NBS itself.  The declaration made Mr. Murakami an insider of Livedoor.  Despite this–he later claimed he didn’t understand the implications of his inside knowledge–Mr. Murakami bought more NBS.

Livedoor subsequently launched a hostile bid for the company.  It failed.  During the battle, Mr. Murakami realized that traditional holders of NBS wouldn’t tender their stock, so he sold his for a ¥3 billion ($36 million at today’s exchange rate) profit.

Mr. Murakami was charged with insider trading and found guilty.

penalties for Mr. Murakami?

They were:

–a ¥1.15 billion ($14 million) fine

–forfeiture of all profits from selling NBS, which amounted to ¥3 billion ($36.5 million)

two years in jail, later commuted to three years of probation.

why the sharp differences in the two cases?

Why should the punishment for insider trading be so startlingly different in these two cases?

Two factors stand out to me:

–the lesser one is that the Murakami case involved much larger amounts of money–although that doesn’t explain why there was no censure of the Chuo Mitsui portfolio manager or of the broker, and no forfeiture of illegal profits.

–the real difference, I think, is that Mr. Murakami was not part of the establishment.  Worse, he was a critic of the traditional social order.  By exposing its failings, he threatened the status quo.  In contrast, both the broker and the Chuo Mitsui portfolio manager were working within the shadow system of favors and obligations that the establishment uses to feather its own nest and keep itself in power.

the real story

That’s the real story here–stubborn defense of the traditional economic order, even after two decades-plus of resulting economic stagnation.

taking out a fresh sheet of paper

the tyranny of what we own

The current structure of our equity holdings exerts an influence on our investment thinking in a number of ways.  Most are normally invisible.  Usually it’s only when performance begins to get ugly that we turn a totally objective eye on what we own.

For one thing, there’s a powerful psychological tendency for our gaze to jump over positions that are losing us money (because we need to be right).  As a result, the dogs of the portfolio stay hidden longer than any of us would like to admit.  That’s why regular performance attribution analysis is so important.  (I’m not saying that we should jettison a holding if it doesn’t live up to our expectations right away.  We should give those expectations a sanity check, though, if the stock takes a nose-dive shortly after day one.)

For another, in a taxable account, we all are tempted to let the IRS tail wag the dog.  That is to say, we all weigh, at least semi-legitimately, the capital gains tax due on profitable holdings as a cost of making any change.  Because the tax is a concrete here-and-now expense, as opposed to the maybe-it-will-happen, maybe-it-won’t potential of future capital gains, it tends to have much more influence than it should in the decision to sell or not.

In a wider sense, there’s always a certain inertia associated with any portfolio, even while it’s still meeting our general performance expectations.  It is our intellectual child, after all.  We’ve done a lot of work in bringing it into being.  We know that more trading and more portfolio turnover, however emotionally satisfying, are almost always associated with worse investment results.  So why rock the boat.

taking out a fresh piece of paper

Periodically, though, it’s useful to ask ourselves what we would buy if we were creating a new portfolio from scratch.

Try it.

Don’t work from a list of existing holdings.  Sit down instead with a blank piece of paper (or document or spreadsheet).   Use whatever research materials you have at hand–a copy of Value Line, a discount broker’s screening services, a list of S&P 500 sector weightings and major constituents.  Read the company annual reports and 10-Ks.  Figure out what a portfolio–built today–should look like.  While you’re doing this, don’t look at what you already own.

When you’re done, compare this list–names and weightings–with what you actually hold.

You may be surprised at the differences.

why write about this now?

When I was managing money for others, I’d do the “clean sheet” exercise every six months or so.  I asked the portfolio managers working for me to do the same.

As it turns out, I’m currently investing in an IRA a lump sum pension distribution I recently received.  I want the money to be in more mature, income oriented stocks than I’d normally be attracted to.  This is compelling me to create a new portfolio from scratch, one with somewhat different objectives than I’m used to.  Hence this post.

I decided to read through a three-month cycle of Value Line reports as a way of generating new ideas.  I’ve been looking at the safety rankings and historical data on dividends and earnings growth.

I’ve been surprised at how many potentially interesting stocks I’ve found.  (Some of the prose reports in VL are quite good;  in others, the main virtue seems to me to be that they have a specific word count rather than any information.  Be careful about the performance rankings:  as I read the aggregate data, they no longer have the predictive power they once did.)

