PrefBlog

The fund underperformed in April, for reasons that remain unclear – see the discussion below.

The fund’s Net Asset Value per Unit as of the close April 30, 2012, was 10.4438.

MAPF returns assume reinvestment of dividends, and are shown after expenses but before fees. Past performance is not a guarantee of future performance. You can lose money investing in Malachite Aggressive Preferred Fund or any other fund. For more information, see the fund’s main page. The fund is available either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited.

The underperformance of MAPF during the month is difficult to understand given the relative index total returns in April:

The biggest component of the fund – by far – is DeemedRetractibles, while the biggest component ofthe index – also by far – is FixedResets. Even allowing for the index to have outperformed due to its higher weighting in the Floating Rate Sector and PerpetualDiscounts, the gap seems too large to be explicable in this manner – and it also seems that the fund return of +0.48% is lower than it should have been.

In cases such as this it is often possible to explain deviations through a change in the Implied Volatility of the embedded call option in StraightPerpetuals – as was the case in June 2008. Accordingly, the first step is to compare the month’s performance of individual DeemedRetractible issues with their Dividend Rate:

Well, that didn’t work at all – perhaps there will be a correlation with end-price (the closing bid on April 30)?

Nope. Current Yield?

Nope. This is getting serious – we need to try some weirder stuff. How about “Ending YTW”?

Nope. Next ex-Date?

Try as I might, I am unable to to come up with a simple relationship between instrument attributes. To illustrate the effect of the performance distribution on the fund’s relative performance, I prepared the following chart which divides DeemedRetractibles into four groups, depending on their incorporation into the index and the fund’s portfolio:

Clearly, the fund’s securities did worse than the index’s securities. But I can figure out why! This is particularly bizarre in the case of the SLF preferreds:

SLF.PR.A and SLF.PR.B are incorporated in the index; SLF.PR.C, SLF.PR.D and SLF.PR.E are in the fund.
SLF

SLF DeemedRetractibles may be compared with PWF and GWO:

It is quite apparent that that the market continues to treat regulated issues (SLF, GWO) no differently from unregulated issues (PWF). It will also be noted that the slope of the regression line did not change significantly over the month: 0.0243 in March vs. 0.0247 in April.

Those of you who have been paying attention will remember that in a “normal” market (which we have not seen in over a year) the slope of this line is related to the implied volatility of yields in Black-Scholes theory, as discussed in the January, 2010, edition of PrefLetter. The relationship is still far too large to be explained by Implied Volatility – the numbers still indicate an overwhelming degree of directionality in the market’s price expectations.

In short, the underperformance of the fund in April appears to be due to random factors. When these random factors work in the fund’s favour, trades are generated as issues that are held become expensive relative to issues not held. This month, unfortunately, things worked the other way. However, I am pleased to observe that a large chunk of the underperformance of SLF.PR.C/D/E relative to SLF.PR.A/B has been recovered in the first four days of May.

Sometimes everything works … sometimes it’s 50-50 … sometimes nothing works. The fund seeks to earn incremental return by selling liquidity (that is, taking the other side of trades that other market participants are strongly motivated to execute), which can also be referred to as ‘trading noise’. There were a lot of strongly motivated market participants during the Panic of 2007, generating a lot of noise! Unfortunately, the conditions of the Panic may never be repeated in my lifetime … but the fund will simply attempt to make trades when swaps seem profitable, without worrying about the level of monthly turnover.

There’s plenty of room for new money left in the fund. I have shown in recent issues of PrefLetter that market pricing for FixedResets is demonstrably stupid and I have lots of confidence – backed up by my bond portfolio management experience in the markets for Canadas and Treasuries, and equity trading on the NYSE & TSX – that there is enough demand for liquidity in any market to make the effort of providing it worthwhile (although the definition of “worthwhile” in terms of basis points of outperformance changes considerably from market to market!) I will continue to exert utmost efforts to outperform but it should be borne in mind that there will almost inevitably be periods of underperformance in the future.

The yields available on high quality preferred shares remain elevated, which is reflected in the current estimate of sustainable income.

Significant positions were held in DeemedRetractible and FixedReset issues on March 30; all of these currently have their yields calculated with the presumption that they will be called by the issuers at par prior to 2022-1-31. This presents another complication in the calculation of sustainable yield. The fund also holds a position in SplitShare issues (BNA.PR.C) which also have their yields calculated with the expectation of a maturity at par.

I will no longer show calculations that assume the conversion of the entire portfolio into PerpetualDiscounts, as there are currently only eight such issues of investment grade, from only four issuer groups. Additionally, the fund has only negligible holdings of these issues.

Different assumptions lead to different results from the calculation, but the overall positive trend is apparent. I’m very pleased with the long-term results! It will be noted that if there was no trading in the portfolio, one would expect the sustainable yield to be constant (before fees and expenses). The success of the fund’s trading is showing up in

• the very good performance against the index
• the long term increases in sustainable income per unit

As has been noted, the fund has maintained a credit quality equal to or better than the index; outperformance is due to constant exploitation of trading anomalies.

Again, there are no predictions for the future! The fund will continue to trade between issues in an attempt to exploit market gaps in liquidity, in an effort to outperform the index and keep the sustainable income per unit – however calculated! – growing.

This entry was posted on Saturday, May 5th, 2012 at 9:16 pm and is filed under MAPF. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.