Tag Archives: ETFs

higher gold prices ahead: the 3Q10 report of the World Gold Council

November 18, 2010 By in China, emerging markets, Gold, Industry Analysis, Japanese development Tags: , , , , , Leave a comment

The conclusion is mine, but the support comes from the just released 3Q2010 report of the World Gold Council, a leading authority on the yellow metal.

The highlights:

world demand

Identifiable world demand is actually up by 12% year on year, despite a 28% rise in the US dollar gold price over that time.  Buying of gold, year to date, breaks down into the following categories by tons:

jewelry 1468.3 t, up 8% year on year,  comprising 52% of demand

Industrial/dental 320.5 t, up 13% year on year, 11% of demand

investment 1350.2 t, up 19% year on year, 37% of demand.

 

Geographically, third quarter consumer demand (i.e., excluding industry and central banks) breaks out as follows:

India     33.2% of demand.   Purchases up 28% year on year, mostly jewelry

Greater China     22.2%     purchases up 16% year on year, mostly investment

Middle East     9.7%     purchases down 10% year on year, mostly lower jewelry

United States     8.9%     purchases up 8% year on year;  jewelry down, investment up

Western Europe     7.6%     purchases down 3% year on year

Turkey     6.8%     purchases up 35% year on year, virtually all investment

Vietnam     3.3%     purchases up 17% year on year; jewelry down, investment up

Thailand     3.2%     purchases up 139% year on year;  jewelry down, investment up

Russia     2.6%     purchases up 17% year on year, on jewelry demand

everybody else     2.5%.

Industrial demand, which is primarily for technology products, has already rebounded to the pre-crisis levels.

Central bank activity has been, from a private investor’s point of view, really odd.  Until 1Q09 and at prices at or below $900 an ounce, central banks were heavy sellers.  Since then, they have turned into big net buyers.  Russia has added 46.2 t to its stockpiles, Thailand 15.6 t, Sri Lanka 6.9 t and the Philippines 4.2t (through late August).

Investment demand breaks out into three categories:

–hoarding of bars, coins, medals–mostly in developing countries, which accounts for 55% of investment and is up by about a third vs. 2009,

–ETFs and similar products, which accounts for 33% of investment and is down by about 40% year on year, and

–“other” identified retail investment–mostly coins bought in the US and Europe, which accounts for 12% of investment and is  also down by more than 40% year over year.

world supply

Happily, supply is much more straightforward than demand.  It comes from:

mine production     62% of supply, up 3% year on year

recycling     41% of supply, down 1% year on year

central bank sales     -3% of supply (since central banks have turned net buyers)

my thoughts

On the supply side first, I don’t think there’s any reason to expect a large increase in the supply of gold from current levels.

Yes, higher prices will make new gold mining projects (which can be developed relatively quickly) economically viable.  At the same time, however, prudent mining practice calls for existing mines to process progressively less gold-rich ore as prices rise.  That way, they maintain profits in boom times, but save higher grade ore for a rainy day.

Again, higher prices should mean more recycling.  But one of the reasons for the sharp increase in recycled gold over the past few years is the recession-induced development of a gold recycling industry in the US.  Output here has presumably reached a steady-state level.  More important, the World Gold Council thinks the rest of the world has pretty much run out of gold lying around to be recycled.

Central bank sales are harder to figure.  Luckily, they’re not that large in the overall scheme of things.  On the IMF still has about 50 t. of gold to sell.  On the other, Russia is carrying out a program to increase central bank holdings of gold.  And some smaller, less stable governments, appear to want to remain net buyers as well.

As to demand, the figures above should make it clear that gold is a developing world phenomenon.  The US and Western Europe make up only 16.5% of consumer demand and 12% of non-ETF investment purchases. (By the way, Japan isn’t mentioned on the consumer list.  That’s because Japanese individuals have been net sellers of gold this year.)