What also strikes me is how few of the stocks I already hold I’m eager to put into the new account.  Part of this, I’m sure, is simply a difference in investment objectives.  But part may also be an indication that some of my holdings are beginning to show their age.

speculative stocks: the gold mine paradigm

speculative stock behavior

Speculative stocks of all stripes are often compared with gold mining stocks–not just any gold stocks but young companies with a potentially important strike but no history of profitable production.  Here’s why:

like gold mines

fraud?

In one sense, it’s because gold mining stocks have been fertile areas for fraud, in financial centers from Perth to Denver to Vancouver.  There was even a case in the US many years ago–a major scandal–where a mutual fund took large positions in junior Canadian miners that had fabulous financials indicating deep undervaluation.  When the portfolio manager went to visit the mining operations, however, he discovered they existed only in the imaginations of promoters who were happily churning out fake financial statements.

stock trajectory

Putting such cases to the side, the stocks of legitimate start-up companies often follow the same trajectory as gold miners as they approach the day when their first major development finally comes into production.

–the new strike is announced.  There’s limited exploratory drilling and little other information other than that the find is good enough to be commercially viable.  The stock goes up.

The lack of information itself opens the door to all sorts of speculation.  Analysts, who are always working from imperfect information in any event, may arrive at their preliminary estimates from an average of the productive capability of other mines in the area, or from the past experience of the geologists or the professionals associated with the project.

Even at this stage, analysts begin to jockey for position with each other by offering, in turn, increasingly more optimistic assessments of the find.  The stock goes up some more.

–financing is lined up.  Further drilling has been done to delineate the find and to justify a bank loan that will fund construction of productive facilities.  Getting a loan means a third party has examined, and signaled its validation of, the geological data and production plan.  This sets off another round of more positive speculative assessment of the find.  The stock goes up again.

–the mine and associated processing facilities are constructed.  As analysts can see the scope of the project, even more bullish reports are issued.  The stock goes up once more.

–the mine opens; production commences.  For most stocks this means reality intrudes on–and shatters–the reverie of stock market speculation.  Dream shifts into reality.  Analysts can no longer imagine extraordinarily high ore grade being processed at a world-record rate.  They have to deal with the facts of, say, ordinary grade ore being processed at pedestrian rates.  The stock plummets.

Almost always, the day that the mine opens is also the day that the stock price peaks.  

TIF’s 4Q11: supply your own adjective

the results

Just before the open on Tuesday March 18th, TIF reported earnings results for fiscal 4Q11 (TIF’s accounting year ends in January of the following calendar year). Sales came in at $1.19 billion, up 8% year on year. Profits were $178 million, or $1.39 per share, a drop of 2% from 2010.

For the full year, sales were $3.64 billion, a yoy advance of 18%. Eps were $3.60, or + 23% yoy.

In a lackluster market, the stock was up more than 6% on the news.

details

Sales for 4Q in the Americas were up 5% yoy; in Asia-Pacific they were up 19%, up 13% in Japan and 3% in Europe.

In early January, TIF had warned that its business had slowed significantly from the torrid pace of the first three quarters of 2011 (see my post). Overall, the results TIF actually reported were slightly better than it signaled at that time. Thanks to a small rebound in January, sales in the Americas were 1 percentage point higher than TIF was figuring, and Europe—of all places—was 2% better.  No change in trend elsewhere.

It doesn’t make a whole lot of difference, but 4Q11 eps would probably have been at least flat with 4Q10 and maybe up a penny, were it not for a year-end upward adjustment of the company’s tax rate. Without going into all the details,  a greater proportion of TIF’s sales than anticipated came from high-tax areas like the US and EU. Put another way, the tax rate adjustment is a consequence of the fact that sales in Asia-Pacific fell off more in 4Q11 than the rest of the world did.

TIF also gave its initial guidance for fiscal 2012—sales growth of 10%, earnings per share growth of 10%-13%–resulting in eps of about $4 for the year. The company thinks the bulk of the advance will come in 4Q12.

During the first half of 1Q12, results are tracking in line with TIF’s expectations.

During the quarter TIF spent $35 million buying back stock, at an average price of $67.26. That’s about 30% less than TIF averaged over the first nine months of the year. To me, it looks like all the buying came before the company’s profit warning. If so, I certainly can’t be too critical since I had no enthusiasm for buying, either.

