Guest post by Peter Tchir.
State of the High Yield Market
The ETF’s and Closed End Funds are attracting a lot of attention. Redemptions and poor performance in the past few days have caught a lot of people’s attention. It also sounds like it is hitting traditional mutual funds. It is worth looking at.
Unmitigated Disaster in Closed End Funds
Here is the craziest closed end fund I know of. The PHK fund was down 26% since its peak but still trades at a premium of 27%. I have never understood why people pay such a premium for a fixed income fund, and never will. To me it is completely irrelevant what this fund does, except as a sentiment for the least thoughtful retail investors. We saw steep declines in other closed end funds. Most had been trading at premium and are back to about intrinsic value. With the leverage they use and small market cap I rarely follow them, but the size of the move is worth looking at.
Even the leveraged loan closed end funds got hit hard. They are still at a premium but seeing drops of 3% to 5%. That is far in excess of the two day drop of BKLN which has had a 1% drop. The leverage and premium explain a lot of that additional drop.
Guest post by Doug Short.
The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It’s a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The numbers are supplied in the Federal Reserve Z.1 Flow of Funds Accounts of the United States, which is released quarterly.
The first chart shows Q Ratio from 1900 to the present. I’ve calculated the ratio since the latest Fed data (through 2012 Q2) based on a subjective process of extrapolating the Z.1 data itself and factoring in the monthly averages of daily closes for the Vanguard Total Market ETF (VTI).
Biderman on ETFs, dividends and float shrinks.
So far this year investors have poured billions into high dividend strategy ETFs. Yet almost all the big dividend ETFs have underperformed the market, even after including reinvested dividends. On the other hand only millions have gone into ETFs whose strategy is based upon float shrink. Companies that have been shrinking the trading float of shares the most using free cash flow have not only significantly outperformed the high dividend ETFs, but the overall market as well.
Those of you who took finance 101 might have learned that there are two ways to distribute profits to shareholders. But before a company can distribute anything, the company first has to generate a cash profit, after taxes and after all capital expenditures. What is left is free cash flow that can either be added to the balance sheet or distributed to shareholders via dividends or float shrink.
Full video below.
Guest post by Vix and more.
There are many ways in which investors can evaluate risk related to the euro zone. Credit default swaps for sovereign debt are one way to evaluate the risk of country default. Sovereign bond yields are a good proxy for a country’s access to funding via the credit markets. The euro crosses and related directional moves are a barometer of the strength of the currency and the euro zone countries as a whole, while various Intrade contracts can lend a sense of the probabilities that investors assign to various events, such as to the risk of one or more countries dropping the euro.
On the volatility side, the VSTOXX (EURO STOXX 50 Volatility Index) the EVZ (CBOE EuroCurrency Volatility Index) provide a market assessment of risk and uncertainty in euro zone stocks as well as the currency.
One piece of analysis I have not seen, however, is an assessment of the relative risk and uncertainty for equity markets in some of the more important euro zone nations. Specifically, Spain, Italy, France and Germany. The chart below attempts to offer up that very information, using 30-day implied volatility for the various country ETFs over the course of the past six months:
So far so vanilla. Now lets look at how, as the ETF market has grown, the clever boys and girls of finance have found ‘innovative’ ways of pumping those ETFs up a bit, just like they did to Securities.
Use of Derivatives in ‘Synthetic’ ETFs
The main innovation in ETFs has been the creation of what are called ‘synthetic’ ETFs which instead of actually buying or even borrowing a basket of shares, use derivatives to track the value of the underlying market without the need to match its composition. Instead the Synthetic ETF enters into an asset swap agreement with a counterparty using an over-the-counter (OTC) Derivative. Before explaining what the heck that means let’s just look at how quickly the Synthetic market has grown.
Synthetic ETFs have grown very rapidly in Europe and in Asia. In Europe Synthetic ETFs are now 45% of the over all ETF market. Synthetics doubled their market share between 08 and 09.
The key to Synthetics is the Counterparty. What happens is the ETF Sponsor designs the deal, the AP (Apporved Participant. Usually one of the big banks or brokers) buys the basket of assets to make it, but then swaps that basket with the Counterparty for a different basket of assets in a derivative swap deal. However it turns out that rather too often for comfort, not only will the Sponsor and the AP be the same bank, but more often than not it will be the Asset Management branch of the same bank who will be the Swap Counter-party as well. It is quite common for the same bank to play all three roles. So a single bank creates the ETF, appoints itself as AP so it can fund it and then its Asset Management desk becomes the derivative counterparty in order to mutate the whole thing into a synthetic ETF. Think about what this does to the risk. What was market risk, where the risk was spread out across all the different shares, is now a single counterparty risk. The bank has effectively put all the ETF’s risk in one basket – itself.
How many of those holding ETF’s know what the ETF stands for? How many know how they work? How many understand the leveraged ETF’s and their risks? How many understand the hedging procedures? How many have actually created, priced, and hedged ETFs? The answer to all the above is probably very few. Despite being a relatively complex field within the creative finance industry, especially the exotic and leveraged versions, few people actually understand what they trade, and even less the risks involved with these products.