India alone is a third of the overall market for gold.  It and China together make up more than half of global demand.  In India, buyers want pure gold, to serve both as adornment and savings.  The same is true for China, though 18k jewelry has been making inroads.   So demand in both places should be a function of economic growth.  If the two were to intend to buy gold next year at only half the current pace–and I think that’s a very conservative estimate–this would mean almost over a 6% increase in total demand.

Absent an increase in recycling, which the WGC says is unlikely, I don’t see where the extra gold will come from.  Even ignoring demand from fiscally unstable areas like Turkey or Vietnam, or continuing central bank buying, as positive factors, it think this spells higher gold prices in 2011.


 


 

 

 

 

 

ETFs, synthetic reconciliation and counterparty risk

October 17, 2010 By in ETFs Vs. Mutual Funds Tags: , , Leave a comment

the issue…

Most ETFs are index-tracking investments.

A key decision for the ETF’s managers is how they will mimic the index while dealing with inflows and outflows of money.

There are two basic choices:

–physical replication, a strategy followed by US-based ETFs: and

–synthetic replication, favored by Europeans.

The fund’s offering documents will spell out what a given ETF intends to, and is allowed to, do.

Physical replication means mimicking the relevant index by buying the constituent elements. In the simplest case, it means buying and selling all the index constituents, in appropriate amounts, as needed. A modified strategy is to use index futures to allow the manager to control the timing of purchase and sales, while still responding immediately to inflows and outflows.

With an index with a lot of members like the S&P 500, it’s also common to find a subset of the index that tracks the overall index with a high degree of accuracy and use it as a substitute for holding the entire index. The ETF can thereby avoid potential problems with trading in illiquid index constituents. Typically, this strategy will be disclosed to investors in the offering documents.  Differences between ETF and index performance that’s attributable to “tracking error” is a risk shouldered by the ETF holder.

Synthetic replication is an extension of the idea that you can use derivatives to supplement holdings of physical securities that are index constituents. In its extreme form, synthetic replication means that the ETF manager negotiates a derivatives deal with an investment bank. The manager agrees to invest the ETF capital in a specified basket of securities and swaps the return on that basket for the return on the ETF’s index.

Synthetic replication has a number of aspects:

–ETF management is simplified substantially, meaning, among other things, that the ETF manager can concentrate on marketing its investment product rather than managing it,

–control of execution of the investment strategy is, in effect, transferred to the investment bank

–the issue of  tracking error can be negotiated away

–the investment bank typically is able to collect income from lending out the securities held by the ETF (presumably influencing the bank’s position about what securities the ETF should hold).

…is always counterparty risk

Synthetic replication also has consequences you should be aware of before buying.

— The swap arrangement negotiated with the bank by the ETF doing synthetic replication is an OTC derivative. This means it’s a contract whose value depends crucially on the financial soundness of the counterparty.

–In the event that the bank is unable to fulfill its obligations to the ETF, shareholders are left with an interest in the securities held in the ETF portfolio. This may, or may not, be the equivalent of the index. In addition, it’s possible that securities lent out to third parties may be involved in litigation and difficult for the ETF to recover and sell.

The risks inherent in synthetic replication are doubtless disclosed in the offering documents.  I’d characterize the risks as having low probability of actually occurring, but potentially having severe negative effects if they do.  The fact that everything is disclosed in the ETF’s official filings suggests that the holder will have no legal recourse against the ETF manager should the counterparty fail.  In selecting this type of ETF, he has taken the risk on himself.

As is the case with leveraged or inverse ETFs, the unwary buyer may only find out about the product’s characteristics when it’s too late to do anything about them.

Causes of the May 6th “flash crash”: the SEC/CFTC report

October 3, 2010 By in day trading, hedge funds, Recent Market Action, securities markets, stock market, Trading Tags: , , , , , , , Leave a comment

Last Friday, the Securities and Exchange Commission and the Commodity Futures Trading Commission issued their joint report on what caused the sudden drop in stock prices on Wall Street in mid-afternoon on May 6th.  The full report is 87 pages–plus some colorful charts–long.