Arguably, continuing to buy below $60 at the same time the company knew its sales shortfall would mean a lot of money tied up in unsold inventory would be too risky. But it certainly implies to me that TIF is not shrugging off the current sales slowdown as something that will soon be behind it.

my thoughts

TIF’s 4Q11 has played out pretty much as I thought it would in January. The only new news from the company announcement is that the situation appears to be stabilizing at the lower rate of sales growth TIF experienced in 4Q11. All in all, I don’t get the market reaction of aggressively bidding up the stock on this information.

Contrary to what I would have expected, TIF shares have also recovered all they had lost vs.the S&P after their January swoon.  And that’s before this week’s earnings report.

The stock now trades at around 18x this year’s earnings. That’s not wildly expensive for a company like TIF. But it’s not cheap, either, especially with perhaps three quarters of lackluster earnings comparisons in prospect.

There’s certainly a risk that my incorrectly lukewarm attitude to the stock at $59 will color my opinion now. Nonetheless, I’m happier on the sidelines now than buying. And I’ve got to at least consider the idea of selling some of what I own into any strength.

playing the Japanese stock market today is harder than it seems

how so?

No, it isn’t the frequent market holidays.

It isn’t the semi-visible, semi-not, zaibatsu/keiretsu business links that tie firms together with amazingly strong (to me, anyway) emotional bonds that foreigners find difficult to assess.

It isn’t the fact that for many Japanese company managements–to say nothing of institutional investors–one foot remains in the samurai world.

None of this helps a foreign investor.  But learning a market’s quirks is arguably part of the price of entry a newbie pays everywhere he goes.

the market structure…

No, the biggest problem for a foreigner today is the structure of the market–the selection of stocks available on the Tokyo Exchange.  Despite the fact that Japan is a wealthy nation and the second-largest advanced economy in the world, its market is dominated by the export-oriented manufacturers, plus the suppliers and distributors that support them, whose heyday (ex the autos) was thirty years ago.

…makes Japan look like an emerging country

The market structure is more like what you’d expect from China or India.  It’s also a little like the US circa 1980.  In the US since then, however, junk bond and private equity barons have taken many older, low growth firms private.  Conglomerates have broken up, or spun off their more glamorous parts, in strategies calculated to maximize their value.  Venture capital has brought a host of new firms into the public arena.  Not so Japan.  There are counterculture exceptions:  Uniqlo and the social networking firms come to mind.  But still…

None of this is exactly news.  But it’s the genesis of the dilemma foreigners now face in the Japanese stock market.

today’s problem:  a weakening yen

Newly initiated quantitative easing in Japan is weakening the yen.  That’s making life more difficult for domestic firms that use imported materials.  And it’s also a lifeline for exporters, who use yen-denominated inputs and sell their products abroad.  So Japanese institutions have been selling the former to buy the latter.  Again, no surprise.  It’s what they always do.

The issue for a foreigner is this:

Ex the autos, the exporters are not a particularly attractive picture.  Historically, they’re a pretty sorry lot in terms of making money.  They face intensifying competition from lower-cost rivals in emerging economies.  By and large, managements are hide-bound and unable to commercialize higher tech products they have.  Law and custom defend dysfunctional incumbents against any shareholder attempts at change .  (Think:  Olympus …or Sharp  …or Pioneer  …or Sanyo   …or Casio   …or Sony).

In addition, for a dollar-oriented investor, at least a part–and probably most–of any yen-denominated gains will be offset by currency losses.  Although my general rule is not to get involved in forex hedging, this is an exception.  Whether you like or not, you probably won’t make much money on your Japanese stocks unless you sell the yen.

…which brings up another potential worry.  Exporters usually run substantial currency hedging operations.  In my experience, they’re pretty good at it.  Nevertheless, it’s always possible that exporters have zigged when they should have zagged.

my bottom line

For a long time, I’ve regarded Japan as a special situations market.  Find an outstanding company; buy and hold.  Enduring the current flight from quality is just a cost of doing business.  I have no desire to chase export-oriented names, although while the yen is softening I think exporters will continue to be market stars.  If I were managing dedicated Japanese money, however, I’m sure I’d find myself under performance pressure to do just that.