A few weeks ago we saw many novice investors get crushed in their TVIX holdings. Below is a good summary, by a non banker, explaining in plain english about some of the risks associated with ETFs. Don’t forget, 80% of the issued ETFs, are done by 6 players. Most of those had to be bailed out by the taxpayers. Those are some risks to think about….From Golem.
Where will the next point of instability be? Not what will trigger the next liquidity and credit crunch and cause the next landslide of panic selling and losses. We can already see many candidates for the trigger. But what will be the mechanism by which it is amplified and spread?
I think that in a couple of years, unless something alters the current trends in money flows, we will come to know ETFs the way we already know the securitization and packaging of sub-prime mortgages into CDOs. I think the signs are already there to suggest ETFs are where the instability and risk is accumulating. If I am in any way correct then ETFs will be to the next stage in our on-going state of siege-mentality crisis what CDOs were to the last.
To substantiate this claim I have to tell you in simplified terms what an ETF is. And then explain how, despite all the differences between mortgage backed CDOs and ETFs, the latter generally being based on stocks, bonds and commodities rather than mortgages, they are undergoing the same evolution from simple to opaque, stable to unstable, are being seen as the provider of liquidity and risk-controlled ‘exposure to risk’, just as CDOs were, when in fact they are concentrating risk and will, in a moment of panic, cause liquidity and lending to collapse.
Guest post by Azizonomics.
Way back in 2009, I remember fielding all manner of questions from people wanting to invest in gold, having seen it spike from its turn-of-the-millennium slump, and worried about the state of the wider financial economy.
A whole swathe of those were from people wanting to invest in exchange traded funds (ETFs). I always and without exception slammed the notion of a gold ETF as being outstandingly awful, and solely for investors who didn’t really understand the modern case for gold — those who believed that gold was a “commodity” with the potential to “do well” in the coming years. People who wanted to push dollars in, and get more dollars out some years later.
2009 was the year when gold ETFs really broke into the mass consciousness:
Another great weekend reading by Grant Wiliams.
ETFs definitely provide
easy diversification, tax efficiency and low ex- penses to investors while offering the benefits of ordinary shares such as limit orders, short- selling and options markets BUT, the desire to entice investors into the market by making a cornucopia of investment opportunities to them through simple vehicles has led to a ‘dumbing- down’ of the investment process in a never- ending quest for the simplest possible route into an idea when the plain truth is, there ArE no substitutes for doing the necessary research required when thinking about investing money into something. The unevenness of the regula- tory regime surrounding these instruments has not exactly helped matters in that it has made investors believe that if they are allowed to do something, it must be safe.
The pejorative term ‘Videogame Generation’ is frequently aimed at the youth of the 90s and 00s who, it is alleged, sit in front of their TV screens mindlessly pushing buttons and pay-
ing no attention to the world around them. It is synonymous with a group of people who, it is felt, look for simplicity and convenience and cannot be bothered to engage with the world. It implies a certain amount of intellectual deser- tion on their part which, when one looks at the complexity of the games they are playing, is perhaps not justified.
If you have ever watched a rapt teen playing Guitar Hero or trying to infiltrate an enemy lair in Call of Duty, you will know, as i do, that these are extremely complex, hard to master and pro- vide enormous gratification to those successful in winning.
It used to be the same with investing, but now that too has been dumbed-down – a dangerous direction in which to go.
Full must read Hmmm Apr 01 2012
Summing up the year for geared ETF holders might be quite the opposite of what they thought, despite being right. This is what they tell you;
Each Short or Ultra ProShares ETF seeks a return that is either 3x, 2x, -1x, -2x or -3x of the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily.
And this is what they don’t tell you, click here.
For value investors, gold miners represent excellent value as operating companies. For macro investors gold equities are essentially a gold derivative, allowing long term leverage to the structural uptrend in gold. Yet for any gold miner investor, the volatility of this asset class has been a defining feature of this sector, all the more so given the backdrop of a consistent long term gold rally. Gold miner volatility reached manic levels earlier this fall as the GDX (a liquid ETF tracking senior gold miners) reached its twelve month high and low within 18 trading days of each other. If silver is the devils metal, the gold miners are the devil’s equities. None the less, we believe investors need to see through this volatility and focus on the facts and probabilities as they develop their 2012 game plans. In addition to a fundamental analysis of the GDX, we also deconstruct the volatility and correlations of the GDX to help frame the inherent risks in this security.
Value. We believe that the GDX can trade to $80/share by the end of 2012, a ~50% return from current levels Our argument for substantial upside falls on the following four points:
1. Compelling valuation – senior gold miners stocks are trading at multiples last seen in the fall of 2008. We also believe the GDX is trading at a significant discount to its intrinsic (DCF) value.
2. Cash flow generation is strong and accelerating. After years of capital expenditure, elimination of top line hedging and steadily rising gold prices, cash flow growth is accelerating.
3. Discount rates are poised to decline as the operational risk profile of these companies is rerated.
4. Return on Invested Capital (ROIC) could soar from high single/low double digit levels today to 30% under even a moderately bullish gold forecast.