The first eight pages give a summary of the findings, which MarketWatch has edited–that is, deleted the footnotes–and presented in two pages that are easier on the eyes.

some background…

1.  I posted twice about the mini-crash when it occurred.  Here are links to the first and second post.

2.  Traditional investment management companies, seeing the appeal of hedge funds to their client base, have created their own hedge fund-like offerings over the past half-decade.  Some have become very popular and are now very large.  One of these, unnamed in the report, triggered the market fall when it placed a large computer-controlled order to sell a specific stock index futures contract, the E-mini S&P 500.

3.  One of the tactics day traders use is to scan the market for unusual movement–up or down, it doesn’t matter–in stocks whose trading patterns they feel familiar with.  When they see abnormal pressure, they’ll step in to take the other side of the trade.  They figure the pressure is temporary and that when it ends the stock will revert to its normal trading level.  They’ll then unwind their position at a profit.  For longer-term market participants, day traders provide a useful liquidity-enhancing service that allows them to shift money from one stock to another more quickly.

4.  Brokers, and especially the big discount brokers catering to individual investors, have their own internal market-making operations.  They try, if possible (they have to abide by rules on searching for better prices from third parties), to match, in-house, one customer’s buy order with another’s sell.  This way, they earn the bid-asked spread, which can be much more than the commission they charge.

The report calls firms that do a lot of this “internalizers.”  There’s nothing necessarily wrong with doing this, either.  After all, someone is going to earn the spread.  The relevant point is, though, that  under normal conditions this order flow never hits the NYSE or other exchanges.

…to understand what happened on May 6th

At 2:32 pm on May 6th, the unnamed mutual fund company initiated an order to sell 75,000 E-mini S&P 500 futures contracts (about $4 billion worth, or a few percent of typical daily trading volume).  They told the SEC/CFTC they did this to try to protect stock positions against losses in a market that had been drifting downward for about two weeks.  The E-mini, traded on the Chicago Mercantile Exchange’s Globex electronic trading platform, is preferred by many to other contracts that are traded using the older “open outcry” (that is, yelling) system.

The portfolio manager who placed the order gave two instructions to his trading desk:

–the order was to be executed by computer, not by a human trader, and

–the order would be fed into Globex in amounts no more than 9% of what had been traded in the prior minute.

The manager could have given other instructions–say, put in a price limit, or a specification of a maximum amount of the order to be done before checking with him/her–but didn’t.

The institution had apparently done an E-mini sell this large only once before.  On the prior occasion, the trade was done partly by humans, partly by computer, and took five hours.  Maybe it didn’t work out as well as the initiating portfolio manager would have liked.  In any event, this time the manager put the order right to the computer, cutting out the human fail-safe.

Either by accident or portfolio manager design, the May 6th trade was completed in 20 minutes, leaving a securities market train wreck in its wake.

(The SEC/CFTC report simply records the fact of this trade.  As someone who has worked with various kinds of trading rooms for three decades, however, I find the account of the trade really strange.

This was a $4 billion order, so a senior person placed it.  Yet, he/she doesn’t seem to have realized how huge it was–it and the earlier sell order were two of the largest three one-day sells in the E-mini of the prior year. At the very least, he/she seems to have made no provision to monitor the trade, even though a new procedure was being used.

No one at the firm seems to have sensed that the trade was having negative ripple effects on the financial markets.  Apparently, no one tried to stop the trade before the 75,000 contracts were sold.  The issue isn’t necessarily that one should have a social conscience, although the firm may well have damaged its professional reputation.  Again, no comments from SEC/CFTC, but the trade execution must have been at terrible prices. Comments in the SEC/CFTC report do suggest that the portfolio manager involved had little grasp of basic features of the E-mini market.)

the order hits the market

As the order began to be executed, short-term traders did their thing.  They took the other side of the trade and sat back to wait.  When the selling stopped, they planned to reverse their positions at a profit.   That would pay for the big lunches they’d just had, or maybe for summer camp for the kids.  Some day traders also looked for discrepancies between futures prices and the physical market and hedged–transmitting, as usual, the futures market action into physical stock trading.

But the mutual fund computer didn’t stop.  Day traders started to get worried, and started to offload some of the risk they had taken on that day, both from this trade and others.  In other words, they started selling, too.  Their defensive behavior had the perverse effect of increasing E-mini volume, however. That meant that, although counterparties were signaling that they didn’t want to trade any more, the mutual fund computer obeyed its instructions and upped the speed of its selling.

Several things happened next:

–market makers either stopped making markets entirely or set bid-asked spreads that they thought only a crazy person would act on,

–which caused a trading halt in the E-mini, helping that market to stabilize and recover.

–retail investors, nervous after two weeks of decline, bad economic news and the market dropping that day, panicked and placed market orders to sell physical stock as well, and

–at least one big “internalizer” effectively shut down in-house operations and directed a big wave of sell orders to third parties–where the loony bids and asks resided.

After twenty minutes, punctuated by the saving grace of the trading halt, the mutual fund computer was sated and shut itself down.  The market rebound was already under way.

lessons learned

I imagine that one person has learned that you shouldn’t put in an order to sell $4 billion worth of anything–especially something new–without watching for a while to see what happens.

The rest of the world has learned that accidents like this can happen.  Presumably, the next time the markets won’t panic as much.

At the end of the day, the exchanges and FINRA (Financial Industry Regulatory Authority) huddled together and decided to void all trades that were more than 60% away from a reference price they determined.  Two aspects of this decision troubled market participants:  it came after the fact, and the process wasn’t clear.  Since the exchanges and FINRA represent the brokers, the natural suspicion–correct or not–is that they cancelled mostly trades they lost money on.  Not an idea that encourages buyers during market declines.

The SEC and FINRA have since developed a set of rules to cover what trades, if any, will be voided as/when this kind of market decline recurs.


mutual fund investors and their investment advisors

September 10, 2010 By in Current Market Thoughts, Getting financial advice, mutual fund holders and financial advisors, Surveying Tags: , , , , , , , , Leave a comment

the ICI survey

I was looking on the Investment Company Institute (the trade organization for the fund management industry) website for aggregate data on the size of tax losses held inside mutual funds and ETFs–the topic of Sunday’s post–when I found a report on a survey of mutual fund investors and their investment advisors.  This was supplemented by a later survey that elaborates on the types of financial advisors used.  I thought the information was interesting, and certainly not what I had expected even though I marketed my products to financial advisors for twenty years.  Here are the survey results:

preliminaries

The survey was done by phone in 2006, before the financial meltdown.  1003 households were interviewed by a third-party professional surveying company.  The report didn’t contain either the survey questionnaire or the raw survey data.

Two characteristics of phone surveys to keep in mind:

–they almost never use cellphone numbers because laws in most states prevent machine dialing of cells, so surveys that include them are more expensive.  This distorts the twenty-something demographic, which probably isn’t so important in this case.

–phone respondents tend to portray themselves in what they consider a more favorable, or more conventionally acceptable, light than they would in an internet survey.

The survey wanted to find out about financial assets held outside workplace retirement plans.

The survey defined a financial advisor as “someone who makes a living by providing investment advice and services.”  This includes not just traditional “full service” brokers, but also independent financial planners, bank and financial institution investment representatives, insurance agents and accountants.

the customer base

1.  Almost all the respondents (82%) had access to professional financial advice.

–Almost half (49%) bought mutual funds exclusively through financial advisors.

–A third bought both through advisors and on their own (through discount brokers or directly from fund companies).  No explanation for this behavior, although I think many customers try to control the fees they pay to financial professionals by maintaining two accounts.  One will be  wrap-fee account with a financial advisor;  the second will be a no-fee discount broker “clone” of the first.

–14% bought exclusively on their own.

–4% had no clue where the funds came from.

A total of 60% of the assets were held through financial advisors.

why customers seek advice

For most customers, there’s an event that triggers the search for a financial advisor.

For people in their twenties or fifty-plus, the event is usually receipt of a large lump sum, either an inheritance or payout of a work-related investment account.

For thirty- or forty-somethings, the event is lifestyle-related, usually marriage or the birth of a child.

what they need

The top four things customers want from a financial advisor are:

1.  help with asset allocation

2.  an explanation of the characteristics of the financial instruments they can buy

3.  help in understanding their overall financial situation

4.  assurance that they’re saving enough to meet their financial goals

Although a large minority(about 40%) of respondents seem to want to turn their money over to an advisor and forget about it, most regard their advisor (correctly, I think) as a consultant rather than a money manager and want to play an active part in making the decisions that define their portfolios.

demographics of advice seekers

The predominant characteristic of people with ongoing relationships with financial advisors is that they don’t use the internet to get financial information.  This group is twice as likely to have a financial advisor as those who do use the internet for financial data.  Here the survey really seems to break down, because it doesn’t say whether these customers don’t use the internet to get any information (my guess) or whether it’s just financial information they get elsewhere–if they get any at all.

What’s also interesting is that this (Luddite) behavior is not characteristic of mutual fund holders as a whole.  Other ICI research from around the same time shows that mutual fund owners tend to be intensive users of the internet, with financial information a particular area of interest.  Apparently, this latter–probably younger and more affluent–group doesn’t use financial advisors.

The other ICI research also suggests that the third of respondents who had some advisor-related funds and some not were predominantly in the latter camp.  The fact that 60% of the assets were bought through financial advisors suggests that the non-internet users are substantially wealthier, and probably older, than internet savvy respondents to the financial advisor survey.

Female decision maker households are 50% more likely than average to have an ongoing financial advisory relationship, as are families with over $250,000 in household assets (remember, this is pre-crisis).

The fourth defining characteristic is age. Respondents who were 55+ were 40% more likely than average to have a financial advisor.

who doesn’t want a financial advisor?

This group, a small minority according to the survey, has three defining attributes:

–they want control of their own investments, a desire that increases in intensity with age

—they (think they)know enough and have access to all the resources they need to make intelligent decisions on their own.  Sixty-somethings and older hold this conviction the most strongly, followed by the under 45 set.  Those in the 45-59 bracket think so too, but have more doubts.

—they don’t like advisors. They think they’re too expensive and that they put their own interests ahead of their clients’.

One in seven respondents, under 45 more often than not, said that they don’t need professional advice because they get it for free from a friend or family member.  Other than my children–who get excellent, if aggressive, investment advice, this group seems to be one fated to live on public assistance later in life.

my thoughts

I wonder if a survey conducted today would get the same results?

Despite long-term planning and all that, many individual investors seem to have sold their equities at the bottom and put the money into bonds, missing the subsequent equity rebound.  According to ICI data, they continue to allocate assets away from stocks and into bonds, despite the fact that bonds haven’t been so expensive vs. stocks in almost sixty years.  Is this conservative move spurred on by financial advisors?  Probably not.

I remember a story that ran in the Wall Street Journal just after the stock market collapse of 1987.  It was about a prescient retail broker in Connecticut who called up all his clients in late summer of 1987, just before the crash, and convinced them to sell all their stocks–which they did.  He called them back in November, at the market bottom, to advise them to buy again.  No one returned his calls.  He packed up and left for Oregon to try to rebuild his business there.

Maybe the same has been happening today.

Another aspect to 1987.  I think the market decline marked a paradigm shift by individual investors.  Prior to that, people typically bought individual stocks through full-service brokers.  Post-crash, I think that many individuals, like those Connecticut customers, lost faith in brokers and turned to independent financial advisors and mutual funds.

Does the financial crisis mark another structural turning point?  Maybe.  If so, it’s probably away from mutual funds to ETFs and away from using financial advisors as consultants with specialized financial expertise to self-reliance.

Mike Mayo vs. Citigroup on deferred taxes: round III

September 8, 2010 By in Accounting, Banks, Current Market Thoughts, deferred taxes, Industry Analysis Tags: , , , , , , , , , Leave a comment

Mike Mayo’s writing about C’s deferred tax assets again.  They now amount to over $50 billion and Mr. Mayo thinks at least part should be written off and removed from C’s balance sheet.

Mr. Mayo, a respected Wall Street bank analyst now working at CLSA, has always spoken his mind, even when he knows it will arouse the ire of the major commercial banks he covers.  Banks–like any large-cap publicly listed companies–know how to play hardball.  They can, and have, cut off his access to top management, and they can deny his employer their securities underwriting, and other investment banking, business.  But that has never stopped Mr. Mayo–who (perhaps out of necessity) has worked for a variety of Wall Street firms over his career.

Last year, Mr. Mayo predicted that C would write off $10 billion in deferred tax assets from its balance sheet at yearend.  The company didn’t, explaining in its 10-K that if all else failed it would repatriate massive foreign accumulated profits to enable it to use the tax losses has accumulated on its balance sheet.

So, Mr. Mayo’s writing again.  Why?  –because C’s deferred tax account has continued to grow, reaching $50 billion at the end of the June quarter–or a third of the bank’s tangible equity.  The number is also very big relative to C’s market capitalization of $110 billion.  If they could all be used today, they would probably represent C’s single most important asset.

That’s the question, though.  They can’t all be used today.  In fact, C is generating more of them.  But can they all ever be used before they expire?  Mr. Mayo thinks not.  C says they will be.

My guess is that Mr. Mayo is technically correct, but that we won’t see a writedown for several years, if we ever do.  Two reasons:

–I don’t think the authorities see any percentage in portraying a major commercial bank as being in worse financial shape than its audited financials show it to be now.  At least a portion of the deferred tax assets are counted in the regulatory capital supporting C’s loan portfolio.  No one wants to mess with that at the moment.

Furthermore, C is not alone in having substantial deferred tax assets.  A C writedown might snowball into an investor demand for similar writedowns by other European and US banks.  That would be playing with fire, also.

–There’s a technical reason, as well.  It’s important to distinguish between a company’s financial reporting books, which it presents to investors, and its tax books, which it shows to the IRS.  A company may take a writedown of, say, $10 billion in US assets on its financial reporting books.

Let’s assume, to keep matters simple, that it has no other taxable US income.  If so, on its income statement, the company will show a pretax loss of $10 billion, a deferred tax benefit of $3.5 billion and an after-tax loss of $6.5 billion.  In the footnotes to its financials, it will show a tax carryforward of $3.5 billion.

What’s crucial is that it uses this accounting treatment whether it actually disposes of the assets or retains them at a nominal value on the balance sheet.  And it may not want to sell the assets right away.

Why not?  –because disposal of the assets is what starts the clock ticking on the limited time a company has to make use of the tax losses.  If you’re not making money now, it’s often better to hold off on disposal.  Doing so can extend the time you have to use the lax losses indefinitely.

In C’s case, we don’t know the details of what it has done.  Only C and its auditors know for sure.

Again, why am I writing about this? I think the C tax controversy is interesting, although I don’t own C and have no intention of buying any soon.  I also am intrigued by the idea that yesterday’s loss can be tomorrow’s asset value.  That can be a key issue in evaluating fallen angel bonds or turnaround stocks.  It also has important implications for mutual funds and ETFs, especially in times like these when the securities have big realized losses and are experiencing redemptions.  More on this last topic in a later post.